Sunday, August 23, 2009

The Fed balance sheet: it is a-growin'

I know that it's a bit cheesy relating the Fed balance sheet to Bob Dylan lyrics, but it just happened. The Fed's exit strategy is policy talk numero uno these days; but that's just it, talk. The balance sheet is still growing!

The annual Federal Reserve Bank of Kansas City Economic Policy Symposium is now over, with a list of top-tier talks addressing macroeconomic policy and financial stability. Carl Walsh says that the Fed must raise rates quickly...when the time is right. From the WSJ Real Time Economics blog (I will be looking for Walsh's paper, as it is not available at this time):
In a paper prepared for a two-day Fed conference here, Mr. Walsh argued that the U.S. must avoid the mistake of the Bank of Japan in lifting rates too soon. The way to do that is to keep rates low past the point at which the economy’s equilibrium, or natural, real rate of interest has risen above zero, he said.

However, once the Fed does start raising the federal-funds rate out of its current record-low range near zero, “it should be increased
quickly,” Mr. Walsh argued. “There is no support for raising rates at a gradual pace once the zero rate policy is ended.”
Well, raising rates (i.e., grow the fed funds target in order to target higher long-term rates) is the last thing on the Fed's plate right now with the reserve credit ex currency swaps trajectory still very much upward.

The chart illustrates the accumulated growth rate of reserve bank credit indexed to September 2008 (i.e., 2 implies that bank credit is double that what it was in September). On the surface, the Fed appears to be in a holding pattern, with reserve bank credit peaking in December 2008 and relatively flat since then (around $2 trillion). But the foreign currency swap lines of credit are masking the true trend in the balance sheet. At the beginning of the year, the Fed held $543 billion in assets related to currency swaps, and these holdings have dwindled to just $69 billion (see the Fed's current balance sheet here).

Ben Bernanke noted the importance of this program in Jackson Hole on Friday:
During this period, foreign commercial banks were a source of heavy demand for U.S. dollar funding, thereby putting additional strain on global bank funding markets, including U.S. markets, and further squeezing credit availability in the United States. To address this problem, the Federal Reserve expanded the temporary swap lines that had been established earlier with the European Central Bank (ECB) and the Swiss National Bank, and established new temporary swap lines with seven other central banks in September and five more in late October, including four in emerging market economies.6 In further coordinated action, on October 8, the Federal Reserve and five other major central banks simultaneously cut their policy rates by 50 basis points.
The Fed is still beefing up, rather than unwinding, its balance sheet. Discussing its exit is prudent, but far from a reality given that the recovery is still up for debate (see David Altig's post at Macroblog relating the speed of the recovery to the estimated output gap).

Rebecca Wilder

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