How Bad Is the Fed's Balance Sheet?

I was astonished when I heard that the Fed was contemplating increasing the Term Auction Facility to $900 billion. I wanted to take another look at the ever-changing balance sheet of the Fed to see how logistically Bernanke might be able to perform such a feat.

The one power that the Fed unquestionably possesses is the ability to create money. It traditionally did so by buying Treasury securities from the public, crediting the sellers' banks with newly created Federal Reserve deposits (a "liability" from the Fed's point of view), and adding the securities purchased to the Fed's asset holdings. Those newly created Federal Reserve deposits are essentially electronic credits that the banks could use to receive delivery of green cash from the Federal Reserve.

The first column of the table below provides a condensed version of the Federal Reserve's balance sheet in the halcyon moments before the credit turmoil began in August 2007. By far the most important asset held by the Fed at that time was some $800 billion in Treasury securities, largely balanced on the liabilities side by a similar value for currency in circulation. Repurchase agreements at that time were used by the Fed as a vehicle to add reserves temporarily, while reverse repos entered on the liabilities side as a factor temporarily draining reserves. The residual reserve balances, after adding up all the factors supplying reserves and subtracting all the other factors absorbing reserves, were themselves a tiny number, under $7 billion.

Balance sheet of the Federal Reserve.
(Based on end-of-week values, in billions of dollars). Data source: Federal Reserve Release H.4.1.

	Aug 8, 2007	Sep 3, 2008	Oct 1, 2008
Securities	790,820	479,726	491,121
Repos	18,750	109,000	83,000
Loans	255	198,376	587,969
Discount window	255	19,089	49,566
TAF		150,000	149,000
PDCF			146,565
AMLF			152,108
Other credit			61,283
Maiden Lane		29,287	29,447
Other F.R. assets	41,957	100,524	320,499
Miscellaneous	51,210	51,681	50,539
Factors supplying reserve funds	902,992	939,307	1,533,128
Currency in circulation	814,626	836,836	841,003
Reverse repos	30,131	41,756	93,063
Treasury supplement			388,850
Other	51,440	56,884	38,717
Reserve balances	6,794	3,831	171,495
Factors absorbing reserve funds	902,992	939,307	1,533,128

The Fed's actions since August of 2007 have often been described as providing "liquidity", though they were not doing so in the traditional sense of expanding reserves or the money supply. We see in the second column of the table above that the increase in currency in circulation between August 2007 and September 2008 was in fact quite modest, and reserve balances actually fell over that period.

The Fed did provide enough money creation to bring the fed funds rate, the interest rate at which banks lend those reserves to one another overnight, down from 5.25% in the summer of 2007 to 2.0% today [update: now 1.5%]. But a number of other interest rates, such as the rate banks lend to one another for a 3-month period, stayed well above that 2% overnight rate, signaling substantial frictions in the interbank market.

To try to address those frictions, the Fed had been significantly changing the composition of the asset side of its balance sheet through the beginning of September 2008, while keeping the total assets essentially constant. These compositional changes included selling off $90 billion in Treasuries and replacing them with repos. This swap was implemented not because the Fed wanted the operations to be short-term, but because it was one device to make a market for the less liquid securities that the Fed accepted as collateral against the repo loans and a device for providing term loans to banks directly.

Borrowing from the Fed discount window increased another $20 billion. The Fed introduced the Term Auction Facility in order to lend an additional $150 billion short-term, serving the same dual objectives of the repos. Maiden Lane LLC was created as a device for handling the $30 billion loan that was part of the Bear Stearns deal. All of these operations by themselves would have increased the money supply and the Fed's total assets. To prevent that from happening, the Fed sold off a comparable volume of its holdings of Treasury securities. By the beginning of September 2008, the Fed had replaced more than $300 billion of its holdings of Treasury securities with assorted riskier loans.

But the real action began last month. As reported in the third column of the table above, the Fed expanded its total asset holdings by $600 billion over the last 30 days, with less than a third of this going directly into reserve balances. The graph below puts the latter magnitude in perspective. When the World Trade Center towers burned down on September 11, 2001, many of the financial institutions that played a key role in trades of government securities and interbank loans were wiped out or incapacitated, posing potentially huge liquidity problems. Reserves ballooned to $67 billion, as excess reserves simply piled up in some banks while others remained in need. Last week's spike of $171 billion was 2-1/2 times as big -- the breakdown of interbank lending last week proved more profound than that caused by the physical disruptions in New York in 2001.

Reserve Balances with Federal Reserve Banks (weekly, not seasonally adjusted, in billions of dollars). Source: FRED.

Anyone who suggests that last week's ballooning reserve deposits represent inflationary pressure or the Fed monetizing the deficit simply doesn't know what they're talking about. Banks are sitting on the reserves, not withdrawing them as cash. When markets settle down, the Fed can and will absorb those reserves back in with sterilizing sales of Treasury securities, just as it did in 2001 or after the more modest spike in August 2007. Providing new reserves aggressively is absolutely and unquestionably the way the Fed needs to respond to this kind of development.

But referring back to the original table, we see that creating new reserves, as dramatic as it was, was dwarfed in magnitude by some of the other actions the Fed took over the last month. The Fed is now lending out an additional $150 billion in its primary dealer credit facility, providing overnight loans to primary security dealers who could not borrow directly from the Fed's discount window. Again this lending seems very much in the spirit of addressing the immediate liquidity needs, defined narrowly in terms of stressed overnight lending markets.

Then there's another $150 B for the AMLF-- the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, or the Name Too Long Even to Acronymize, $61 B for "other credit extensions" (primarily the AIG deal) and close to a new $300 billion over the last year in "other Federal Reserve assets", in which currency swaps are probably the biggest single item. A hundred billion here, and a hundred billion there, and pretty soon you're talking about real money. Macroblog has a nice visual of how these goodies all add up:

Federal Reserve assets in billions of dollars. Source: Macroblog.

But how did the Fed acquire all that stuff, with "only" a $160 B increase in reserve balances and a $30 B increase in currency outstanding? The answer is to be found in a new entry on the liability side described as "Treasury supplementary financing account." This was announced by the U.S. Treasury through the following somewhat obscure release:

The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week. To manage the balance sheet impact of these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

Announcements of and participation in auctions conducted under the Supplementary Financing Program will be governed by existing Treasury auction rules. Treasury will provide as much advance notification as possible regarding the timing, size, and maturity of any bills auctioned for Supplementary Financing Program purposes.

Here's what I take that to mean. I gather that the Treasury auctioned off some extra T-bills to the public, in addition to their usual weekly auction, and simply kept the receipts as deposits in an account with the Fed. If that were the end of the story and the Fed kept its total liabilities constant, it would result in a huge (completely infeasible technically) drain on reserve balances and currency in circulation, as banks sought to deliver reserves to the Treasury's account to honor their customers' purchases of the T-bills.

So the Fed offset the supplemental Treasury auction with a matching purchase of private assets, such as the PDCF and AMLF, thereby temporarily delivering reserves to banks which the banks in turn could hand over to the Treasury supplementary account. The net result of such dual Treasury/Fed operations is that the newly created "reserves" would just sit there in the Treasury supplementary account doing nothing other than standing as an accounting entry. In other words, the device allowed for a huge expansion of the Fed's balance sheet without causing any change in currency in circulation or reserve deposits.

Which leaves Bernanke's gun cocked and reloaded, and he's ready to keep shooting. And so the Fed announced on Monday that it's up, up and away for the term auction facility:

The sizes of both 28-day and 84-day Term Auction Facility (TAF) auctions will be boosted to $150 billion each, effective with the 84-day auction to be conducted Monday. These increases will eventually bring the amounts outstanding under the regular TAF program to $600 billion. In addition, the sizes of the two forward TAF auctions to be conducted in November to extend credit over year end have been increased to $150 billion each, so that $900 billion of TAF credit will potentially be outstanding over year end.

But those Monday developments are ancient history now, because on Tuesday we got a brand new acronym:

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

I had four calls yesterday from reporters, all asking the same question: Will it work?

I wish I knew the answer. I bet Bernanke wishes he knew, too.

Comments

[bearfund:]

First you say that "[w]hen markets settle down, the Fed can and will absorb those reserves back in with sterilizing sales of Treasury securities...". Well, that would seem sensible enough. Then you show the composition of the Fed's balance sheet, demonstrating that you see, but you do not see. The Fed doesn't have much left in the way of Treasuries. If it sold enough to sterilize all that money, it would have none at all. Now, surely, the Treasury will be borrowing a lot more, and the Fed can certainly buy as many of those securities as it wants. That would both grow and start repairing the balance sheet, and would make possible some eventual sterilization efforts. Frankly, I doubt that this will ever happen. Instead the Fed will just continue growing its balance sheet until it is certain the tide has turned, by which time hyperinflation will be unavoidable. As usual, the central banks are 90 degrees out of phase and their "countercyclical" efforts are actually reinforcing the business cycle and fanning the flames.

2008 Oct 08 09:32 AM

[Chris B:]

Hiding the expansion of the fed's assets and liabilities in accounting hidey-holes changes nothing about the government's credit worthiness or the solidity of the currency.

The bottom line is we are taking massive gambles to avoid a normal and healthy recession. If these steps were the wrong ones to take after the tech stock meltdown of 2000-2001, why are they necessary now?

2008 Oct 08 09:53 AM

[moonbat1775:]

Let's see. The government creates Treasury notes and sells these to the Fed for cash which the Fed creates out of nothing. The Fed then uses those Treasury securities to mop up the money it just lent the government?

2008 Oct 08 10:06 AM

[JasonC:]

No gamble at all - demand for safe treasuries is infinite at the moment.

What is actually missing is direct action to arbitrage the huge spread between treasuries and corporates. The Fed appears to think that should be left to banks or other private investors, but that approach obviously isn't working. And the reason why is clear - British semi-nationalization, Wa Mu, AIG, Lehman, Fannie, Bear - all of them scream that the authorities will simply pick a fate out of the air for any financial institution they please, each one different from the last, idiosynatic, responding to populist demands to hang all bankers on the one hand, and panic over the fear that creates on the other.

The Fed simply has to do it itself, because nobody is going to trust governments this erratic and populist-driven. Until an investor in the bond of a bank can expect return *of* principle, there is no private banking system - it is a ward of the state. The authorities can make it safe to invest in bank debt, or they can continue playing the idiot populist game of blaming the institutions they are trying to save.

If they decide that bank debt is going to be safe and is going to pay, they can do so and show that it is so by buying it. Balance sheet accounting has nothing to do with it. It is a political decision and they can create the money involved.

The western world has to decide, this instant, whether is wants to have a financial system or not. If it does, it needs to permanently get rid of the idea that it can punish all financiers for being financiers. Either it is possible to lend to a bank and profit by doing so, or it isn't. Make up your freaking mind.

2008 Oct 08 10:12 AM

[Jason Rines...:]

Excellent comments.

2008 Oct 08 10:54 AM

[Reinko:]

The first table above (the one in the green) has to be 'millions of US$' and not billions of US$.

Just a factor 1000 to large.

I sometimes wonder what kind of math is teached at the US high schools...

2008 Oct 08 10:57 AM

[SW Richmond:]

Jason, you refute your own points.

"..that approach obviously isn't working. And the reason why is clear - British semi-nationalization, Wa Mu, AIG, Lehman, Fannie, Bear - all of them scream that the authorities will simply pick a fate out of the air for any financial institution they please, each one different from the last,"

Absolutely agree. No one is smart enough to manage an economy, and therefore no one should have the power to try to do so. And I agree that one would have to be an idiot to put money in this market, when the loose cannons at Treasury and Fed roll about the deck, smashing indiscriminately and unpredictably everything they come close to.

And then you go on to deride "populism" three or four times; the unwashed masses are obviously too stupid to know what's good for them, yes? So the chosen ones will make decisions for all, yes? Just like Paulson, yes? You agree with central control, you just don't think they're doing it right.


"The western world has to decide, this instant, whether is wants to have a financial system or not."

My answer is Yes, but not THIS one. I want a truly private one, not one that is in the hands of an international banking cabal made up of overeducated underachievers who went to ivy league schools, ran and profited from the very schemes that are crashing the world's economies right now, and yet somehow still believe they know how to run a world economy.

DIRECTED ECONOMIES DON'T WORK, and no amount of pining for the old days will make it work. When money itself requires massive intervention to retain its credibility, the problem lies in the (fiat) money itself, and in the mechanism put into place to make it possible (the central banksters).

We are now in the throes of massively unwinding decades of malinvestment, made at the direction / control of the morons that run the current system. Hang them, from piano wire, right fricking now.

2008 Oct 08 11:10 AM

[moonbat1775:]

"My answer is Yes, but not THIS one. I want a truly private one,..." SWRichmond

Amen, Amen, Amen

For the trillionth (up from billionth) time: What part of "government backed banking cartel" sounds like the free market?

2008 Oct 08 11:25 AM

[Smarty_Pants:]

What's that? The sound of helicopter blades?

We're SAVED!! (not)

2008 Oct 08 12:01 PM

[flow5:]

This was the operating procedure used extensively by Treasury-Reserve authorities during WWII. And back then, legal reserves stood (as of Oct 21, 1943) at 83.1%, of deposit liabilities. The Treasury's balances piled up in anticipation of the need for further funding, in the financing of the war. This ultimately became the rational, for the long-standing exclusion of the Treasury's General Fund Account, from the assets included in the money stock.

The source of alarm and confusion is that there’s no unique price effect of federal outlays as compared to state and local government outlays, or expenditures by the private sector. The shifting of funds to and out of the Federal Reserve has a dollar for dollar effect on member bank reserves, but that problem is dealt with through open market operations. Whenever excessive reserves are pumped into the System because of "support" operations, the Manager of the Open Market Account sterilizes the System’s legal reserves, after the need for the support operation has passed.

I believe that there is another example? that during WWI,I the member banks could have converted their IBDDs into the entire amount of Federal Reserve bank notes (National Currency $660 mill) without the necessity of any expansion of Reserve Bank Credit.

2008 Oct 08 01:49 PM

[fran:]

are the treaury documents held by the FED of equal value to those held by the SSA "trust fund"?

more "full faith and promise" stuff?

America, you're bankrupt and more of the world nations are joining into the fray.

2008 Oct 08 02:09 PM

[Moon Kil Woong:]

Great we have a rouge Fed printing billions of $. No wonder no one trusts anyone, esp. since the fed should reverse their actions eventually and leave everyone high and dry. Get your free money while you can. Sorry sir, only for my bank friends and rich businesses that over leveraged like them. If your a ordinary person give me your money, not that it will be worth anything if I have a say about it.

2008 Oct 08 11:21 PM

[bearfund:]

constructe, actually given that "everyone knows" the Fed will eventually reverse their actions (I disagree), it would be a lot better for them to just do that now. Right now I, and I know many of you, have piles of gold bullion sitting in vaults and safes. Because the prevailing interest rates on currency are negative, and the government in its wisdom has decided that gold and silver will no longer circulate, that wealth is going to stay right where it is, helping no one and contributing nothing to growth. However, had the Fed raised interest rates this morning to 15% instead of cutting them to 1.5%, I would have been happy to buy some dollars and start lending at interest rates ranging from 17 to 30%. That captive wealth could be put to work. The Fed underestimates the extent to which lowering interest rates actually hinders growth in exactly this manner. It should be prohibited by law from lending money at an interest rate below the 24-month moving average of CPI increases - calculated in the original way (i.e., right now it would be about 9%).

2008 Oct 08 11:52 PM

[venividivici:]

Thank you for your excellent posts SWRichmond. You are a shining light of reason. America needs people like you.

2008 Oct 09 10:07 PM

[zrussell:]

"Potter's (FED) not selling, Potter's buying!"

Mar 19 05:48 PM