How to read a central bank

By G.I. | WASHINGTON D.C.

When a central bank expands its balance sheet, is it bullish or bearish? It depends. In today's world where liquidity traps prevail, the reason why the balance sheet expands is as important as how much.

Two data points today help illustrate. First, the European Central Bank conducted its second three-year Long Term Refinancing Operation. (You can read my colleague's take here.) Second, Ben Bernanke, chairman of the Federal Reserve testified to the House Financial Services Committee, and hinted that more quantitative easing - the purchase of bonds by printing money - was a bit less likely. He called the recovery "uneven and modest by historical standards" but that was better than "frustratingly slow,” the description he used at the start of this month.

Which is the more bullish development? I would argue it is the Bernanke testimony. This may seem counterintuitive, so let me explain. Both the ECB's LTRO and the Fed's QE result in a larger balance sheet. But the mechanism is quite different. The size of the ECB's loan operation was determined not by the ECB (i.e. the supply of funds), but by the banks (i.e. the demand for funds). The more fearful the banks are of losing access to private funding, the more they borrowed. A bigger ECB balance sheet is a bullish policy response (more liquidity) to a bearish fundamental (banks worried about funding). Yes, the LTRO has made the economic environment less treacherous than it otherwise would be, but it is not the same as the ECB pro-actively deploying monetary policy to spur demand.

By contrast, QE is such a pro-active policy. As with LTRO, the Fed's QE results in an expansion of its balance sheet: it buys a bond (an asset), and creates an equivalent amount of reserves (liabilities) in the process. But how much the balance sheet expands is the Fed's choice. It has decided, whether the banks like it or not, that it will force several trillion dollars of extra reserves into them. The Fed has been toying with a third round of QE for some time now. Mr Bernanke's testimony is a bearish policy response (less likelihood of QE3) to a bullish fundamental (improving outlook). Stocks declined on the testimony, but that's as it should be: in a normal recovery, stocks are tugged higher by earnings and lower by rising bond yields. If that seems strange, it's because recently it hasn't been true. In a liquidity trap, interest rates mean little to stocks because they're always assumed to be zero. Maybe this won't last: the outlook may disappoint, Mr Bernanke may yet launch QE3. But for now, the diminished prospect of QE3 should be taken for what it is: a natural corrollary to the accumulating good news on the economy.