An interesting trend has developed in the Federal Reserve’s asset holdings, a trend that the newly created term auction facility is designed to accelerate.
The Fed seems to have become in some people’s minds an institution with immense and mysterious abilities to solve all our current economic problems. But we should not forget that its primary power and responsibilities come from the simple act of controlling the nation’s supply of money. The Fed creates new money by purchasing assets from private sector holders, paying for these purchases by adding an accounting entry to the Federal Reserve deposits in the recipient’s bank. These deposits can then later be used by the bank to make a withdrawal of currency, so that ultimately the Fed’s asset purchases end up as currency held by the public.
The overnight interest rate on Federal Reserve deposits lent from one bank to another is known as the federal funds rate. Because this rate is extremely sensitive to the quantity of reserve deposits in the system, the Fed can (and largely does) think of its money-supply decision solely in terms of this one interest rate. To the extent that we instead summarize monetary policy in terms of the quantities of assets as opposed to levels of interest rates, we would almost always be focusing on the liability side of the Fed’s balance sheet, namely the reserve deposits credited and currency outstanding.
The table below revisits a summary of the Fed’s balance sheet that I employed in a discussion in September. I noted then that despite the aggressive operations by the Federal Reserve in August, as of mid-September there had been no effect on outstanding currency. Updating those calculations, we see that since September, there has been a $5 billion increase in currency in circulation, but this is hardly something to alarm monetarists (whom I define as those who put more emphasis on the supply of money rather than the level of interest rates), because there is always a surge in currency in November attributable to a big increase in demand for cash during the Christmas shopping season. In fact, this year’s November currency gain was much more modest than in a typical year. In each of the previous three years, the currency increase from mid-August to mid-December averaged $14.5 billion, almost three times what we’ve seen for 2007.
Aug 8 to Dec 12
|Total dollars created||818,498||822,726||4,228|
|Less: Reverse repos||-31,647||-37,942||-6,295|
|Discount window loans||251||3,047||2,796|
|Total dollars held||818,498||822,746||4,248|
|Currency in circulation||813,051||818,295||5,244|
Although there’s not much special on the liability side of the Fed’s balance sheet this season, the asset side is another story. In years past the Fed has implemented the Christmas currency surge with a big purchase of Treasury bills in November. Over each of the last three years, the Fed’s holdings of Treasury securities increased by $18 billion on average between the second week of August and the second week of December. This year, that magnitude decreased by $16 billion. The Fed has made a huge swap from Treasuries into repurchase agreements this season compared with its fourth-quarter operations in years past.
When I first commented on the switch from outright Treasury purchases to repos last September, I thought the explanation was that the Fed wanted to retain flexibility for dealing with financial market turmoil. As the switch has continued in stark contrast to previous November operations, however, it’s become clear that this was a deliberate policy decision on the part of the Fed. The Fed now appears to be using the choice of the assets it acquires through open market operations, rather than solely the consequences of those operations for the supply or reserves and currency, as an instrument of monetary policy. With repos, the asset that the Fed acquires is essentially a collateralized loan payable by the private counterparty to the transaction. The collateral for the loan could be Treasury securities and their derivatives, or certain debt obligations or mortgage-backed securities issued by Fannie Mae or Freddie Mac.
The Fed’s new term auction facility seems primarily designed to advance this objective further. Under the plan, banks can borrow directly from the Fed using even weaker collateral than is allowed for repos. Other things equal, this new borrowing would create new reserve deposits. To prevent this from having an effect on the supply of total reserves or the money supply, the Fed intends to contract its holdings of Treasury securities even further, announcing this week that it will redeem an additional $15 billion in Treasury bills.
Steve Cecchetti, former Research Director of the Federal Reserve Bank of New York and currently a professor at Brandeis University, is coming to the same conclusion:
At its most basic level, the TAF is simply another mechanism for doing open market operations. It seems like one of those technicalities that we normally ignore as being irrelevant. To understand why they are doing this, we need to think about the fact that the central bank can use operations to either change the size of its balance sheet or the composition of the assets that they hold. The first of these is what we teach and understand. It is the traditional policy directed at maintaining the federal funds rate at its target level. The second is different, and that’s what the TAF is about. This new mechanism is aimed at shifting assets from US Treasury securities (that are purchased for the permanent holding or taken in repurchase agreements) to some of the lower quality stuff that is accepted as collateral for discount loans. And the purpose of this is to try to reduce the risk premia charged in the one-month and three-month interbank lending markets.
So why is it the responsibility of the Fed to try to set not just the level of the fed funds rate but also the spread between the funds rate and the LIBOR rate? One possibility is that the Fed thinks that the market is currently overweighting the riskiness of short-term interbank loans. If so, that seems to be a different vision of the role of monetary policy from that articulated by Ben Bernanke in 2002:
I think for the Fed to be an “arbiter of security speculation or values” is neither desirable nor feasible.
A second possible justification is that the market is correctly pricing the riskiness of these assets, but that the chief risk involves an aggregate financial event that the Fed, through actions like the TAF, could mitigate or avoid altogether.
anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed.