Yesterday, the US Federal Reserve published an article exploring the monetary policy impact of the potential issuance of a retail central bank digital currency (CBDC). He envisions a scenario where the digital dollar is widely adopted both for payments and as a store of value. In this case, it could force the Federal Reserve to buy more Treasuries and have an ever-larger balance sheet.
For context, the Federal Reserve already holds $5.8 trillion in Treasuries, about a quarter of the total supply of $23 trillion. In January 2020, the figure was $2.4 trillion on a supply of $16.7 trillion, or 14%.
The main assumptions of the research are that the digital dollar would only be available to US households and businesses and would not earn interest. Financial institutions do not hold significant amounts of CBDC for analysis. The demand for reserves from commercial banks is assumed to be stable, which is recognized may not occur in practice.
If consumers exchange money for CBDCs, it has little effect on commercial banks or monetary policy. However, if consumers exchange trillions in bank deposits for CBDCs, the impact will be significant.
The first impact is that bank deposits will decline and commercial banks will reduce reserve deposits held at the central bank. Initially, the composition of the Federal Reserve’s balance sheet changes, but the total size remains the same. However, the overall size of commercial banks’ balance sheets is shrinking.
There is a reasonable probability that some banks will want to increase their reserves. One approach would be to offer more attractive deposit rates to consumers, putting upward pressure on interest rates. The paper acknowledges that these higher rates could reduce demand for CBDC because it is unpaid, but ignored it for analysis.
Potentially, the upward pressure on rates could happen quite quickly. In the short term, the central bank could offer the discount window and repo facilities to lower the rate. However, if demand persists, the Federal Reserve could buy Treasuries, increasing the reserves available to commercial banks. The net effect is that the Federal Reserve has a larger balance sheet and holds more Treasuries.
The paper also explores the demand for a retail CBDC, which is unpredictable. For example, strong demand during periods of financial stress could complicate the management of the Federal Reserve’s balance sheet. And when interest rates are low, there may be higher demand for a CBDC that does not offer interest.
Meanwhile, the banking industry has responded to the Federal Reserve’s consultation on a digital dollar. The American Bankers Association sees no justification, while others worry that banks will incur costs to be a CBDC intermediary with little benefit. And at a congressional hearing last week, Republicans asked if the Federal Reserve would be willing to sue if Congress did not pass supporting legislation.