Former BoE staff clash over reserves accounting in Central Banking debate

Imposing ‘mark-to-market' accounting on central bank reserves would be an extremely ill-timed move as real interest rates return to positive territory, according to London School of Economics professor Charles Goodhart. But university lecturer and former Bank of England (BoE) reserves portfolio manager Tim Young said not doing so is akin to "an ostrich sticking its head in the sand".

The two locked horns over the suitability of mark-to-market accounting in the context of a wider discussion of central bank investment policy as monetary policy normalises, during a Central Banking On Air live debate.

The debate, hosted by Central Banking journal editor Chris Jeffery, began with Goodhart and Young agreeing with Scott Dickinson, head of the Middle East, South Africa and sovereign wealth at BNP Paribas Securities Services, that the return of positive real interest rates should not necessitate a wholesale re-evaluation of central banks' investment strategies.

Dickinson said the Federal Reserve's move to taper its asset purchases "heralded an effort to offset shocks through diversification", but that in reality "shocks have been felt in all asset classes so the diversity that might have been sought has not necessarily been realised".

Goodhart pointed out that the return on central banks' investments is "always secondary to having enough liquid assets that they could realise in a crisis". Central banks therefore "frequently divide their portfolios into two: liquid assets – and I can't see that changing – and the rest in a slightly diversified portfolio, which you pretty much hold to maturity".

Moreover, Goodhart said, the "domestic portfolio in almost all cases swamps the foreign exchange", meaning "any profitability will depend on the domestic interest rate environment", in a reference that appeared geared more towards the major central banks of advanced economies, such as the Federal Reserve, the Bank of Japan and the Bank of England. "Any profitability from the foreign exchange will be peanuts in comparison."

Young said he was concerned about "this idea that it's reasonable to reach for yield" – fearing it might lead central banks to take on more risk than they really ought. "There's a case for central banks to talk to their finance ministries and say ‘look, we can't generate the return'," he said, though he conceded that "on the other hand there aren't as many triple-A assets out there".

Mark-to-market clash

When the discussion turned to transparency, Young raised the question of whether central banks should mark their assets to market, arguing that "if you're committing yourself to a policy, I think you should know what it's doing for you".

Goodhart, on the other hand, laid out the argument that since the majority of a central bank's reserves are held to maturity, there is little need in marking them to market throughout the asset's life – and doing so would needlessly risk creating the impression that the central bank is "bearing significant losses", which could have "quite severe" political implications.

The former BoE monetary policy committee member re-iterated that the value of foreign exchange reserves is "peanuts compared to the question of the valuation of the domestic assets – particularly at a time of re-normalisation of monetary policy", concluding that "if ever there was a time not to suddenly produce mark-to-market accounting for central banks, it would be now".

Young said he "totally disagreed" with that – likening the attitude to "an ostrich sticking its head in the sand", and repeating his point that the losses "are real losses".

Goodhart argued that was not true for the public sector as a whole. "To the extent that the central bank loses, effectively the Treasury gains – so within the public sector it's a wash," he said. "It's purely a question of presentation."

"On an existing bond," Goodhart explained, "the coupons and the value at maturity remain the same. To the extent that interest rates have risen because inflation is higher, the real cost to the Treasury has actually gone down."

In response, Young said: "We [the central bank] pay interest on the reserves, so if interest rates rise, the return on the assets bought doesn't, but the outlay on the interest on the reserves does. So these are real losses to the public sector."