This week, we revisit our discussions on the ever expanding size of central bank balance sheets and discuss what it means for asset prices, credit bubbles and interest rates in the event of a sustained, synchronized global economic expansion, if at all we were to get one.
The chart below shows the updated position till March 2012 for the size of balance sheets of all major global central banks.
Chart 1: Index of central bank balance sheet size: Jan 2002 = 100
Source: Decimal Point Analytics
The trend of significant increase in central bank balance sheets continues unabated. Currently, the argument put forth for this rise is that the sharp fall in the velocity of commercial bank money is being compensated by a rise in quantity of central bank money. In theory there should be no disagreement with this arithmetical equality. However, the reality of interaction of politics with economics is more complex. If we look at the chart above, even during the periods of synchronized global economic expansion of 2003-2007, the central banks did not reduce their balance sheet sizes to compensate for credit expansion by commercial banks.
This lop-sided response of central bankers to booms and busts, coupled with huge, and perhaps a competitive increase in central bank balance sheet size has increased the possibility of high inflation if we were to see an economic expansion, if at all. Further, if central bankers try to deflate that inflation problem, the economic expansion may get seriously hurt, making the expansion a short-lived one. In other words, we may be stuck at low global growth rates for a long period. The only possible solution to this stickiness is a major technological breakthrough, one which manages to reduce the cost of production, and hence limit any cost-push inflation across the entire spectrum of economic activity.