Normalizing the Central Bank’s Balance Sheet: Implications for Inflation and Debt Dynamics; Pedro Gomis Porqueras (Deakin University)

Abstract

We explore the effects of reducing the overall size of the central bank’s balance sheet and lowering its maturity structure. To do so, we consider an environment where fiscal policy is passive and the central bank follows the Taylor principle. Moreover, the monetary authority has size and compositional targets of its balance sheet. When short-term public debt exhibits premia, changes in the central bank’s balance sheet have implications for longrun inflation, real allocations and for the uniqueness of equilibria. To ensure a unique and a locally stable steady state, the central bank should target a low enough maturity composition of its balance sheet. In our numerical exercise, calibrated to the United States, we find that long-term debt holdings by the central bank should be less than 1.8 times of their short-term positions. Moreover, the process of balance sheet normalization should be slow enough. Compared to a traditional Taylor rule, a modified rule, that takes into account the premium, increases the prevalence of multiplicity of steady states and delivers lower welfare. Thus, we argue that the traditional Taylor rule is appropriate for managing interest rates in the presence of premia.

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