Deconstructing the Fed's Balance Sheet

Jim Hamilton at Econbrowser dissects the balance sheet of the Federal Reserve, explaining in excruciating detail why you shouldn't be alarmed at the chart you see below.

Here's the part that should make you feel better.

That is, the part where Fed Chairman Ben Bernanke transforms from the $800 billion man back in September to the $2.3 trillion man (and counting) in December without creating any new money.

Beginning in September, the Fed decided it couldn't afford to sell off any more of its Treasuries, but wanted to lend more and still have no effect on the money supply. To do so it needed to find a way to funnel the reserves created by the new loans it would make into categories on the liabilities side that would not result in more cash held by the public. The first such device was to reach an agreement with the Treasury for the Treasury to simply hold on to a huge volume of Federal Reserve deposits, some $484.6 billion as of last week. The way this worked is that two operations were implemented simultaneously.

First, the Fed created a lot of new deposits, for example, $318.8 billion from the Commercial Paper Lending Facility alone. Second, the Treasury borrowed an additional half trillion from the public, forcing somebody in the public to send a check to the Treasury. In the aggregate, the reserves created by the Fed through the CPLF end up just being parked in the Treasury's account with the Fed, with no creation of money.
...

The second measure that the Fed employed to allow this ballooning of its assets was to start paying banks an interest rate on reserves that is exactly equal to its target for the fed funds rate itself, essentially eliminating any incentive for the banks to lend fed funds and encouraging banks instead to simply let excess reserves accumulate. Last week, banks were sitting on about $800 billion in excess reserves with the Fed, doing absolutely nothing with them. The Fed was in effect lending those funds in place of the banks.

It's good to know that the Treasury Department can just go out and borrow a half trillion dollars for the Fed if and when it wants to.

It helps that the rest of the world remains scared to death of just about any asset other than U.S. Treasuries and is more than happy to keep buying the stuff.

Reading through the rest of this piece, you get the feeling that the Fed really knows what they're doing and they have things well under control, up until the point where you read:

Ben Bernanke has made a gamble with something approaching $2 trillion. If the gamble wins, taxpayers owe nothing. If the gamble loses, taxpayers are committed to borrow a sum equal to any losses and start making interest payments on it.

Ultimately, things don't sound nearly as good at the end as they did in the beginning.

Comments

[AlexR:]

Is the Fed making a mistake? If the money supply is really not increasing, what's the talk of quantitative easing all about?

2008 Dec 22 05:25 PM

[herbert hoover:]

A Ponzi scheme worthy of Bernie Madoff.

Question: What's the difference between Madoff and Benacke?
Answer: There is none.

2008 Dec 22 07:47 PM

[stopwhining:]

Only way this charade holds up is with China's continued to support to act as creditor. I wonder how long they can continue to buy Tbills in light of slowing growth and the prospect of a falling USD. That said, where else can they put their money? In the 1930's, we financed the world in an effort to lend consumers the money required to buy excess production, now, China is lending us money to buy their exports. Now, as then, the situation has become co-dependent. That said, there are fundamental differences that will impact how this plays out.

At what point does the international community balk at the prospect of lending us additional capital? That is tough to say. So long as we can avoid blowing money on unnecessary wars (and diffuse larger real conflicts), we may yet survive with our hide intact.

2008 Dec 22 07:58 PM

[jepittman:]

The $800 billion in excess reserves belongs to commercial banks. These reserves are earning virtually nothing since the rate on fed funds fell to zero to 1/4% last week. This rate is well below the banks' cost of funds. If they do not find a way to lend it at higher rates the banks are going to lose a lot of money. There are no yields on any short term security that compensates the banks with a positive spread. The solution is for the banks to lend the money to qualified retail borrowers at profitable rates. This is one of the primary sources of economic stimulus that is building in the pipeline. Incidently I have seen reports that the excess reserves have reached $1 trillion.

2008 Dec 22 08:23 PM

[smiley1:]

The Fed is bankrupt...fancy accounting or no fancy accounting...the 2+ trillion on their books isn't worth $0.5 trillion at the end of the day...

2008 Dec 22 08:59 PM

[smiley1:]

'other assets' gimme a break...there is no transparency here...if there were, we'd all be running for the hills....

2008 Dec 22 09:01 PM

[Anthony Alfidi:]

In other words, the Fed has become the Treasury's off-balance sheet entity, just like Enron's SPEs or Citgroup's SIVs. This is what we can expect rom a government committed to adopting the private sector's "best practices."

People who howl for the Fed to force banks to lend should read ths article and consider the implications. The Fed's custody of these banks' assets is keeping them solvent. Lending out the reserves created by the Fed will spark inflation and remove a big prop for bond prices (collapsing the bond bubble).

2008 Dec 23 12:31 AM

[Moon Kil Woong:]

An interesting note to this is what I have mentioned a few times before. Whereas the Fed and Treasury are publicly stating they are supporting quantitative easing and inflating the money supply, they are actually contracting the money supply. By paying interest on Fed deposits they are encouraging banks to deposit more than the necessary amount with them choking off the money supply and money multiplier.

It is true if the Fed can issue more money on Treasury debt and issue money by buying public debt they essentially can issue an infinite amounts of money since the first increases the public debt and the buying the public debt can increase even more public debt. However, the ugly part about sanitizing the loss and paying interest still rears it's ugly head. So the Fed and the Treasury have been squeezing all the markets to get as much cash it can to pay for the bad debt (presumably in the future). So in effect, without a mechanism for purging the system of all the bad debt, and with a general intolerance for the public to shoulder bank bad debt losses no real inflationary or stimulus is being done. Quite the opposite, asides from TARP which also has the same problem. No one wants it to take the loss either although the public surely is.

So the government's actions stagger on deflating the market and putting off recognizing and allocating the losses until later. There will be no good time when the public will happily accept the losses. So just like Japan, except this cycle to continue on and on and on. Just like what happened in Japan.

You will know when the downturn is over because there will be financial blood in the street. Someone someday will have to atone for the loss (bankruptcy, public write offs, prison time, and the like). That would be the good result.

The bad one is where we choose to let banks spend decades of long slow write offs using interest on your debt to pay off the excesses of the last few years as slowly as a you pay off a 20-30 year mortgage. All while an entire generation languishes in a prolonged recession.

2008 Dec 23 03:42 AM