The Fed’s balance sheet explosive growth, Is it a macroeconomics issue?Gaetan “Guy” Lion. May 2009

Introduction:We all have seen a version of the following graph. It shows the asset side of the Federal Reserve balance sheet ballooning from $1 trillion to $2.3 trillion just during the second half of 2008.

Source: www.econbrowser. Federal Reserve assets in billions of dollars. Data source: Federal Reserve Release H.4.1.

The often mentioned implication of this rapid growth in the Fed’s assets is that the money supply and inflation are bound to explode.

The usual rebuttal is that this is a risk worth taking when fighting the worldwide Great Depression II and its associated risk of a long deflationary period. Also, the dire Japanese deflation over the past two decades is another cautionary reference. Thus, the inflation/deflation risk is asymmetric. Deflation is far more dangerous since it is so much harder to correct.

The Fed’s balance sheet raises several interesting questions, including: 1) How has the ballooning of the balance sheet impacted the Money supply so far? 2) Will Bernanke eventually lose control of preempting inflation? 3) By the time the economy recovers, how will Bernanke shrink the Fed’s balance sheet

without causing a recessionary shock?

Let’s investigate those issues.

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Review of the Fed’s basic balance sheet management.Historically, the Fed has managed its balance sheet in a straightforward manner. Typically 85% of its assets consist of Treasuries it buys from banks. And, its liabilities consist of currency that the banks received from the Fed. Such currencies represent around 90% of liabilities. As depositors withdraw the currency held by banks and spend it on goods, the vendors deposit such currency and the deposit-loan money creation gets going. The Fed also conducts open market operations to buy or sell Fed Funds to set the Target Fed Funds rate. This is the Fed’s main monetary policy tool. Until mid 2008 (as shown on the earlier graph), the Fed’s balance sheet had remained fairly static. This all changed in mid 2008.

Basic Federal Reserve balance sheet accounting.The basic accounting equality:

Assets = Liabilities + Equity

has a different nomenclature for the Fed’s balance sheet (Federal Reserve Statistical Release. H.4.1). In this case it is:

Total factors supplying reserve funds = Factors absorbing reserve funds + Reserve balances.

As a matter of simplicity, we will refer to this equality as:

Assets = Liabilities + Reserves.

Reserves are different than Equity. They also have a regulatory meaning as banks are required to maintain reserve balances at the Fed. But, until recently such reserves were trivial amounting to less than 1% of the Fed’s balance sheet. But, this has radically changed (not the reserve requirements but the excess reserve level).

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Let’s look at the assets side:

Source: Fed's H.4.1 release. in $ million

Assets Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 May-09

Treasuries 717,813 744,210 778,939 754,613 476,014 583,272 GSEs & MBS securities - - - - 20,878 508,154 Repos 33,000 45,250 36,000 42,500 80,000 - Term auction credit facility (TAF) - - - 20,000 450,219 428,835 AIG loans - - - - 39,507 45,110 Primary dealer and other broker-dealer credit  - - - - 38,190 - Asset backed CP MMF liquidity facility - - - - 23,993 27,291 Commercial paper funding facility - - - - 331,686 157,083 Other loans 57 114 488 4,535 84,941 53,948 Maiden Lane(s) (AIG, Bear Stearns assets) - - - - 75,206 62,211 Central bank liquidity swaps               - - - - - 235,112 Other assets denominated in foreign currencies 39,367 39,154 39,342 55,837 621,990 66,673 Treasury currency 36,476 36,541 38,245 38,807 38,843 42,359 Other (gold stock, etc…) 13,734 14,294 13,652 12,905 11,907 10,845

Total factors supplying reserve funds                  840,447 879,563 906,666 929,197 2,293,374 2,220,893

We can see that the balance sheet, except for marginal growth, was very static from yearend 2004 to 2007. But, note the creation of the Term auction credit facility (TAF)1 in 2007. From 2004 to 2007, Treasuries do dominate the asset side of the balance sheet as expected as shown below:

Dec-04 Dec-05 Dec-06 Dec-07Treasury/Assets 85.4% 84.6% 85.9% 81.2%

But, in the last two periods the explosive growth of TAF and other new credit facilities to support: a) Primary dealers, b) Money market funds, c) Commercial paper issuers, d) Purchase assets from AIG and Bear Stearns, and e) Foreign Central Banks to assist in their purchase of foreign currencies

… the above caused the balance sheet to more than double in 2008 and remain at that level in May 2009. In the last two periods, Treasuries now represent only a small fraction of the Fed’s balance sheet as shown below highlighted in yellow:

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 May-09Treasury/Assets 85.4% 84.6% 85.9% 81.2% 20.8% 26.3%

This is probably an unprecedented situation. It begs us to investigate what is going on the liabilities side.

1 TAF is actually two different set of term facilities. The first one allows the Fed to lend for up to 27 days, the second one for up to 84 days. The total credit issuance capacity of TAF is $900 billion.

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How about the liability side of the Fed’s balance sheet.

Source: www.econbrowser. Federal Reserve assets in billions of dollars. Data source: Federal Reserve Release H.4.1. The above picture represents a balance sheet size that exactly matches the one on the asset side shown on the first page. This graph is less known vs the asset side one. Yet, to fully understand the implication of the Fed’s balance sheet growth; the liability side is more important than the asset side.

Source: Fed's H.4.1 release. in $ millionLiabilities Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 May-09

Currency 758,397 794,900 819,930 829,193 886,651 906,713 Reverse Repos 29,938 30,372 32,126 40,542 88,317 67,758 U.S. Treasury deposits & SFP 5,734 4,243 4,470 4,529 407,305 237,859

Other liabilities 37,127 41,663 44,155 50,151 96,112 57,695

Total factors absorbing reserve funds 831,196 871,178 900,681 924,415 1,478,385 1,270,025

Reserve bal. with Fed. Reserve Bks            9,251 8,385 5,985 4,782 814,989 950,868

840,447 879,563 906,666 929,197 2,293,374 2,220,893

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Just as Treasuries dominated the asset side in the first four time periods, and then were dominated by other assets, the same is true for Currency on the liabilities side. Currency which formerly accounted for 90% of (Liabilities + Reserves) now accounts for only 40% of it.

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 May-09Currency/(Liabilities+Reserves) 90.2% 90.4% 90.4% 89.2% 38.7% 40.8%

The Federal Reserve matched its staggering growth in assets on the liability side through two new funding vehicles:

1) First, it used a new Supplementary Financing Program (SFP) whereby the U.S. Treasury issued several hundred $billion in Treasuries sold to the public and deposited those at the Fed (shown in orange below). This facility was announced in September of 20082; and

2) Second, the Fed started paying banks the Fed Funds rate to motivate them to simply let their excess reserves accumulate on the Fed’s balance sheet (shown in green below).

Source: Fed's H.4.1 release. in $ millionLiabilities Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 May-09

Currency 758,397 794,900 819,930 829,193 886,651 906,713 Reverse Repos 29,938 30,372 32,126 40,542 88,317 67,758 U.S. Treasury deposits & SFP 5,734 4,243 4,470 4,529 407,305 237,859

Other liabilities 37,127 41,663 44,155 50,151 96,112 57,695

Total factors absorbing reserve funds 831,196 871,178 900,681 924,415 1,478,385 1,270,025

Reserve bal. with Fed. Reserve Bks            9,251 8,385 5,985 4,782 814,989 950,868

840,447 879,563 906,666 929,197 2,293,374 2,220,893

Those two actions (U.S. Treasury issuing debt and simply parking them at the Fed) and banks letting a huge level of excess reserve accumulate amounts to taking a huge amount of Currency out of the system. Those two measures essentially negated any monetary expansion implications associated with the ballooning of the asset side of the balance sheet.

As shown below, those two measures now clearly dominate the liability side of the balance sheet.

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 May-09(U.S. Treasury deposits + Reserves)/(Liab. + Reser.) 1.8% 1.4% 1.2% 1.0% 53.3% 53.5% Quantitative Easing vs Quantitative Restricting.If the ballooning the asset side of the Fed’s balance sheet is commonly referred to as quantitative easing by purchasing securities and making loans to financial intermediaries that boosts currency in circulation to be redeployed in lending… The ballooning of the liability side through the mentioned U.S. Treasury SFP and the Fed paying interest on banks reserves is equivalent to quantitative restricting as it takes currency out of circulation. And, it effectively negates the quantitative easing generated by the asset side.

2 The Treasury auctions Treasury bills to the public. The interest on the debt is directly paid by the Federal Reserve. This Government debt may fall outside the Congressional debt ceiling mandate. As long as the Fed does generate the corresponding interest income on the asset side, the servicing of this debt is not problematic.

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How has the ballooning of the balance sheet impacted the Money supply so far? The mentioned quantitative restricting allowed for the Fed to more than double its balance sheet, yet maintain Currency and the money supply on a moderate growth path as shown below:

Dec 04Growth rate Dec 04 to May 09

2005 2006 2007 2008 May-09 to May 09 growth p.a.Fed's balance sheet 4.7% 3.1% 2.5% 146.8% -3.2% 164.3% 24.6%Currency (Feds liability) 4.8% 3.1% 1.1% 6.9% 2.3% 19.6% 4.1%M2 4.0% 5.4% 5.6% 9.4% 2.5% 29.8% 6.1%M1 -0.3% -0.7% -0.1% 17.2% -2.8% 12.7% 2.7%

The staggering growth rate of the Fed’s balance sheet of nearly 150% in 2008 had no impact on the growth of either Currency on the Fed’s liability side or the money supply (M1 or M2). It also had no impact on the overall growth rate for the entire period (from December 2004 to May 2009). The growth of Currency remained moderate and in line with M1 and M23.

Will Bernanke eventually lose control of preempting inflation? This does not appear likely. Bernanke is running a much tighter ship than understood. The balance sheet is large but is perfectly matched from a money supply growth management perspective. The additional $1.2 trillion in new credit facilities on the asset side is matched by the same amount in the U.S. Treasury SFP and excess bank Reserves on the liability side.

What matters from a money supply growth and inflation risk is not the size of the balance sheet, but instead the amount of Currency on the liability side. This amount as reviewed above has remained stable. .

By the time the economy recovers, how will Bernanke shrink the Fed’s balance sheet without causing a recessionary shock?First, given that the balance sheet is in equilibrium now he really does not need to shrink it. The media often thinks of the entire $2.2 trillion balance sheet as excess liquidity that Bernanke will need to “mop up.” But, this is not the case. If there is any excess liquidity, it would be captured in the Currency account which is the residual of the quantitative easing credits less the quantitative restricting debits. The Currency account has been growing by a very moderate 4.1% p.a. over the reviewed period and a bit faster since 2008 to combat deflation. The resulting growth in the money supply in 2009 has still been rather tepid. Such moderate growth rates do not suggest any excess in liquidity. Our analysis answered our original questions, but it raises some others…

What will happen when the banks will redeploy their huge excess Reserves to put those funds to better use? The banks could at some point withdraw their excess Reserves of about $940 billion. This could double the Currency level and cause a proportional huge jump in M1 and M2. But, the Fed has a lot of ways to eliminate the prospective excess Currency. Below, I am just showing one of many possibilities. 3 Granted this is in part by design since Currency represents a substantial part of M1 that in turn represents a part of M2.

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in $ million

Assets May-09 Restructured Change

Treasuries 583,272 343,272 (240,000) GSEs & MBS securities 508,154 508,154 Repos - - Term auction credit facility (TAF) 428,835 128,835 (300,000) AIG loans 45,110 45,110 Primary dealer and other broker-dealer credit  - - Asset backed CP MMF liquidity facility 27,291 27,291 Commercial paper funding facility 157,083 57,083 (100,000) Other loans 53,948 53,948 Maiden Lane(s) (AIG, Bear Stearns assets) 62,211 62,211 Central bank liquidity swaps               235,112 235,112 Other assets denominated in foreign currencies 66,673 66,673 Treasury currency 42,359 42,359 Other (gold stock, etc…) 10,845 10,845

Total factors supplying reserve funds                 2,220,893 1,580,893 (640,000)

Liabilities

Currency 906,713 906,713 Reverse Repos 67,758 67,758 U.S. Treasury deposits & SFP 237,859 537,859 300,000

Other liabilities 57,695 57,695

Total factors absorbing reserve funds 1,270,025 1,570,025

Reserve bal. with Fed. Reserve Bks            950,868 10,868 (940,000)

2,220,893 1,580,893 (640,000) As shown above, the $940 billion conversion of excess bank Reserves into Currency would be absorbed by:

… First on the asset side:By selling $240 billion in Treasuries;Not renewing $300 billion in Term Auction facility credits;Not renewing $100 billion in Commercial Paper funding facility credits; … Then on the liability side: Increasing U.S. Treasury deposits (SFP) by $300 billion.

As a result, the Currency account would remain unchanged at $906.7 billion.

The mentioned restructuring transactions could be achieved reasonably quickly as they are all associated with credits of fairly short term nature. If the Fed would still run into time

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constraints4, it could substitute reduction in TAF with additional sales in Treasuries on the asset side. And, the U.S. Treasury could step up its SFP program too.

How about the independence of the Fed?The existence of the U.S. Treasury Supplementary Financing Program (SFP) whereby the U.S. Treasury essentially raises Government debt on behalf of the Fed strongly suggests the Fed and the Treasury are currently working closely together. Many other features of the current restructuring of financial service regulations confirm a strong cooperation between the two government bodies. The Fed and the Treasury may be working now as closely together since they had in the mid to late 90s with Greenspan at the Fed and Robert Rubin as Secretary of the Treasury and Laurence Summers as his Deputy when they addressed together many international finance crises including the Mexican bail out. Now Summers is Director of the National Economic Council. And, Tim Geithner, the former President of the New York Fed, is Secretary of State. One can expect the Treasury and the Fed to work closely together for two reasons. First, financial crises tend to foster cooperation rather than independence between the two bodies. Second, both Bernanke and Geithner think alike. They have a strong working relationship when Geithner was at the Fed. They are both highly creative pragmatists. For the ones who are big on Fed independence, they may have to settle on a Fed-Treasury codependence. And, the Fed is certainly no wall-flower in this joint venture.

References and acknowledgment:

Two economists who share an excellent blog (www.econbrowser.com) lead me on studying the liability side of the Fed’s balance sheet. They are:

James D. Hamilton, Professor of Economics at UC San DiegoMenzie David Chinn, Professor of Public Affairs and Economics at the University of Wisconsin.

Some of their related blog entries include:

Balance sheet of the Federal Reserve, October 7, 2008.Federal Reserve balance sheet, December 21, 2008.Money creation and the Fed, March 27, 2009.

However, the direct compilation and analysis of data (from H.4.1 Federal Reserve) was my own.

4 Some of the Term Auction Facility Credits can go out to 84 days.

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