Federal Reserve Chair Ben Bernanke last week released a statement of how the Fed intends to manage its bloated balance sheet over the next few years. Here I offer my interpretation of what his plan involves.
Bernanke drew a distinction between three different categories of assets that the Federal Reserve has held on its balance sheet. The first involve extension of short-term emergency credit to financial institutions:
our financial system during the past 2-1/2 years has experienced periods of intense panic and dysfunction, during which private short-term funding became difficult or impossible to obtain for many borrowers. The pulling back of private liquidity at times threatened the stability of major financial institutions and markets and severely disrupted normal channels of credit. In its role as liquidity provider of last resort, the Federal Reserve developed a number of programs to provide well-secured, mostly short-term credit to the financial system.
This lending came in the form of a wide variety of new facilities, which summed to almost $1.6 trillion by the end of 2008, but are now almost entirely wound down or phased out, as Bernanke observed:
As was intended, use of many of the Federal Reserve’s lending facilities has declined sharply as financial conditions have improved. Some facilities were closed over the course of 2009, and most other facilities expired at the beginning of this month. As of today, the only facilities still in operation that offer credit to multiple institutions, other than the regular discount window, are the TAF (the auction facility for depository institutions) and the Term Asset-Backed Securities Loan Facility (TALF), which has supported the market for asset-backed securities, such as those that are backed by auto loans, credit card loans, small business loans, and student loans. These two facilities will also be phased out soon.
Subset of Federal Reserve assets, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to February 10, 2010. Wednesday values, from Federal Reserve H41 release. swaps: central bank liquidity swaps; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility plus net portfolio holdings of TALF LLC; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements;
Bernanke also discussed the emergency measures to support Bear Stearns and AIG in the same terms, while acknowledging that the assets the Federal Reserve acquired through these operations are at best highly illiquid and not something that the Fed is going to be able to unload any time soon.
Federal Reserve assets associated with Bear Stearns and AIG emergency measures, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to February 10, 2010. Wednesday values, from Federal Reserve H41 release. Maiden 1: net portfolio holdings of Maiden Lane LLC; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III plus preferred interest in AIA Aurora LLC and ALICO Holdings LLC;
Bernanke described a third category of the Fed’s assets this way:
after reducing short-term interest rates nearly to zero, the Federal Open Market Committee (FOMC) provided additional monetary policy stimulus through large-scale purchases of Treasury and agency securities. These asset purchases, which had the additional effect of substantially increasing the reserves that depository institutions hold with the Federal Reserve Banks, have helped lower interest rates and spreads in the mortgage market and other key credit markets, thereby promoting economic growth….
With its conventional policy arsenal exhausted and the economy remaining under severe stress, the Federal Reserve decided to produce additional stimulus through large-scale purchases of federal agency debt and mortgage-backed securities (MBS) that are fully guaranteed by federal agencies. In March 2009, the Federal Reserve expanded its purchases of agency securities and began to purchase longer-term Treasury securities as well.
Although Bernanke described these purchases as almost a completely separate set of decisions from the first two categories, it seems not coincidental that, when you look at the total of all the assets the Fed is holding, the expansion of MBS purchases exactly offsets the declines from phasing out the short-term lending facilities. As a result of the MBS and agency purchases, the total assets of the Federal Reserve today exceed the total reached at the peak level of activity for the lending facilities in December 2008.
All Federal Reserve assets, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to February 10, 2010. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility plus net portfolio holdings of TALF LLC; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III plus preferred interest in AIA Aurora LLC and ALICO Holdings LLC; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.
Where did the Fed obtain the funds to make all these loans and later buy all this MBS? Mechanically, the Fed implements any of these operations simply by crediting new deposits to the account that the receiving party maintains with the Federal Reserve. You can think of those accounts as electronic credits that the bank could ask at any time to redeem in the form of green currency delivered in armored cars by the Fed to the bank. Because the Fed had no desire to deliver this quantity of currency, up until the fall of 2008 it essentially sterilized the new loans by selling off some of its holdings of Treasuries. This sterilization shows up as a $300 billion decline in the bottom blue category in the figure above between August 2007 and September 2008, during which period the height of the graph corresponding to the sum of all Fed assets remained quite stable. The purchasers of these T-bills delivered back to the Fed the same deposits that the Fed had created with its various loans, so that total reserves in the system were unaffected.
You can also keep track of those deposits and where they end up directly in terms of total Federal Reserve liabilities, which are plotted below. The height of this graph for every week is by definition exactly equal to the height of the preceding graph. Whereas the first graph summarizes the assets that the Fed holds, the second tracks where the dollars that the Fed created to purchase those assets ended up. The categories “service” and “reserves” in the figure below correspond to what I described above as electronic credits for cash, whereas “currency” refers to the physical green stuff. As a result of the Fed’s sterilizing sale of its Treasuries, there was essentially no impact of any of the lending programs on the Fed’s total outstanding liabilities until the fall of 2008.
Federal Reserve liabilities, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to February 10, 2010. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.
But the great expansion of lending in the fall of 2008 far exceeded anything the Fed had the capacity to sterilize. The Fed therefore asked the U.S. Treasury at this time to do some additional borrowing on the Fed’s behalf (represented by the yellow region in the graph above) and just hold the funds idle in the Treasury’s account with the Fed. Essentially this amounted to the same kind of sterilization action as when the Fed sold T-bills out of its own portfolio– the reserves the Fed created through its new lending facilities ended up in the Treasury’s account with the Fed and then just sat there. The Treasury’s balance with the Fed has subsequently declined, and most of the deposits that the Fed has created are currently simply sitting idle at the end of each day as excess reserves held by banks, represented by the light green area in the graph above.
Although banks may be content at the moment to hold a trillion dollars idle as excess reserves each day, one would suppose and hope that this will change as the economy recovers. But the resulting multiple expansion of credit and withdrawal of the reserves as currency would be impressively inflationary– the $1.1 trillion in credits for cash currently held by banks is a bigger number than the cumulative sum of green currency that the Federal Reserve has delivered to banks week after week since its inception a century ago, and exceeds by a factor of 100 the levels of excess reserves that banks held three years ago. Hence the need for an “exit strategy”, or how the Fed is going to manage its balance sheet when conditions begin to improve. Communicating the Fed’s plans for doing so was a key purpose of Bernanke’s statement last week:
The FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. In due course, however, as the expansion matures the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures. The Federal Reserve has a number of tools that will enable it to firm the stance of policy at the appropriate time.
Most importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on banks’ holdings of reserve balances. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates….
Here the Fed Chair lost me. If the purpose of holding the MBS is indeed to produce a monetary stimulus, and if the purpose of raising the interest rate paid on reserves is indeed to produce a monetary contraction, why would the Fed want to do both at the same time? And yet Bernanke made pretty clear that he has no plans to sell off the MBS, which would be the logical way to contract. Instead it sounds like the Fed basically intends to hold those MBS to maturity:
I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid…. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities. Although passively redeeming agency debt and MBS as they mature or are prepaid will move us in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted.
The puzzle is resolved if the Fed is thinking of raising the interest rate on reserves not so much as a tool for contracting aggregate demand, but instead as a device to persuade banks to continue to sit on a trillion dollars in excess reserves. Indeed, Bernanke went on immediately after discussing the option of raising the interest rate paid on reserves to discuss two other tools available to the Fed for dealing with that bulging light green area in the graph above:
The Federal Reserve has also been developing a number of additional tools it will be able to use to reduce the large quantity of reserves held by the banking system….
One such tool is reverse repurchase agreements (reverse repos), a method that the Federal Reserve has used historically as a means of absorbing reserves from the banking system….
As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers.
I’ve discussed reverse repos and the Term Deposit Facility at length previously. My position is that these devices, as well as the strategy of paying interest on reserves, all amount to the same essential operation as when the Fed used supplemental borrowing from the Treasury to sterilize its initial lending operations in the fall of 2008. In each case, the financial instruments we are talking about– whether it is the T-bills issued by the Treasury to fund the Fed’s supplemental Treasury account, funds lent to the Fed through the Term Deposit Facility, reverse repos with the Fed, or reserve balances that banks are persuaded to hold in their account with the Fed overnight– all have the same basic structure. The government (either in the form of the Treasury or the Fed) promises to deliver to the holder of that asset (namely to the owner of the T-bill, the lender for the Term Deposit Facility or the reverse repos, or the 5:00 p.m. holder of reserve deposits) the original borrowed sum plus interest. I would describe any such instruments as borrowing from the public. The Fed’s Plan A (raise interest rates on reserves), and Plan B (expand reverse repos), and Plan C (Term Deposit Facility), is that it will continue to borrow, as able and needed, in order to hold on to its MBS until those assets gradually decline as they mature or are prepaid.