Research Summary
The report explores the potential impact of introducing a Central Bank Digital Currency (CBDC) on the Federal Reserve’s balance sheet and the broader financial system. It discusses how the effects would vary depending on the demand for CBDC and how the Fed manages its balance sheet. The report also presents a stylized model to analyze the behavior of various sectors in a closed economy relevant to a central bank’s balance sheet management.
Key Takeaways
Impact of CBDC on the Federal Reserve’s Balance Sheet
- CBDC as a New Form of Liability: The introduction of CBDC would represent a new form of liability for the Federal Reserve, distinct from cash and reserves. The impact on the Fed’s balance sheet would depend on factors such as the substitution of CBDC for cash and bank deposits, the response of banks to CBDC, and the Fed’s management of reserves and its balance sheet.
- Changes in Balance Sheet Composition: If the demand for CBDC primarily reflects the public exchanging bank deposits for CBDC, there could be a significant change in the composition of the Fed’s liabilities, with a large decline in reserves and an offsetting large increase in CBDC. This could put upward pressure on wholesale funding rates unless the Fed expands its balance sheet.
- Reserve Management Purchases: In scenarios where CBDC demand is high, the Fed may need to undertake reserve management purchases and significantly expand its balance sheet to alleviate upward pressure on the wholesale funding rate. The balance sheet could expand by nearly $1 trillion if purchases are undertaken to maintain the level of reserves at their level prior to the introduction of CBDC.
- Uncertainty and Limitations: The report emphasizes that its quantitative exercise regarding the effects of CBDC on the balance sheet is preliminary and subject to considerable uncertainty. This is due to the lack of information about potential design features of CBDC, the demand for CBDC, and how banks might respond to its introduction.
- Foreign Demand and Flight-to-Safety Considerations: The model does not incorporate important channels through which CBDC might impact the balance sheet, such as foreign demand for a U.S. CBDC or precautionary demand arising from flight-to-safety considerations. These factors could potentially lead to a larger expansion in the size of the Federal Reserve’s balance sheet.
Modeling the Impact of CBDC on the Financial System
- Stylized Model: The report introduces a stylized model that characterizes the behavior of various sectors in a closed economy relevant to a central bank’s balance sheet management. The model consists of a banking sector, a nonbanking sector (households and firms), and a central bank (the Fed) that supplies reserves to the banking sector.
- Role of Banks: Banks in the model obtain funding from deposit and non-deposit wholesale markets, make interest-bearing loans, and hold reserves. They maximize their profits by choosing the amount of funding, loans, and reserves. The demand for funds by banks influences the deposit and wholesale funding rates, while their supply of loans affects the loan interest rate in the economy.
- Introduction of CBDC: The introduction of a non-interest bearing CBDC provides households and firms with a new medium for conducting transactions. The equilibrium of the model without CBDC is compared to the equilibrium after CBDC has been introduced to study the long-run implications on the Fed’s balance sheet.
- Impact on Banks: The introduction of CBDC could potentially increase banks’ reliance on less stable sources of funding, leading to an increased demand for reserves. However, if banks’ balance sheets contract with the decline in deposits, they may demand fewer reserves, and the Federal Reserve may consider reducing the supply of reserves.
- Numerical Exercise: A numerical exercise was conducted to estimate the long-run impact of introducing CBDC on the Federal Reserve’s balance sheet and income. The parameters used in the model were chosen to be in line with existing literature. The range of estimates for how much the private sector substitutes CBDC for bank deposits is crucial in determining the impact on the Federal Reserve’s balance sheet and the banking sector.
Actionable Insights
- Consider Balance Sheet Management: Policymakers should consider balance sheet management considerations when contemplating the introduction of a CBDC. The potential effects of CBDC on the financial sector depend on how the Federal Reserve manages its balance sheet. If the Fed does not conduct reserve management purchases, there could be a larger reduction in bank assets and more upward pressure on bank funding costs, potentially pushing the policy rate (EFFR) outside of its target range.
- Investigate the Potential Impact on Banks: Further research should be conducted to understand the potential impact of CBDC on banks. The introduction of CBDC could potentially increase banks’ reliance on less stable sources of funding, leading to an increased demand for reserves. However, if banks’ balance sheets contract with the decline in deposits, they may demand fewer reserves, and the Federal Reserve may consider reducing the supply of reserves.
- Explore the Demand for CBDC: More information is needed about potential design features of CBDC, the demand for CBDC, and how banks might respond to its introduction. The demand for CBDC could be even larger than modeled, leading to a larger expansion in the size of the Federal Reserve’s balance sheet, or it could be lower than modeled, resulting in a smaller impact on the balance sheet.
