Handbook No 27
by Simon T Gray
When central banks enter into transactions to implement their monetary policy, they necessarily make use of their own balance sheets. Whether they are undertaking open market operations (OMO) to inject or drain funds from the banking system, or allowing the banks to use standing facilities to borrow or deposit funds, the central bank’s balance sheet will be impacted: the funds in question are commercial bank balances held at the central bank.
Ideally, operations undertaken to implement policy should have a predictable impact on the economy, via the banking system. This means that the central bank needs to know the context in which it is operating: what is the current availability of commercial bank balances compared with the level of demand, and how is this expected to change in the near term? An accurate current picture and good forecast of the central bank’s likely future balance sheet is required.
The same information on the central bank’s balance sheet is also needed if the central bank wishes to manage liquidity pro-actively. Most central banks do, whether it is to avoid a shortage of liquidity impacting on the payment system, or an excess impacting short-term yields and/or the exchange rate.
This Handbook examines the issues involved in forecasting the central bank’s balance sheet. This is normally referred to as ‘liquidity forecasting’ since the item on the balance sheet which central banks typically try to manage is commercial banks balances, a subset of high-powered liquidity.