It is clear that central bank balance sheets will have increased in a completely unprecedented manner from 2008 to 2012, unless we count previous episodes of hyper-inflation ~ FT

Central banks fire the second barrel of QE | Gavyn Davies | Insight into macroeconomics and the financial markets from the Financial Times – FT.com

The scale of recent central bank action is extraordinary, by any historic standard other than that of late 2008.

The dependence of the markets on the central banks is, of course, nothing new. But nor has it ever been greater than it is now.

The financial markets are becoming ever more dependent on the continuing willingness of the central banks to use their balance sheets to rescue the global economy. The central banks are not flinching from their task. In fact, they are in the process of firing their second barrel of quantitative easing at the global crisis. It could prove to be as large as the first barrel in 2008/09.

In the graph, the low estimate for the Fed makes no allowance for Operation Twist, and assumes that there will be no announcement of QE3 in the first half of next year. The high estimate assumes that Operation Twist is the equivalent of a $600 billion increase in the balance sheet. Alternatively, the result would be the same if we make no allowance for Operation Twist, but assume that the Fed’s new programme of dollar swaps turn out to be worth $300 billion, and that the Fed also undertakes purchases of mortgage securities worth $300 billion in the first half of next year.

For the ECB, I assume that the rate of expansion in the balance sheet which has been observed since early August is broadly maintained up to mid 2012. This might prove to be too conservative, given the scale of the liquidity injections announced last week,

Only if the Bundesbank throws its body across the tracks will the estimates in the graph prove markedly too high.

All of this would amount to an enormous further increase in the overall size of central bank balance sheets. The second graph shows that the scale of this second episode of QE could rival that of the first episode in 2008/09. The calculation shows the 12-month change in the total central bank balance sheet for the four main developed economies, weighted by shares in GDP and expressed as a percentage of the normal size of these balance sheets before 2008. This method of calculation enables us to compare the size of the two monetary injections more meaningfully than the simple percentage increase in the balance sheet.

Either way, it is clear that central bank balance sheets will have increased in a completely unprecedented manner from 2008 to 2012, unless we count previous episodes of hyper-inflation

Because this behaviour is so unprecedented, it is hard to predict the medium term consequences of such a massive dose of QE. Many economists argue that, in the absence of any rise in inflation expectations, central bank balance sheets are in effect infinitely large, and can be used as needed to combat the crisis. Given the outsize scale of what the central banks are now doing, this argument needs increasingly careful examination in future blogs. But one conclusion already seems clear. If this strategy does not work, there will be little else left in the locker of the emergency services.

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