When Does a Central Bank’s Balance Sheet Require Fiscal Support?

The large balance sheet of many central banks has raised concerns that they could suffer significant losses if interest rates rose, and might need a capital injection from the fiscal authority. This paper constructs a simple deterministic general equilibrium model, calibrated to US data, to study the the impact of alternative interest rates scenarios on the central bank’s balance sheet. We show that the central bank’s policy rule (or, equivalently, inflation objectives), and the behavior of seigniorage under high inflation are crucial in determining whether a capital injection might be needed. We show also that a central bank that is seen as ready, in order to avoid a need for capital injection, to create seignorage by altering its inflation objectives, can thereby lose control of the price level. We conclude that for current balance sheet levels of the Federal Reserve system, direct treasury support would be necessary only under what seem rather extreme scenarios. However this result depends on assumptions about demand for non-interest bearing Fed liabilities (mainly currency) that cannot be firmly grounded in empirical estimates. Higher balance sheet levels, or a lower currency demand than assumed here could force the central bank to request a capital injection in order to maintain its inflation control policy. Date: April 14, 2014; First Draft: April 2013. PRELIMINARY AND INCOMPLETE DRAFT Marco Del Negro, Federal Reserve Bank of New York, [email protected]. Christopher A. Sims, Princeton University, [email protected] We thank Seth Carpenter, and seminar participants at the Bank of Canada, ECB, and FRB Philadelphia for very helpful comments.The views expressed in this paper do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System. 1 JEL CLASSIFICATION: E58, E59