Echo

The Fed's balance sheet is changing: reserve balances set to grow

Thursday, December 4, 2008

The Fed is unwinding the temporary Treasury Supplemental Financing Program (TSP), while at the same time, planning to purchase direct GSE (government sponsored entity, mainly Fannie Mae and Freddie Mac) obligations. Interestingly, the Fed is sterilizing the TSP flows back to the Treasury – at least on paper and for now – but it will not sterilize the purchase of GSE debt. This illustrates the Fed’s move away from traditional policy – reducing the short term interest rate – and toward new policy: quantitative easing and changing the composition of its balance sheet.

The chart illustrates the contribution of the Fed’s liabilities to the total factors that absorb reserve balances (Table 1 on the H.4.1 statemet). Most of the components have remained rather stable except for the creation of the TSP account (currently $479 billion), which was created for the sterilization of Fed’s massive liquidity operations (see this post for details).

On November 19, the Fed started to unwind the TSP account as the bonds/bills came to term, and there question as to the sterilizization of these funds. The Treasury will pay back the initial bond buyers, but at the same time, the Fed is reducing reserve balances, so the flows are (at least on paper) sterilized. Since November 19, factors that absorb reserve balances (the chart above) fell $89.8 billion - mostly from the unwinding of the TSP account – while contemporaneously, factors affecting reserve balances fell by more, or $104.3 billion.

The Fed seems strangely concerned about sterilizing the flows back to the Treasury (public). As the unwinding of the TSP account continues, it will be interesting to see how this works on the Fed's balance sheet.

Also affecting the Fed’s balance sheet is the planned purchase of $600 billion in GSE debt and MBS (mortgage-backed securities) - I call this FARP (Fed Asset Relief Program). The Fed is expected to initiate its purchase of $100 billion in GSE direct obligations as soon as this week (here is the Fed’s FAQ page), and some have asked how the Fed will pay for this.

The Fed will create reserves (straight out of the horse’s mouth) and hold the GSE securities in the SOMA account.

The SOMA account is currently valued at $488.7 billion (2nd line of Table 1 on the H.4.1 statement), which includes $12.3 billion of GSE debt (line 8 Table 1). The SOMA account (line 2 Table 1) of the Fed’s asset holdings will rise by $100 billion in new GSE debt without an offsetting transaction on the liabilities side (chart above). Therefore, reserve holdings will rise by $100 billion, and this will not be sterilized.

The Fed has changed strategies to quantitative easing – adding non-sterilized reserves balances to the banking sector to keep the money supply afloat. The Fed is also altering the composition of its balance sheet – raising agency debt relative to its Treasury holdings and adding MBS holdings. Both tactics are anomalous policy measures used when standard policy – reducing the short-term nominal interest rate – has reached its limits (the zero bound). The Fed is desperate, but doing the right thing.

Rebecca Wilder

9 comments:

Irrational Doomsday Blog December 4, 2008 at 8:30 AM  

I don't think they are doing the right thing at all, to be honest.

It's the right thing if you believe that US gov't pledges are absolutely safe. And you believe that the gov't must act to prevent or soften a downturn at any cost.

But I'm forming the opinion that the gov't is actually exacerbating this problem by introducing central planning and disrupting the natural clearing of bad debt from the system via firm failure.

And the gov't is undoubtedly taking on significant credit risk, and outlaying more than it can afford to pay back.

They are testing the limits here, they're already way, way beyond anything that's ever been done. And I'm more worried about a currency collapse now than a deep recession/depression.

If this was Angola instead of the United States, would you be saying they were desperate and doing the right thing, or desperate and flirting with disaster?

Janie December 4, 2008 at 10:59 AM  

Well said, Irrational Doomsday!

David Pearson December 4, 2008 at 11:00 AM  

Rebecca,

I don't know if the Fed can sterilize the remainder of the TSP. To do so, they would either have to sell Treasuries or withdraw credit to its various customers: banks, CB's, etc. Both are doubtful given that 1) the Fed doesn't have sufficient Treasuries; and 2) its not likely to engage in a reversal of the swap lines, TAF, etc. at the same time that deflationary expectations are rising.

So what's your candidate for the source of sterilization? If I had to pick, I'd say the $ dollar swap lines. It seems the panic de-leveraging and dollar-flight has subsided, so the Fed might not need to provide as much dollar liquidity to global Central Banks.

Rebecca Wilder December 4, 2008 at 4:47 PM  

Hi David,

I would say that the swap lines are the only candidate. As you stated, it would be monetary suicide to try and take back $500 billion in liquidity all at once - or even incrementally close together in time.

I don't know if the Fed will actually sterilize the flows - need to wait and see on that one. Just think that it is interesting that the Fed is (seemingly) trying to save face as they return the funds to the public.

Rebecca

Flow5 December 6, 2008 at 11:55 AM  

A growth in required reserves would ordinarilly reflect an increase in reservable liabilities (net transactions accounts).
I.e., an increase in required reserves could involve 2 different senarios, resulting in 2 different outcomes.

First, depositors could shift their deposit accounts (their deposit classification preferences) from (TDs) into (DDs), (ATS), (NOW), share draft, etc...i.e., no change in the money stock. Not likely.

Second, an increase in required reserves would reflect an increase in the money stock...probable.
The growth in required reserves should be considered significant.

An increase in required reserve balances, reflects a growth reservable liabilities, (or a growth in transactions accounts, or in components of M1).

Thus, rates-of-change in required reserves should proceed pari passu, with rates-of-change in Nominal GDP.

Flow5 December 6, 2008 at 11:56 AM  

Could the difference in reserve requirement adjustments be the factor distorting this figure?
(1) The reserve ratio on net transactions accounts depends on the amount of net transactions accounts at the depository institution. http://www.federalreserve.gov/monetarypolicy/reservereq.htm
(2) Net transaction accounts in excess of the low-reserve tranche are currently reservable at 10 percent
(3) The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent is the "low-reserve tranche.
(4) Reserve requirements are imposed on commercial banks, savings banks, savings and loan associations, credit unions, U.S. branches and agencies of foreign banks, Edge corporations, and agreement corporations.
(5) Total transaction accounts consists of demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturing in seven days or less.

Flow5 December 6, 2008 at 11:57 AM  

(M1) consists of
(1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions;
(2) traveler's checks of nonbank issuers;
(3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and
(4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions.

(M2) consists of M1 plus
(1) savings deposits (including money market deposit accounts);
(2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and
(3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds.

Flow5 December 6, 2008 at 11:58 AM  

As of Nov. 24, 2008
(M2) components:
(1) total savings deposits have declined from $4,025b (sept) to $3,984b
(2) small denomination time deposits have increased from $1,320b (sept) to $1,359b
(3) retail money funds have increased from $1,024b (sept) to $1,054b

(M1) components:
(1) currency has increased from $777b (sept) to $806b
(2) demand deposits have INCREASED from $344b (sept) to $426b (at thrifts and commercial banks)
(3) other checkable deposits have decreased from $309b (sept) to $299b. (NOW & ATS accounts)

The rise in demand deposits could explain the increase in required reserves since Sept08. But it's not adjusted for fluctuations in reserve requirement, and would be distorted to that extent.

MUCH MORE STIMULUS IS REQUIRED

Flow5 December 6, 2008 at 12:07 PM  

"The Fed is unwinding the temporary Treasury Supplemental Financing Program (TSP)"

Historically, the Treasury's General Fund Account has never been included in the tabulations of the money stock. I.e., because during the end of WWII, the Treasury parked $26b in this account, but later cancelled these balances. Just as in WWII, the Treasury's balances never circulated (TSP).

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