Do disinflation policies ravage central bank finances?

Abstract

Summary Advanced-economy central banks are currently experiencing losses. To examine how rate-tightening cycles affect central bank finances, we study the financial statements of ten advanced-economy central banks during the 1970s and 1980s, the most notable and comparable policy environment to the present. We find that central bank profits actually increased in response to the anti-inflationary measures of the 1980s. We thus discuss how central bank profits depend on their policy instruments as well as their balance-sheet position when rate tightening begins, rather than on the tightening per se. Unlike today, central banks in the 1980s avoided losses because they did not remunerate bank reserves and their balance sheets did not carry the legacy of a decade of large asset purchases at low interest rates and long maturity. Our counterfactuals show that only a combination of these factors could have triggered losses in the 1980s: none of them is sufficient on its own. When losses emerged in the late 1970s, before the Volcker shock, they were due to foreign exchange reserves depreciating. In these instances, when central banks carried them forward and did not rely on transfers from the government, there was no loss of central bank independence or their ability to fight inflation.