Friday, June 19, 2015

Shrinking The Fed Balance Sheet

Gillian Tett of Financial Times has written an article on the eventual "normalization", or shrinking, of the Fed balance sheet: "A bloated US Federal Reserve prepares to shape up".

She correctly points out that "the realm of activist balance sheet management sits in something of an intellectual vacuum". In order to help fill this vacuum, I'd like to offer some thoughts on the subject. This is in no way an easy subject as it requires adopting a somewhat unconventional view on "money", so we all need to tread carefully.

Ms Tett writes:

"The second, related, issue is what happens to the funds that private banks have parked as spare reserves at the central bank in recent years. In the five years before the 2008 crisis, these “reserves” were tiny, just $11bn on average each day, partly because the Fed did not pay interest to banks. 
But by 2014 the reserve balance had risen to $2.6tn and the Fed pays 25 basis points of interest."

In reality, the private banks can't but hold these excess reserves, so it is actually the Fed who has parked these reserves... at the Fed. It explained this already in 2009 (NY Fed Staff Report 380):

"...the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves... reflects the size of the Federal Reserve’s policy initiatives"

So it is best to call them "excess reserves", not (the tautological) "spare reserves". It follows that the interest paid on these reserves doesn't affect the total amount of these reserves. Here is what the Fed has to say on the interest on both required and excess reserve balances (

"The interest rate paid on balances maintained to satisfy reserve balance requirements... is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions. The interest rate paid on excess balances... gives the Federal Reserve an additional tool for the conduct of monetary policy. ...during monetary policy normalization the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances."

By adjusting the interest rate it pays on excess reserve balances, the Fed can affect the interest rate banks (the ones with excess reserves) charge other banks (the ones with reserves below the required level) for these reserves on the interbank lending market. Back in time, when only a few of us had heard of QE, the Fed managed the interbank rate mainly by managing the total amount of reserves through open market operations, trying to ensure there weren't much excess reserves at all in the system. But now that the the amount of reserves is very, very excessive, the Fed has to manage the interbank rate through the price it pays on excess reserves.

A related thing I'd like to address here is the maturation of the Fed-held Treasury bonds. In the absence of a budget surplus, the Treasury will need to issue new bonds to the public when these bonds mature -- i.e. it will "roll over" the maturing debt. Technically speaking, when the new bonds are sold to the public, (excess) reserves will be moved ("drained") from the buyers of these bonds -- so called primary dealers -- to the Treasury's General Account (TGA) at the Fed. This "money" on the TGA will be "destroyed" as the Treasury settles its maturing Fed-held debt -- just like deposits are said to get destroyed when private bank loans are repaid. Both sides of the Fed balance sheet shrink by the same amount: on the asset side the bond disappears, and on the liability side the balance on the TGA is reduced. The Fed doesn't "receive money" from the Treasury, but neither do commercial banks receive money when a mortgage is repaid. There is no free lunch for the government connected to this. 

The outcome of all this is that the reserves which were created "from thin air" when the Fed bought the bonds are no more *, and the public, instead of the Fed, is holding the (new) Treasury bonds. It's almost like QE never took place -- although it must be the journey, and not the destination, which matters here. This outcome doesn't really differ from the outcome should the Fed sell the Treasury bonds to the public before they mature, so it's mainly a matter of timing -- avoiding market shocks, as Gillian Tett says.

Conclusion: The excess reserves will shrink either as the Fed-held bonds mature or as the Fed sells (or lends) them to the public. The private banks, in aggregate, cannot lend them out.

As is often the case, I believe we can learn something new about Quantitative Easing as we ponder its opposite: Quantitative Tightening.

* Had the maturing bonds been privately held, the total amount of reserves would have stayed intact. Reserves would have been recycled, via the TGA, from the buyer of the new bond to the holder of the maturing bond.

This is not much different, say, from a situation where a member of the public holds a corporate bond, as opposed to a situation where a commercial bank holds a corporate bond. In the former situation, bank deposits are transferred from the issuer of the maturing bond to the holder of this bond, whereas in the latter situation a bank deposit held by the issuer is "destroyed" when it makes a bond repayment to the bank. It is sometimes good to view the central bank as a bank like any other.