Central bank liabilities and profits

Central banks (CentBs) have drastically expanded their balance sheets in the wake of the global financial crisis. The Federal Reserve (Fed) and the European Central Bank (ECB) followed the example of the Bank of Japan (BOJ) by buying trillions of dollars and euros worth of long-term bonds, a policy known as quantitative easing (QE).

The CentBs make these purchases by “base money”, i.e. cash and reserves1. Neglecting legal restrictions, CentBs can create base money at will.

There is a lot of controversy among economists about QE and its consequences for the balance sheets of central banks.

This post discusses the question of whether or not base money should be considered a liability of the central bank. After that issue is understood, we can clarify when the CentB can book a profit and how this affects government finances.

One of the stated goals of QE is to raise inflation. Some worry that once this happens, rising interest rates will cause massive losses to the central bank, resulting in unspecified “bad things”. I argue that these fears are unjustified. Continue reading “Central bank liabilities and profits”