Christine Lagarde, the President of the European Central Bank (ECB), this week raised the critical question whether, in view of market failures, market neutrality should remain the guiding principle driving central banks’ policy portfolio management. Her spotlight on market neutrality underscores growing and overdue scrutiny of what has been a key principle in central banking — but also one that, on closer inspection, stands on shaky grounds.
Central banks frequently invoke market neutrality as a core concept guiding the implementation of monetary policy. They highlight this principle as underpinning their aim to minimize the possible distortionary effects of their interventions on financial markets, and thus to limit their interference with market price discovery mechanisms.
Despite its ubiquity in policy debates, central bank market neutrality is a myth. All along the monetary policy implementation process, central banks make choices which favour some assets more than others and thus shape relative prices, as well as relative funding conditions for firms. Central banks may have compelling reasons for these choices, but they must not hide behind a veil of alleged market neutrality to avoid scrutiny and a discussion of alternative proposals.
Central bank interventions are conceptually at odds with market neutrality Non-neutrality of transmission channels
Deviations from market neutrality start with the fact that central bank interventions are already conceptually at odds with the notion of neutrality. Central banks intervene to change market outcomes. Many interventions may only target a change in the short-term interest rate, while others may seek to shift interest rates along the entire yield curve. Some may aim to address liquidity constraints in specific market segments. Others have the objective of maintaining an exchange rate target. Whatever their goal is, interventions are not neutral. In fact, the point of central bank interventions is, well, to intervene.
Non-neutrality of private and public sector asset allocations
With this in mind, the objective of market neutrality obviously needs further clarification. Central banks have largely put forward an understanding of market neutrality that defines being neutral as closely aligning their interventions with the allocation prevailing on capital and debt markets. This falls short in several ways.
First, central banks use multiple transmission channels in the implementation of monetary policy, each of them having different effects on firms’ funding conditions. The provision of liquidity through refinancing operations, for example, is different from the injection of money through asset purchases. Whereas the former allows banks to refinance themselves for loans they have given, the latter is largely limited to traded securities. As a result, the choice of the transmission channel creates, for instance, different effects for small and medium-sized enterprises (SMEs), which are predominantly bank-financed — and hence mostly affected by refinancing operations — in comparison to larger corporations that also have access to market financing — and hence also impacted by asset purchases. In deciding which transmission channels to use and which conditions to implement, central banks decide between different impacts on different segments of the economy.
Non-neutrality of private sector asset purchases
Second, in the context of domestic and foreign asset purchases, central banks decide how they allocate their balance sheet between public and private sector assets. This allocation is not neutral. Moreover, within public sector purchases, central banks also make choices. Most central banks focus on buying and selling sovereign bonds. For single-country central banks, who are investing in their own currency, the decision how to do that is straightforward. However, for central banks such as the ECB, which is covering a multi-country currency area, or for central banks managing foreign reserves in several currencies, like the Swiss National Bank (SNB), the issue of neutrality in sovereign bonds purchases is much trickier.
Prior to the pandemic, for example, the ECB had chosen to allocate its sovereign bond portfolio in line with the shares each Eurozone member holds in the ECB capital. While understandable, this approach was already different from an allocation based on sovereign bond market capitalization, which usually constitutes central banks’ benchmark for market neutrality. In response to the fallout from COVID-19, the ECB went a step further and expanded its flexibility to deviate from this capital key and account for heightened risks individual member states are facing as a result of the pandemic.
Asset classes and investment vehicles
Third, deviations from market neutrality in central banks’ private sector asset purchases abound. For starters, central banks largely confine their purchases to listed assets — in particular bonds. Firms that have neither issued equity nor bonds are generally out of scope. This choice favours larger firms and comes at a disadvantage to SMEs that rely essentially on bank loans for their funding.
For the firms that have equity and bonds outstanding, central banks make additional choices subject to a wide range of often totally sensible, yet non-neutral, criteria.
Credit risk, minimum issuance and maturity
One of them is the choice of asset classes and investment vehicles to purchase. Some central banks, such as the SNB, buy equities, others focus exclusively on bonds. A few, such as the Bank of Japan (BoJ), have invested into real estate. None, to our knowledge, has yet moved into private equity. Some only have direct holdings, others — such as the BoJ and the Federal Reserve (Fed) — also invest into funds. Moreover, some central banks buy asset-backed securities, others do not. The BoJ, the ECB and the Fed invest in asset-backed securities, but the assets used to back such securities vary. The ECB, for example, buys mostly residential mortgages and car loans; the Fed buys student loans, auto loans and credit card loans. In contrast, the SNB and the Bank of England (BoE) do not hold asset-backed securities in their balance sheets at all. The ECB also differs from other central banks as it holds covered bonds.
Another filter in central bank purchases is based on economic sectors. Market neutrality implies that central banks buy assets across the entire economy. Most central banks, however, exclude (with varying degrees) equity and bonds issued by the financial sector. The BoE and the ECB, for example, only buy non-financial bonds, but accept bonds issued by financial subsidiaries of non-financial companies. The SNB does not buy shares from systemically important banks.
Non-neutrality of index choices
Finally, and crucially, central banks assess credit risk as a key criterion to decide whether a bond is eligible for purchase or not. In that context, until recently, all major central banks limited their bond purchases to those rated as investment grade. In response to the economic fallout from the pandemic, however, several central banks have departed from this rule. The ECB, for example, has declared that it is not required to sell a bond in the event of a downgrade below investment grade. Similarly, the Fed has extended eligibility to subsequently downgraded bonds (“fallen angels”). Central banks also apply filters in terms of minimum issuance and maturity of a bond — thus further deviating from a fully neutral position.
All the criteria listed above highlight that central banks make choices in terms of which firms and securities are eligible and which firms and securities are thus excluded, very often for valid reasons, from central banks’ private asset purchases. Those which remain eligible benefit from direct and indirect central bank support, which gives them access to better financing conditions on financial markets compared to others.
Fourth, within a given set of eligible assets, central banks also deviate from market neutrality through the index they choose for allocating their holdings. The BoJ’s and SNB’s equity holdings offer two illustrations of such non-neutral choices.
Market neutrality — from myth to reality
The BoJ implements most of its equity investments through the purchase of Exchange Traded Funds (ETFs) that track either of three indexes: the TOPIX — more than 2'000 domestic firms listed on the first segment of the Tokyo Stock Exchange (TSE) — the Nikkei 225–225 highly liquid stocks on the TSE — or the JPX-Nikkei 400–400 companies that are chosen based on a wide range of quantitative and qualitative criteria, such as profitability as well as the appointment of independent outside directors. In addition, the BoJ has set aside an allocation to ETFs with a particular focus on firms that proactively invest in physical and human capital. Each of these indexes applies selection criteria and filters out smaller or larger segments of the stock market. It leaves the BoJ with very different exposures to individual equities — including, for example, different exposures to fossil fuel companies — that do not always correspond to their market capitalization. The choice of indexes and the decision how big an allocation to make to each of them, has thus significant non-neutral implications.
The same holds true for the SNB. Like the BoJ, the Swiss central bank highlights that its “equities are managed according to a set of rules based on a strategic benchmark comprising a combination of equity indexes in various markets and currencies.” It also clarifies that “the equity portfolios in the foreign exchange reserves comprise of shares of mid-cap and large-cap companies in advanced economies and, to a lesser extent, shares of small-cap companies” A closer look at its US equity portfolio, which amounts to more than USD 100bn, reveals that the SNB indeed holds proportionally more mid- and large-cap companies than small-cap companies and thus deviates from a fully neutral investment approach.
Clearly, the reality of central banking is not one that aligns with the principle of market neutrality. Central banks make non-neutral choices in their interventions. Their reasons for making them are often absolutely valid. Yet, they are choices and should thus be subject to debate and scrutiny.
Such debate and scrutiny are even more important where markets fail. The calls by Christine Lagarde as well as her colleague on the ECB Executive Board Isabel Schnabel for a review of the market neutrality principle in the face of climate change are a case in point. Central bankers now widely acknowledge that climate risks are mispriced in financial markets, a situation that leads to inefficient outcomes in terms of economic prosperity, financial stability, and — crucially — environmental sustainability. If left unaccounted for by central banks, it also increases the risk exposure of their balance sheets.
Against this background, moving from myth to reality on the principle of market neutrality is critical. We need an open and transparent debate on the choices central banks make. We need a thoughtful review of policy alternatives. And we need to ensure that this conversation brings in voices from across society to reflect the opportunities and challenges we jointly face.
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 References to market neutrality are omnipresent in central bank communication. They appear in official speeches and communications (see, e.g., Christine Lagarde and Yves Mersch for the ECB, Thomas Jordan and Andréa Maechler for the SNB), in discussions of governing boards (see, e.g., the Meetings of the Federal Open Market Committee) or in technical documentations (see, e.g., the ECB Economic Bulletin, the BoE Market Operation Guide or the BoJ publication about functions and operations.
 See https://www.ecb.europa.eu/mopo/implement/omt/html/cspp-qa.en.html, question Q1.5.
 With its investments in the US, the SNB falls under a provision of the US Securities Exchange Act that requires institutional investors to disclose their equity holdings in the US, thus providing a granular view on its investments in this market.