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.
|Aug 8, 2007||Sep 3, 2008||Oct 1, 2008|
|Other F.R. assets||41,957||100,524||320,499|
|Factors supplying reserve funds||902,992||939,307||1,533,128|
|Currency in circulation||814,626||836,836||841,003|
|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.
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:
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.