What’s going to happen to the Fed’s balance sheet?

The Federal Reserve has increased its assets from $900 billion in 2007 to over $3,150 billion and still climbing today. On the liabilities side of the Fed’s balance sheet, reserve balances held by banks have gone from $10 B in 2007 to $1,750 B and climbing today. My expectation had always been that this would be a temporary situation, with a return to historical norms when economic conditions improved. Recently, three different teams have independently studied what that transition back to normal might look like. One study was carried out by Robert Hall and Ricardo Reis (professors at Stanford and Columbia, respectively) and another by Seth Carpenter, Jane Ihrig, Elizabeth Klee, Alexander Boote, and Daniel Quinn (all economists at the Federal Reserve Board). I participated in a third study with David Greenlaw at Morgan Stanley, Peter Hooper at Deutsche Bank, and Frederic Mishkin at Columbia. Our analysis used a similar methodology to that conducted by the Fed staff, and we reached similar conclusions to theirs, while Hall and Reis took a broader and more theoretical perspective. Here I describe the methods and findings of our study.

In our baseline calculations we assumed that the Fed continues to buy long-term assets at its current pace through the end of 2013. We further assumed that beginning in January, the Fed would buy new assets only to the extent necessary to replace maturing holdings so as to keep total assets steady through 2014, and then begin to sell MBS late in 2015 in order to arrive at zero MBS holdings after 2019. These and other assumptions are summarized in the table below, with the implied path for Fed assets displayed in the following graph.



Variable Assumed growth path
Asset purchases Continue at current pace through December 2013, slow to maintenance levels (stock stable) through 2014, stop (stock declines) in 2015.
Asset sales MBS sales start late 2015, completed in 2019
MBS prepayment Follows market models
Liabilities Currency grows at 7% AR (2pp above Blue Chip forecast for nominal GDP growth per historical experience);
Required reserves Grow at 4% AR
Interest rates Driven by Blue Chip consensus forecast
Fed capital Grows at 10% AR per historical average
Operating expenses Grow on historical trend





Figure 1. Federal Reserve assets under baseline simulations. Source: Greenlaw, Hamilton, Hooper, and Mishkin (2013).

Reserves would return to more normal historical levels from one of two forces. Some of the reserves will end up as currency held by the public, represented by the green region in the graph below. Selling off the Fed’s assets (or allowing them to mature without replacing) would be the other main force bringing excess reserves back down.



Figure 2. Federal Reserve liabilities under baseline simulations. Source: Greenlaw, Hamilton, Hooper, and Mishkin (2013).

We assumed that interest rates would rise over the next several years as predicted in Blue Chip consensus forecasts, as summarized in the figure below.



Figure 3. Baseline interest rate assumptions. Source: Greenlaw, Hamilton, Hooper, and Mishkin (2013).

The relevance of these assumptions is that if the Fed is buying assets when long-term rates are low, and selling them when rates have risen, the Fed will make a capital loss on its purchases, as indicated by the red region on the graph below. The Fed will also have to be paying more in interest on reserves as rates rise (the blue region below).



Figure 4. Baseline income receipts and expenses. Source: Greenlaw, Hamilton, Hooper, and Mishkin (2013).

According to our baseline calculations, during 2017-2019 these expenditures for the Fed will be greater than income coming in from interest on retained assets (the green region in the graph above). This can be seen more clearly in the graph below, which plots Fed inflows minus outflows for each year.



Figure 5. Federal Reserve net income available for remission to the Treasury. Source: Greenlaw, Hamilton, Hooper, and Mishkin (2013).

Is this a problem that the Fed will be operating at a loss? One perspective is to note that for the past several years the Fed has been making unusually large profits which it returned to the Treasury, and we are anticipating that this will continue to be the case for the next several years. One calculation of interest is to look at the cumulative profit or loss by the Fed since the financial crisis began. This cumulative net sum remains positive in our baseline simulation (the black line in the figure below)– the Fed’s profits in its good years exceed its losses in its bad years.



Figure 6. Federal Reserve cumulative net income relative to pre-crisis trend under alternative scenarios. Source: Greenlaw, Hamilton, Hooper, and Mishkin (2013).

On the other hand, there is still an interesting logistical question of how the cash shortfall will be covered. JP Koning argues that recapitalization of the Fed by the Treasury in such circumstances is not a sure thing. The Fed’s Plan A appears to be that they will simply create new reserves as necessary to cover any losses incurred. In terms of the accounting, the creation of new reserves (a Fed liability) coincides with the acquisition of an asset recorded in the Fed’s new “deferred asset account”. The theory is that this is simply an account that gets credited, and represents a claim on future Fed earnings which normally would have been returned to the Treasury but which instead will be retained by the Fed in order to rebuild the Fed’s working capital. That is, the deferred asset account is an IOU from the Treasury to the Fed, counted by the Fed as one of its assets.

Accounting aside, there is an interesting question how that would play out in terms of politics and public perceptions of the Fed. I could certainly imagine politicians grandstanding over the fact that the Fed will be paying out billions to big Wall Street banks at the same time that the Fed is losing billions of dollars for taxpayers. And how would this affect expectations of inflation in an environment when on the fiscal side interest expenses and debt continue to grow while the Fed’s only resource for covering its losses is to print more money?

The Fed could spare itself some of this awkwardness by simply refusing to sell any of its assets, as a result of which it would never have to realize the loss. According to our market model of mortgage prepayment, the Fed could allow its MBS simply to mature on their own, in which case we would be back to normal levels of reserves by 2020 instead of 2018 (see the red hashed region in Figure 2 above). This would allow the Fed to continue to report a positive profit, as represented by the dashed blue line in Figure 7 below.



Figure 7. Federal Reserve net income available for remission to the Treasury under alternative scenarios. Black: baseline assumptions. Dashed blue: no asset sales. Red: interest rates 100 basis points higher than baseline scenario beginning in 2016. Source: Greenlaw, Hamilton, Hooper, and Mishkin (2013).

On the other hand, if interest rates should rise more quickly than the Blue Chip consensus, the Fed’s losses would be larger than anticipated under our baseline assumptions. In our paper we evaluate a number of alternative possibilities. To highlight the most dramatic of these, if the Fed continues expanding its balance sheet during 2014 rather than hold it constant as assumed in our baseline scenario, and if interest rates are 200 basis points higher starting in 2016 than assumed in our baseline, we calculate that the Fed’s deferred asset account could reach as high as $370 B.

Now, some might argue that this is exactly the purpose of the Fed’s large-scale asset purchases, namely, to take maturity risk off of holders of Treasury bonds (and thereby reduce the term premium on long-term bonds), and absorb that risk on the Fed’s own balance sheet. Absorbing risk means that in some states of the world you take a loss. Nor should any of our calculations be taken to suggest that the Fed’s efforts so far to provide support for a weak economy have been a mistake– the benefits in terms of lower unemployment could greatly exceed the loss, even if those benefits were valued solely for their implications for receipts and expenditures of the U.S. Treasury.

Notwithstanding, before we made these calculations, my assumption had been that the Fed would eventually sell most of the assets it has recently required. However, I’m now guessing that the Fed may never be comfortable doing that. And if you’re never going to sell, it’s a reason to be a little more cautious about how much more you plan to buy, particularly if, as I believe, the incremental benefit of additional purchases at this point is small.

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33 thoughts on “What’s going to happen to the Fed’s balance sheet?

  1. W.C. Varones

    Some years back, I asked on this site whether any central bank had ever been able to shrink its balance sheet.
    Menzie replied with the example of Japan in the 2000’s. That was true at that point, but it didn’t last long. We all know that the BOJ has had to blow out its balance sheet once again.
    I remain skeptical of the Fed’s “exit strategy.”

  2. Rick Stryker

    Thanks very much for the post. 2 questions:
    If the Fed needs to drain reserves to prevent an incipient rise in inflation, how can it avoid selling its assets?
    Also, how did you calculate the mark-to-market losses on the portfolio as assets are sold? Did you use MBS and Treasury pricing models? Sorry if it’s obvious and I missed it but it wasn’t clear to me.

  3. JDH

    Rick Stryker: Alternatives to asset sales are raising interest on reserves and raising required reserves. Realized capital losses are calculated by using the interest rates specified in Figure 3 to calculate the market value in each year of each asset.

  4. Nemo

    The Fed believes they will never have to sell assets because they can contain inflation by raising interest on excess reserves (IOER).
    The theory is that you can keep people from spending money by printing new money and giving it to people who already have money.
    What could possibly go wrong?

  5. 2slugbaits

    Accounting aside, there is an interesting question how that would play out in terms of politics and public perceptions of the Fed.
    So my reading is that while the execution and economics of the Fed’s unwinding might be a little tricky (and we better hope Bernanke’s successor is at least as capable), the primary risk is political. At one end of the political spectrum there is the “Occupy” crowd that sees everything the Fed does as a big bank bailout, while at the other end of the political spectrum we have a certain Tea Party governor threatening Texas justice if the traitor and currency debaser Helicopter Ben visits the Dallas Fed.
    And how would this affect expectations of inflation in an environment when on the fiscal side interest expenses and debt continue to grow while the Fed’s only resource for covering its losses is to print more money?
    Here we need a good (and plausible) model of how private sector actors form inflation expectations. Adaptive expectations isn’t fashionable, but forward looking rational expectations models aren’t much better, if at all. Do we really think a large one-off spike in currency held by the public would be enough to re-anchor inflation expectations? I think you need two things in order to have inflation. The first is aggregate demand strong enough that it will put pressure on reserves. And for that to happen you really need a tight labor market sufficient to sustain “cost push” wage increases. Not exactly an immediate concern. The second requirement is a belief that the Fed will continue to “print” money over an extended period and will not make any future effort to contract the economy.
    I believe, the incremental benefit of additional purchases at this point is small.
    The thing that I don’t believe is getting enough attention is CBO’s assumption that we won’t suffer another deep recession over the 10 year horizon. For me that risk argues for an even more aggressive fiscal policy that ensures we get back to full employment as soon as possible. As you say, there probably isn’t much benefit in QE5, which tells me immediate fiscal consolidation makes no sense because it makes it quite likely that we’ll enter another recession before we’ve completely recovered from the Great Recession. We should learn from Great Britain’s mistakes. Here’s an analogy. The bubonic plague haunted Europe before the mid-14th century and many times after the mid-14th century. What made the Great Plague so “great” and catastrophic was the series of bad harvests and famines over the preceding three decades that so weakened the population. I worry a lot about entering the next recession still at the ZLB and large deficits due to weak economic growth.

  6. Bruce Carman

    Note that the historical precedent for the debt-deflationary regime of the Long Wave Trough is for central bank reserves (including gold historically) to converge with the value of bank loans (or higher during outright price deflation).
    Therefore, US bank loans will cease growing or contract signicantly in the years ahead (run offs, charge-offs, restructuring, etc.), the Fed’s balance sheet will expand well beyond ’13 and the implied $4 trillion by year end, or some combination, the latter being the more likely scenario.
    Note also that the post-’07 (onset of the debt-deflationary regime) trend rate of M2 plus institutional money funds and large time deposits (M2+) less bank cash assets (not counting vault cash) has decelerated from the long-term 6% rate to 3% today, coincident with post-’00 and -’07 trend nominal GDP rates decelerating from 5% before ’00 to 3.6% and 2% since ’07. These trend rates of M2+ and GDP are the post-’07 debt-deflationary normative rate, not unlike the 1890s, 1930s-40s, and Japan since ’98.
    A 2-3% M2+ (less bank cash) and 2% or slower nominal GDP implies that total gov’t spending will grow very little, if at all, and central bank reserve printing, growth of bank cash assets, and asset liquidation will contribute 100% to net money supply and any nominal GDP growth that occurs in the years ahead.
    Consequently, nominal interest rates will remain low and continue lower for many years to come (think Japan); the yield curve will continue to flatten with bank net margin contracting, discouraging loan growth; real interest rates will become less negative and trend around 0%; the Fed will continue QEternity indefinitely; equity market P/E will decline from 17-19 to half that in the next 5-10 years; corporate earnings will mean revert or overshoot; Aaa- and Baa-rated corporate bond yields will continue to decline; and post-’07 real GDP per capita will continue to contract.
    The debt-deflationary regime of the Long Wave Trough has barely begun. The next shoes do drop will be the real estate credit busts in Canada, Australia, China-Asia, and parts of the EU. We have a long way to go to correct the excesses of the debt/asset cycle of the reflationary Long Wave Downwave of the past 30 years.

  7. 2slugbaits

    Accounting aside, there is an interesting question how that would play out in terms of politics and public perceptions of the Fed.
    So my reading is that while the execution and economics of the Fed’s unwinding might be a little tricky (and we better hope Bernanke’s successor is at least as capable), the primary risk is political. At one end of the political spectrum there is the “Occupy” crowd that sees everything the Fed does as a big bank bailout, while at the other end of the political spectrum we have a certain Tea Party governor threatening Texas justice if the traitor and currency debaser Helicopter Ben visits the Dallas Fed.
    And how would this affect expectations of inflation in an environment when on the fiscal side interest expenses and debt continue to grow while the Fed’s only resource for covering its losses is to print more money?
    Here we need a good (and plausible) model of how private sector actors form inflation expectations. Adaptive expectations isn’t fashionable, but forward looking rational expectations models aren’t much better, if at all. Do we really think a large one-off spike in currency held by the public would be enough to re-anchor inflation expectations? I think you need two things in order to have inflation. The first is aggregate demand strong enough that it will put pressure on reserves. And for that to happen you really need a tight labor market sufficient to sustain “cost push” wage increases. Not exactly an immediate concern. The second requirement is a belief that the Fed will continue to “print” money over an extended period and will not make any future effort to contract the economy.
    I believe, the incremental benefit of additional purchases at this point is small.
    The thing that I don’t believe is getting enough attention is CBO’s assumption that we won’t suffer another deep recession over the 10 year horizon. For me that risk argues for an even more aggressive fiscal policy that ensures we get back to full employment as soon as possible. As you say, there probably isn’t much benefit in QE5, which tells me immediate fiscal consolidation makes no sense because it makes it quite likely that we’ll enter another recession before we’ve completely recovered from the Great Recession. We should learn from Great Britain’s mistakes. Here’s an analogy. The bubonic plague haunted Europe before the mid-14th century and many times after the mid-14th century. What made the Great Plague so “great” and catastrophic was the series of bad harvests and famines over the preceding three decades that so weakened the population. I worry a lot about entering the next recession still at the ZLB and large deficits due to weak economic growth.

  8. Left Coast Bernard

    Prof. Hamilton,
    I’m still having trouble with the fact that when the Fed buys a T-bill from someone in the public, that means that Uncle Sam’s debt has been re-paid. Uncle Sam no longer owes anyone any money or interest.
    If that T-bill matures, you say that the Fed may simply buy another T-bill from the public.
    It is also the case that the Treasury will pay the Fed the value of the T-bill on maturity, as if the Fed is a member of the public. Then later, the Fed will return the Treasury’s payment to the Treasury as profit from the Fed.
    It seems strangely artificial. Once the Fed has a Treasury bond on its books as an asset, then Uncle Sam is carrying the same bond in his books in two places: once as an asset and once as a liability at the Treasury.
    The Fed and the Treasury are only a few blocks apart in Washington. Why don’t they meet for lunch once a month and balance these out?
    If the Fed wishes to buy another T-bill, it wouldn’t have to ship some cash to its offices from the Bureau of Printing and Engraving, also just a few blocks away. The Fed would just get the cash it needs from the usual place.

  9. JBH

    I thought this was a wonderful paper when I read it a couple weeks ago. I’d like to especially complement you on the way the relevant regression equations were centered on the page in block form at just the right places throughout the paper with all the pertinent statistics right up front for all to see. This is the way empirical economics should be presented! R-squares and t-ratios placed right with the equations interwoven right into the flow and not otherwise relegated to the bowels of some appendix, or as is often the case not even shown.

    Some reviews claim the paper covered too-short-a-time-period, country coverage was not applicable to the US, etc. I myself found this not at all problematic. Relevant data of real time value is not always easy to work up. We do the best we can. But here is a big concern. You lay out the results of your model but then focus mostly (and narrowly) on the consequences of the Fed getting upside down on its ability to repay the Treasury the interest and principal from the QE assets on its balance sheet when it begins its exit. You’re off in the wing here, not center stage; there are far bigger fish to fry. Where is the discussion of the potentially huge unintended consequences that hardly anyone is even aware of? Take the bazooka fired this weekend at all the depositors in Cypriot banks. The unintended consequences promise to roil markets dramatically tomorrow and Tuesday and even more so beyond. This is a first in the history of modern fiat money. Where is the analogous discussion stemming out of your work of the manifold unintended consequences that will go off in all directions like fireworks when the Fed begins exiting its QEs? Hopefully coming soon.

  10. JDH

    Left Coast Bernard: The Fed pays for the Tbill by creating new reserves, on which the Fed pays interest (currently 25 basis points). The Treasury pays the interest on the Tbill to the Fed (currently 10 basis points on a 3-month bill). So the combined income statement of the Treasury/Fed is out 15 basis points per year on every dollar transaction.

    If the Fed buys a 10-year bond (currently paying over 2%), there is a net profit for the Treasury/Fed in the transaction, which is the kind of operation that has produced the recent large profits and large remissions from the Fed to the Treasury.

    However, the Fed may subsequently end up selling the 10-year bond at a loss, and in the mean time be forced to pay a higher interest rate on reserves held by banks, as represented by the red and blue regions respectively in Figure 4. These are what we are talking about here.

  11. ppcm

    At the time of collapse, the commercial loans as applied to the total real estates mortgages including private and corporate, were in an amount hovering around 5 Trillions USD ( figures as provided by the US central Bank when consolidating the balance sheets of the main banks operating on the US territory). When trying to approximate a total loss estimate, a Pareto distribution as applied on the total sample of the MBS was of around 1 trillion USD. Those are losses on the impaired value of the real estates with a normal distribution of owners. Should the distribution be changed as it is, the capital loss is transferred to the Central Banks and withheld from the banks. The US Feral Reserve has purchased 1.2 Trillion USD in MBS, the artificial value of the MBS today has to be matched by the same level of employment and incomes and capital gains of the private sector yesterday.
    Everything remaining the same for the interest rates when shoring upwards I-S L-M

  12. MarkS

    Dr. H –
    1. From the last partagraph of “Crunch Time” – “If long-run fiscal policy were shifting in the right direction, consistent with a gradual decline in the debt burden, accommodative monetary policy would be the appropriate response to a weak economy.”,
    What makes you think that adding more credit market debt to the $56 Trillion already accrued in the USA would be the “appropriate response”? Isn’t the real problem that the current level of credit debt can no longer be serviced, requiring subsidy by the FED to prevent collapse?
    2. Why does your “Assumed Growth Path” (Table just before Figure 1 above), have FED capital increasing at 10%/y while required reserves increase at only 4%/y? Isn’t one of the greatest problems exposed by the 2007 meltdown, that banks had insufficient reserves to absorb losses?

  13. flow5

    Contrary to Friedmanites, reserves aren’t a tax so the remuneration rate should be lowered, & reservable liabilities & reserve ratios should be raised.
    The IOeR policy blunder induces dis-intermediation (where the size of the NBs shrink but the size of the CB system remains the same) – just like in the 1966 S&L crisis.
    Reg Q ceilings should be re-imposed on the CBs (banks pay for what they already own), & the money stock should be controlled via legal reserves & not via interest rate pegs.
    Monetary policy objectives should be formulated in terms of desired rates-of-change (roc’s) in monetary flows (MVt) relative to roc’s in real-gDp.
    Contrary to economic theory, monetary lags are not “long & variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, & for (2) inflation indices (for the last 100 years), have been mathematical constants. However, the FED’s target (interest rates), is indirect, varies widely over time, & in magnitude.
    And roc’s in bank debits (our means of payment money times its rate of turnover-MVt) can serve as a proxy for all transactions (aggregate monetary purchasing power).
    I.e., allow member-bank legal-reserves to grow at no greater rate than would allow the rate of increase in MVt to equal the rate of increase in real-output.

  14. flow5

    I.e., the IOeR policy fosters an easier FOMC money policy & eventually stagflation. Real-gDp is up only 2.5% in 16 quarters ($13,326 in 4th qtr 2007 vs. $13,656 in 4th qtr 2012). And it took 4 years to get back to “break even”. But the PCE is up 5.5% in 16 quarters ($110.275t in 9/2008 vs. $116.342t in 1/2013). Reflation has accelerated faster than real-output (giving us stagflation). It’s all because economists don’t know the difference between money & liquid assets (Gurley-Shaw thesis).

  15. Steven Kopits

    From Reuters:
    In a radical departure from previous aid packages, euro zone finance ministers want Cyprus savers to forfeit a portion of their deposits in return for a 10 billion euro ($13 billion) bailout for the island, which has been financially crippled by its exposure to neighboring Greece.
    The Euro zone finance ministers have engineered a universal bank run in Cyprus by design? Are these guys out of their minds? If I’m a Spainard or Italian, do I have to count on the possibility of this sort of tax? It may make bank runs virtually impossible to contain within the Euro zone.
    Further, if I were a Cypriot, I’d vote to leave the Euro zone, indeed the EU, in a flash.

  16. dan berg

    The Fed has increased its assets (lets say) 300%; the Chinese have increased debt/credit/M2 over 800% and rising; are there really no risks, limitations, repercussions?

  17. Ricardo

    Professor,
    Thank you very much for the analysis. It is superb!
    I have noticed that the FED balance sheet has remained relatively stable for about 18 months. While the FED has increased its purchases of MBS it has reduced other areas especially its special programs. It is interesting to note that our current sluggish recovery in a significant way tracks the level of the FED balance sheet. Could this be due to the effects of crowding out by FED?

  18. pete

    using book values here rather than market values? Gold is a very big piece of the Fed’s assets at current prices, about 40X its book value.

  19. Ricardo

    Steven Kopits wrote:
    …if I were a Cypriot, I’d vote to leave the Euro zone, indeed the EU, in a flash.
    Steven, If I were a Cypriot, I’d vote to leave the Cypriot banking system – maybe even Cyprus itself.
    When I heard this story over the weekend I burst out laughing. How long would it take these Cypriot politicians to withdraw their money if they thought they would lose 10%? Yet, they think their fellow Cypriots are so stupid that they wouldn’t?
    And they wonder why the Cypriot banks are in trouble?

  20. Steven Kopits

    Ricardo –
    My concern is that the Cyprus grab has the imprimateur of 15 EU finance ministers and the IMF.
    There is an assumption that the Russians will take a 10% haircut and leave their money there. What if they remove their money after the haircut? This bailout could be much more expensive at the end of the week, even with the haircut.
    My concern is that, under a given set of circumstances, the EU may not be able to control bank runs. Ordinarily, a bank run is caused by the belief that others are withdrawing their money and the bank will be unable to provide the liquidity. This is remedied by promising unlimited liquidity and full value to depositors.
    However, if depositors believe their savings will be subject to a tax, a bank run cannot be managed by providing incremental liquidity. The EU has potentially destroyed a critical policy tool with this Cyprus initiative.
    That Christine Lagarde would sign up to this policy on behalf of the IMF is, to me, simply shocking. For what? To make a point? To grab $10 bn from some Russians? This sort of petty-mindedness is driving IMF and EU finance policy? To me, it speaks to an incredible lack of technical skill and unbelievable recklessness.

  21. Gilbert

    The Fed was banking on the fact that a Cyprus style bail-in would be applied in the United States as well, removing further need for Quantitative Easing. With that plan rejected even in the small island nation of Cyprus, QE infinity will continue and no real escape plan seems possible.

  22. JJTV

    High excess reserve balances will be the norm heading forward for three reasons:
    1) High Excess Reserve Balances Reduce Delays in the Payment System (evidence supports this and it has been measured since Oct 9, 2008)
    2) Increased reserve balances resulted in dramatic reductions in the demand for daylight credit provided by the Federal Reserve. This reduces the risk exposure of Federal Reserve Banks and the deposit insurance fund to a bank failure.
    3) By paying interest on reserves, maintaining these balances is made less expensive for banks, as they suffer little or no opportunity costs by holding reserves overnight and throughout the day.
    The Fed believes high excess reserves create a more efficient payment system and provides them more control over the interest rate.
    The IoER policy implemented in 2008 also moved the Federal Reserve out of a “corridor system” and into a “floor system”. Under a floor system the level of reserves and the overnight interest rate are divorced. The IoER or “floor level” also becomes the deposit level. This disconnect works as long as there are sufficient excess reserves within the system, which in the case of the US, there are adequate excess reserves.
    It should also be noted that future increases in the overnight rate are simply announced with the lending and deposit rates changing in tandem. Traditional models of draining reserves via FOMO are no longer required. Reserves are not the dual of overnight interest rates. Thus, when the Fed would like to “tighten” policy it will not be required to reduce the size of it’s balance sheet as draining operations are no longer required to hit the overnight target.
    The Fed likely has no intention of reducing the size of it’s balance unless it sees necessary for reasons outside of setting rates.

  23. MDueker

    Thanks for this post. One of your responses to a comment is: “Alternatives to asset sales are raising interest on reserves and raising required reserves.” What is the current status of the plan to use the nascent reverse-repurchase facility, wherein the Fed would sell long-term bonds off its books for 90 days at a time and roll over the agreements repeatedly. As long as the 3-month T-bill yield remained below the coupon yield on the underlying long-term bond, the Fed would avoid a loss on these bonds, even as long-term yields rose. Is this facility still set to be put into action, say in 2015?

  24. flow5

    Interest rates are the price of loan-funds, not the price of money. The price of money is represented by the various price indices.
    But the Fed’s monetary transmission mechanism presumes that a “liquidity preference” curve exists which represents the supply of money. In this system, interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world – a world in which interest is paid on checking accounts.
    Keynes’s liquidity preference curve (demand for money) is a false doctrine (confuses money with liquid assets). I.e., the money supply can never be managed by any attempt to control the cost of credit.
    In 1959 the Fed began allowing the member banks to count vault cash towards their reserve maintenance requirements. By confusing liquidity reserves, with legal reserves the FOMC began to lose control of the money stock (just as the BOG & FDIC raised Reg Q ceiling for the CBs on 5 successive occasions). This caused dis-intermediation & induced stagflation.
    Then in 1965, as the CBs began to buy their liquidity (instead of following the old fashioned practice of storing their liquidity), the FRBNY’s “trading desk” switched open market operational guidelines (from using a net free, or borrowed reserve position), to be dictated by the FFR “bracket racket” – which made the job of legal reserve management impossible. I.e., the effect of tying open market policy to a federal funds bracket is to supply additional (and excessive free legal reserves) to the banking system when loan demand increases.
    In 1980 the Fed thoroughly confounded by inflationary pressures, provided the NBs with the legal basis to become 38,000 CBs. Legislation also required all non-member CBs to join the system.
    But by mid 1995, legal (fractional) reserves ceased to be binding – as increasing levels of vault cash/larger ATM networks, retail deposit sweep programs (c. 1994), fewer applicable deposit classifications (including allocating “low-reserve tranche” & “reservable liabilities exemption amounts” c. 1982) & lower reserve ratios (esp. c. 1990-91), & reserve simplification procedures (c. 2012), combined to remove reserve, & reserve ratio, restrictions.
    As predicted in June 1980, under the DIDMCA, our means-of-payment money supply (then designated as M1A by the Board of Governors) came to approximate M3 (fueling the boom/bust in housing).
    Thoroughly confounded by recessionary pressures, the Fed introduced the payment of interest on excess reserve balances – thus forestalling any recover from the Great-Depression & requiring massive infusions of government credit to counteract. To wit this caused dis-intermediation within the Shadow Banks & accentuated stagflation once again.
    I.e., if the remuneration rate isn’t eliminated there will be a permanent unemployment problem.

  25. flow5

    As Hamlet said “There is something in this more than natural”:
    From the standpoint of a system’s context, the commercial banks do not loan out existing deposits (saved or otherwise). Every time a CB makes a loan to or buys securities from the non-bank public it creates new money.
    Voluntary savings are impounded within the CB system (& remunerated excess reserves freeze the flow of existing savings). That is our political & economic problem.
    When the Fed converted excess reserves to the CB’s earning assets in Oct 2008, they inadvertently induced dis-intermeditation (not deleveraging). And by artifically reducing the demand for, & supply of, loan-funds, Fed policy reduced the net interest margins for both the banks & savers.
    In order to join savers with borrowers (match savings with investment), Fed policy must be changed to eliminate the payment of interest on interbank demand deposits. Savings must be encouraged to flow through the NBs (as these funds actually never leave the CB system in the first place – the NBs are the CB’s customers).
    This would benefit the CBs, NBs, savers, & the whole economy. CB profits would rise because lowering the remuneration rate would produce higher & firmer interest rates, higher net interest margins, stablize maturity matching, & stimulate the flow of savings into investment in multifaceted ways.
    All studies show that the lower the ratio of time (savings deposits) to demand deposits (within the CB system), the higher the ratio of profits to the net worth of banks irrespective of the size of the bank. The size of the CB system is not synonymous with its profitability (i.e., flows to the NBs result in a larger decrease in expenses relative to profits). The 1966 S&L crisis is prima facie evidence.
    The secret to reversing all of the trends for the last 50 years is to get the CBs out of the savings business (this world is not meant for ordinary mortals; it’s for the merest few—men of occult knowledge and ethereal genius – Edward Meadows).

  26. Thomas

    It is simply astounding that seemingly educated and discerning people cannot grasp the obvious solution, the only real solution, to this crisis of solvency. Here are the US data points in approximate terms: total deposits and currency in the system of $10T, total public and private funded debt in the system of $60T. Since almost all money in a fiat system is a deposit liability somewhere in the banking system, and all debt resides somewhere on the asset side, there is need for an additional $50T on the liability/equity side in order to achieve balance. Alternatively, the asset side would need to shrink by $50T. Shrinking the asset side involves writing off bad loans, including sovereign ones, i.e. shrinking the global balance sheet and unwinding 100 years of debt supported asset inflation. How did the system become so imbalanced? Answer: a critical equity component of the systemic balance sheet was devalued and kicked out leaving a gaping hole. So here’s the money quote: it’s the gold, stupid. The present state of insolvency can be solved virtually overnight if the economics profession will open its mind, cast off nearly 100 years of propaganda, and return gold to the balance sheet of the banking system at a value that fills the hole. It’s the only asset capable of being written up with minimal systemic distortion. It is no one’s liability so there is no credit or debt attached. The central banks need to declare gold a marked to market reserve as the ECB has already done and enter the market bidding for gold until equilibrium is achieved. Problem solved. Keep it free. Stop setting the cost and supply of money and just let markets function. The current top down fiat monetary control system is an abomination that should offend any sentient discerning economic thinker.

  27. flow5

    “return gold to the balance sheet of the banking system”
    The last legal link to gold (prior to the “gold cover” bill of March 19, 1968), was fictional, the economic tie tenuous, & its protection was a myth.

  28. ROBERT BAESEMANN

    One problem that does not seem to get the intention it deserves is that there never was an organized market for publicly traded MBSs or CDOs. These things were bonds created out of bonds. They were huge opaque and cumbersome. For accounting purposes, they were valued a using Mark to Model accounting which meant they were valued using computer simulation models or theoretical computer models. Transactions that actually occurred were often made at prices subject to automatic buy-back provisions which is called bond parking and very different from market transactions. Since late 2006, knowledgeable people warned that the balance sheets on which MBSs appeared were at best optimistic fiction. Once the frailty of bank balance sheets became apparent, the Short Sellers swarmed on the weakest of the big banks, and ultimately they destroyed Lehman Bros. When the FED went into the business of buying MBSs based on Freddie and Fanny mortgages, There were no market prices, the FED was the only buyer of any consequence, and there seems to be no conclusion other than the FED paid book value for the MBSs it bought. Given that MBSs were subject to default if 15% of the constituent mortgages defaulted, one would think the FED now owns MBSs worth far less that what they paid for. The FED could use auctions to sell off its stock at MBSs and realize market prices, but those prices might be far far less than what the FED paid. Moreover, the FED sales at real market prices would inevitably force the revaluation of MBSs on the balance sheets of banks meaning crisis time all over again. So FED liquidation of its MBSs seems highly unlikey; rather the FED seems doomed to hold those assets until they mature.

  29. Thomas

    from flow5
    “protection was a myth”
    I’m not arguing for a classical gold standard where currency is convertible into a fixed volume of gold (price fixing), nor that a cover ratio is necessary. I’m saying that it is foolish to ignore this asset class as a reserve of the banking system. I’m arguing that by admitting the present top down centrally planned monetary system with no recognition of gold is a failure, and simply returning a market determined gold component to the monetary system, we could solve the crisis almost overnight and put this nightmare behind us. But the economics profession will have to abandon its irrational hatred for gold in order for this to happen.

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