Unwinding the Fed’s balance sheet

A central bank’s primary objective is to maintain the purchasing power of its currency by carefully controlling its supply. It traditionally controls the supply of its currency by buying (or selling) financial assets (generally government debt) with its own, newly created monetary liabilities (the money base or M0). This is often described as printing money. Thus a central bank’s assets grow apace with its monetary liabilities. Commercial banks lend central bank base money to their customers thus creating deposits (bank money). The money supply, as usually measured, consists of central bank currency in circulation plus deposits with banks (M2). When it grows too fast its value declines (inflation).

Prior to the collapse of the gold (exchange) standard in the earlier 1970s a central bank’s supply of its base money was anchored to its obligations to maintain the convertibility of its currencies to gold (via the dollar) at its official price. Since then, central banks that did not peg the exchange rate of their currency to the U.S. dollar or some other currency, generally sought to control their money supply so as to maintain stable prices (0-2 percent inflation).

Setting a central bank’s policy interest rate (e.g. the fed funds rate) below or above the market’s equilibrium rate causes its base money to grow faster or slower. See figure 1.

fed1At the end of 2007, total Federal Reserve assets were $890.6 billion, only modestly higher than five years earlier ($732 billion). One year later, the figure more than doubled to $2.2 trillion and peaked at the end of February 2015 at $4.5 trillion. The counterpart to these assets on the liability side of the Fed’s balance sheet are what economists call the monetary base, (currency in circulation and bank deposits with the Federal Reserve Banks). Over the same period, these liabilities grew a comparable amount ($0.8 trillion to $4.1 trillion). See figure 2.

fed2bHistorically the money supply, generally measured as currency in circulation plus all bank deposits – M2, has been a relatively stable multiple of the monetary base (M2/M0 – the money multiplier) and grows at the same rate. Over this same period (2008 – February 2015) M2 rose from $7.7 trillion to only $12.0 trillion, less than doubling. What is going on?
When the interbank lending market (Fed funds market) froze up following the failure of Lehman Brothers in September 2008, the Federal Reserve did what central banks were created to do by pumping billions of dollars into the market, thus avoiding the collapse of many banks suddenly unable to fund their assets in the money markets. However, in November of that year the Fed began to buy large quantities ($600 billion) of mortgage-backed securities along with Treasury notes (called Quantitative Easing and later dubbed QE1). The Fed’s purpose was to support the mortgage market in the face of great uncertainty over the soundness and thus value of many subprime mortgages and to support debt markets more generally (i.e., to keep interest rates low). While the growth in M2 increased some in this period, it did not grow anything like the explosion of the monetary base (and the Fed’s balance sheet). See figure 3.

fed3To accomplish this trick the Fed accelerated the use of its authority to pay interest on bank deposits with it granted in the Financial Services Regulatory Relief Act of 2006. The Emergency Economic Stabilization Act of 2008 accelerated the effective date to Oct. 1, 2008. By setting the rate paid to banks on their reserve deposits with the Fed high enough relative to short-term rates in the market, the Fed induced banks to keep most of the new base money the Fed was creating with its quasi fiscal QE1 on deposit with the Fed as excess reserves (reserve deposits in excess of legally required reserves) rather than creating new bank money by lending it.

To quote from the Fed’s press release on Oct. 6, 2008: “The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.

“The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate.”

The payment of interest on bank reserve deposits with the Federal Reserve Banks gave the Fed a new policy instrument. It could now, and did on a large scale, buy up large amounts of debt in the market, targeting specific markets if it choose to (such as mortgage-backed securities), without increasing the money supply by paying enough interest to banks to keep the new base money deposited with the Fed as excess reserves. Quantitative Easing 1 was followed by QE2 and QE3, but the massive increase in the Fed’s assets (and base money) did not result in a comparable increase in the money supply (M2). This new tool will be important in controlling the monetary impact of the Fed’s unwinding of its mammoth balance sheet. See figure 4.

fed4As the American economy recovers from the Great Recession, the economy’s demand for credit will grow. While total bank credit declined from 2008 Q3 until 2011 Q2, it has been growing since, reaching a rate of over 7.6 percent in 2014. The Federal Reserve began to reduce the size of its QE3 purchases at the end of 2013 (tapering) and ended them all together in October 2014, at which time its total assets had reached $4.5 trillion and monetary liabilities (monetary base) had reached $4.0 trillion, of which $2.6 trillion were excess reserves. If banks draw down their excess reserves at the Fed to meet credit demand too quickly, the money supply will grow too fast causing inflation. What are the risks of such inflation in the next few years?

The Fed plans to unwind its massive balance sheet by allowing maturing assets to be repaid without reinvesting the proceeds in new assets. As of Aug. 5, 2015, about half of the Fed’s $4.5 trillion assets had a maturity greater than 10 years (most of which is mortgage-backed securities) and $1.1 trillion had maturities between one and five years (virtually all of which is U.S. Treasury securities). A natural run off of these securities as they mature will take about 10 years to reduce bank excess reserves back to their normal level (about zero) after which any maturing securities will need to be replaced plus additional open market purchases will be needed to provide for normal (non inflationary) monetary growth.

During this period, bank excess reserve balances with the Fed will need to be managed carefully to enable their gradual but not excessive draw down to finance growing bank lending. That management will rely on the Fed’s new tool, its interest rate paid on excess reserves. A bank with excess reserves will not generally be willing to offer them to other banks in the interbank market, unless the interbank rate (fed funds rate) is more attractive than the rate paid by the Fed on excess reserves. Thus setting this rate will become the Fed’s primary tool for targeting the fed funds rate until excess reserves are used up.

The primary risk of this arrangement comes from the possibility, though not likelihood, that to prevent inflation the Fed’s policy rate (and thus short-term interest rates in general) will need to increase faster than the banking system can absorb without negative spreads (a downward sloping yield curve). Negative spreads (between the cost of and return on funds for banks) cause losses to banks, which, if they last too long, can use up banks’ capital. The Fed would be reluctant to push rates up that fast. The other danger, as always, is that political pressure on the Fed will lead it to increased rates too slowly, again resulting in excessive money growth and inflation.