As financial markets seized up last year and the economy sank to deeply negative growth rates, the Federal Reserve aggressively deployed a wide range of policy tools. It not only cut the federal funds rate all the way to its effective lower bound, but it turned to so-called unconventional monetary policy measures to stabilize the financial system and stimulate the economy.
These measures had dramatic implications for the Fed’s balance sheet. Back in mid-2007, the Fed held a simple portfolio that included outright holdings of about $800 billion of Treasury securities and relatively little else. As the use of unconventional policies intensified in the fall of last year, the balance sheet expanded quickly and included a broad array of assets and facilities. As one sign of this expansion, the statistical release summarizing the balance sheet, the H.4.1 release, expanded from four pages to twelve. The balance sheet today stands at around $2.25 trillion, several times the size it was before the financial crisis.
As suggested by that massive increase, the Fed’s balance sheet has moved to the forefront of its policy efforts. Accordingly, to understand the policy choices that lie ahead for the Federal Reserve, one has to understand how the balance sheet got to where it is and what effects it has had on financial markets. That will be the topic that I address in my remarks tonight. Before proceeding, I should note that the views I express here are my own and are not necessarily shared by the Federal Open Market Committee (FOMC) or other Federal Reserve staff members.
Evolution of the Balance Sheet
The initial expansion of our balance sheet was driven primarily by efforts taken to provide short-term funding to the markets. These facilities—including the Primary Dealer Credit Facility, the Term Auction Facility, the foreign-exchange swaps with other central banks, the Commercial Paper Funding Facility, and the various money market support facilities—were focused on extending credit at maturities of up to three months to various types of firms. These liquidity facilities were a key part of the government’s efforts to restore stability to the financial sector. To be sure, they were only part of a broader policy response that had many important dimensions, as other efforts had to address the substantial capital needs of financial institutions and the considerable uncertainty that investors faced about the health of the financial system. But giving financial institutions greater confidence about their access to funding, and that of their counterparties, was a crucial step toward achieving stability. At this juncture, it is well appreciated that short-term funding markets are functioning much better and that liquidity pressures for most financial institutions have subsided.
I would argue that creating these liquidity facilities and implementing them was a lot harder than exiting from them. In fact, the exit from these facilities to date has been fairly straightforward. Almost every facility was designed to provide a useful source of funding during stressed financial market conditions but to be an unattractive source of funding once markets returned toward more normal functioning. That structure has worked extremely well. Summing across these facilities, the total amount of credit extended has fallen from a peak level of $1.5 trillion late last year to around $160 billion today. We expect these balances to continue to decline over time, with many of the facilities set to expire on February 1.
With the liquidity facilities winding down, the composition of the Fed’s balance sheet has shifted notably towards the assets acquired under the large-scale asset purchase programs, known inside the Fed as “LSAP” programs. The Fed is currently in the process of purchasing nearly $1.75 trillion of Treasury, agency, and agency mortgage-backed securities through the LSAP programs. We have already completed our purchases of Treasury securities, totaling $300 billion. And our purchases of agency securities and mortgage-backed securities (MBS) are well advanced. Indeed, we have completed purchases of $155 billion of agency debt securities to date, out of a target level of $175 billion, and of just over $1 trillion of MBS, out of a target level of $1.25 trillion.
With these purchases, we have a total of about $1.8 trillion of Treasury, agency, and mortgage-backed securities on our balance sheet today. These holdings have been steadily increasing as the liquidity facilities have wound down. As a result, although the total size of our balance sheet has held relatively steady since the fourth quarter of last year, there has been a very important rotation taking place in its composition toward the assets purchased through the LSAP programs. As we complete the purchases scheduled through the first quarter of 2010, this component of the balance sheet will continue to grow, with the total amount of securities held projected to reach $2.1 trillion.
Given the importance of these asset holdings in the current balance sheet, I will focus my remaining comments on them, addressing three broad questions. First, what were the intended effects of the asset purchases and were they achieved; second, will winding down the purchases cause an adverse reaction in markets; and third, how will policymakers manage to tighten financial conditions with the expanded balance sheet.
Intended Effects of Asset Purchases
The first question I consider is whether the asset purchases have had their intended effects. It is important to recognize that the LSAP programs differ from the Fed’s liquidity policies in terms of their policy intent. The LSAPs were not aimed at supplying liquidity to financial institutions or at reducing systemic risk. Instead, they were intended to support economic activity by keeping longer-term private interest rates lower than they would otherwise be.
A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.
For Treasury securities, the reduction in yields would occur through narrowing the term premium, or the expected excess return that investors receive for their willingness to take duration risk. By removing a considerable amount of duration through its asset purchases, the Fed has kept the term premium narrower than it otherwise would have been. In addition, the purchases of mortgage-backed securities remove prepayment risk from the market. Investors generally find it challenging to hold the negative convexity of MBS associated with prepayment risk, and hence they demand an extra return to bear that risk, which keeps MBS rates higher than they would otherwise be. The removal of a considerable amount of this risk by the Fed’s purchases would be expected to lower MBS rates by offsetting this effect. With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.
In addition to the portfolio balance channel, Fed purchases could raise the price of a particular asset if it improved the liquidity of that instrument. That effect would presumably arise in situations in which trading flows were very one-sided and the Fed’s purchases restored some balance to market dynamics. In those circumstances, the liquidity premium could fall if investors and dealers knew that they could unload that type of security in volume to the Federal Reserve at market prices.
Even if we understand the way that the LSAPs could have an effect on longer-term interest rates, actually quantifying that effect is a challenge. It is difficult to measure precisely the total effect of the LSAPs on longer-term interest rates, but I believe that the effect has been substantial. This can be seen in the movements in longer-term Treasury yields and MBS rates around the times of key announcements about asset purchases. It is also supported by other empirical research, including some regression models that the New York Fed staff has been developing. Taken together, those measures suggest that the effect of all LSAP programs on the 10-year Treasury yield could be as large as 50 basis points, though I reiterate that such estimates have considerable uncertainty surrounding them.
The effects on the MBS rate have been even larger. That can be seen most easily in the spread of yields on mortgage-backed securities over those on Treasuries, adjusted for the prepayment option embedded in those securities. The option-adjusted spread has narrowed by about 100 basis points since the announcement of the program, with more than half of that decline occurring on days of substantive statements about the MBS purchase program.
How has the Fed been able to generate these substantial effects on longer-term interest rates? One word: size. The total amount of securities to be purchased under the LSAPs is quite large relative to the size of the relevant markets. That is particularly the case for mortgage-backed securities. Fed purchases to date have run at more than two times the net issuance of securities in this market. In the securities with 4 percent and 4.5 percent coupon rates, which have been among the most actively produced mortgage-backed securities since purchases began, the Fed has accumulated about two-thirds of the total outstanding amount of those issues. In other words, the Fed has been a substantial presence in these markets and has accordingly left a big footprint.
Another reason for the large impact on MBS rates, in particular, is that the market began from a point of substantial spreads—ones that were well above market norms. These wide spreads could have reflected poor liquidity and an elevated liquidity premium on these securities, or perhaps an extreme risk aversion to any asset containing the word “mortgage.” In either case, Fed purchases would have acted to narrow the premium, bringing MBS rates down by a disproportionate amount as the MBS spread returned to more normal levels.
As the purchase program has progressed, the MBS spread has fallen to levels that are narrower than its historical average, and the liquidity considerations have turned completely in the other direction. Indeed, one issue that the Open Market Desk at the New York Fed now faces is whether its purchases are so large that they reduce market liquidity. The program has to strike the right balance between being large enough to have a meaningful impact on rates, but not so large that it impairs market functioning. As just noted, the LSAPs appear to have been successful in generating an effect on rates, and we are also taking steps to try to limit the adverse effects on market liquidity.
Winding Down the Asset Purchases
The apparent success of the LSAP programs has a flip side, in that we must consider how market pricing will evolve during and after the termination of the programs. This brings me to the second question that I consider: Will markets have an adverse reaction as the Fed winds down its purchases?
One key issue in this regard is whether the market effects mentioned before arise from stock or flow effects. The portfolio balance effects discussed earlier would presumably be associated with changes in the expected stock of assets held by the public. Under this view, even an abrupt end to the Fed’s purchases, if fully anticipated, would not cause an adverse market response, as it would not represent a discrete jump in the outstanding stock of securities held by the public. However, we want to allow for the possibility that the flow of asset purchases, or the ongoing presence of the Fed as a significant buyer, may also be relevant for market pricing. In that case, the end of the Fed’s purchases could cause an increase in longer-term interest rates, at least temporarily until the market has had more of an opportunity to adjust to the Fed’s absence.
On theoretical grounds, it would seem that the main impact of the Federal Reserve purchases reflects stock effects. However, flow effects could matter as well, particularly given the very large MBS purchases we have been making. The bottom line is that we cannot be absolutely sure about the degree to which market effects arise through one channel or the other.
For that reason, the FOMC has adopted a strategy of gradually tapering the size of asset purchases as the programs approach their end. This is a cautious approach. It should help to smooth out any possible market reaction associated with the flow of purchases, and yet it has no cost under a stock-based view. Tapering gives the market time for new investors (or perhaps previously displaced investors) to enter the MBS market in the place of Fed purchases. A tapering strategy was applied to our Treasury purchases with success, as the end of that program did not prompt any notable market response—exactly as we had hoped. However, tapering may be a more important consideration for the termination of the MBS program, given its larger relative size.
Related to this discussion, it is useful to note that exiting from LSAPs can involve a tension that is absent in the Fed’s liquidity facilities discussed earlier. The liquidity facilities were established in response to considerable market strains that had caused the price of term liquidity to skyrocket. In responding, the Fed could be confident that it was pushing market rates toward levels that would be considered normal over the intermediate term. LSAPs, in contrast, could in practice push risk premiums below the levels that would be sustainable over the medium term. Doing so could still be an optimal approach, in terms of achieving macroeconomic outcomes, even if it requires that market pricing will eventually have to reverse.
That reversal would be relatively slow under the portfolio balance theory, if the Fed were to allow its asset holdings to passively run off as they mature. As normal market issuance patterns proceed and as the assets purchased by the Fed mature, the market portfolio will gradually revert back to where it would have otherwise been, allowing risk premiums to gradually renormalize.
Tightening Financial Conditions with an Expanded Balance Sheet
Of course, reducing, and ultimately ceasing, our purchases is only one dimension of exiting from the LSAP programs. The other challenge that the programs pose is that they have injected large amounts of reserves into the banking system in a persistent manner. Thus, the final question I consider is how policymakers will manage to tighten financial conditions, when deemed appropriate, with the expanded balance sheet.
The banking system currently has more than $1 trillion in reserves. These reserves are the liability on the Fed’s balance sheet that corresponds to the aggressive expansion of its asset holdings. The balance sheet is still growing and, absent asset sales, will remain unusually large for years. These balance sheet dynamics, left on their own, would keep reserve balances high for some time, potentially complicating the Fed’s efforts to tighten monetary policy when appropriate.
Based on this consideration, it is not surprising that the Federal Reserve has been dedicating extensive effort to developing the framework and tools that could be used to tighten monetary policy even with a large balance sheet. This is a topic that is frequently discussed by FOMC members in their public speeches and in other communications.
A key part of the framework is the ability to pay interest on excess reserves. This authority alone may allow the FOMC to control short-term interest rates to its satisfaction, even if the banking system is saturated with a large amount of excess reserves. Indeed, the interest rate on excess reserves should act as a magnet for other short-term interest rates, keeping them relatively close together. In the current environment, the federal funds rate has remained modestly below the rate paid on reserves, typically by 10 to 15 basis points. If that spread were to remain steady near those levels even as the interest rate on excess reserves was increased, then policymakers would have sufficient control over short-term interest rates without the use of additional instruments. They could still choose a target level of the federal funds rate and could hit it by adjusting the interest rate on excess reserves.
However, policymakers face some uncertainty about how stable that spread will remain as short-term interest rates increase. The behavior of the spread today might not be that informative in this regard, as the proximity of short-term interest rates to the zero bound prevents the spread from getting much larger. In my view, the most likely outcome is that the spread will not widen substantially as short-term interest rates increase. However, if the spread does become large and variable, then policymakers will need other tools for strengthening their control of short-term interest rates.
With that in mind, monetary policymakers have asked the Federal Reserve staff to develop the ability to offer term deposits to depository institutions and to conduct reverse repos with other firms. These tools are similar in nature, as they both absorb excess reserves by replacing them with a term investment at the Fed. By removing reserves that would have otherwise been available for overnight lending, these tools could pull the federal funds rate and other short-term interest rates up toward the interest rate on excess reserves, providing the Fed with more effective control over the policy rate.
The development of both of these tools has made considerable progress. As indicated in the recent statement from the New York Fed, the Open Market Desk will soon begin conducting a series of small-scale, real-value term reverse repo transactions as part of our efforts to ensure the readiness of this tool. With the successful completion of those transactions, we will have achieved the operational ability to do term reverse repos with primary dealers against Treasury and agency debt collateral, using the triparty system for settlement. In addition, we continue to work on our ability to use MBS collateral in these operations and on a potential expansion of the set of our counterparties. At the same time, the staff is actively working on the Term Deposit Facility. The FOMC has said that it views completing the operational work necessary to establish these tools as an important near-term objective.
It is important to underscore that market participants should not confuse the efforts to achieve operational readiness of these tools with a change in the stance of monetary policy. The mandate handed to the staff by the FOMC was to develop the tools in order to have them ready when needed, with no clear direction on when that time will come. At this point, our efforts are simply aimed at meeting that mandate.
Of course, building the tools is only half the battle. Determining how to use them properly will be at least as challenging.
In that regard, it is useful to consider what these tools can achieve and what they cannot. As noted earlier, draining reserves with these tools could help to improve our control of short-term interest rates, which is the critical issue for ensuring that policymakers can tighten financial conditions when necessary. However, draining reserves with these tools does not undo the portfolio balance effects of the LSAPs. These operations would basically substitute one short-term, risk-free asset for another—replacing what is in effect an overnight loan to the Federal Reserve (reserves) with another short-term loan to the Fed (a reverse repo or term deposit). It is hard to believe that the willingness of an investor to hold risky assets or of a bank to make risky loans would be affected in any meaningful way by this substitution between such similar assets.
A key issue here is whether reserves have some special importance for the availability of credit. Some market observers have a very reserve-focused perspective on the transmission mechanism of monetary policy, arguing that high reserve balances inevitably lead to rapid credit expansion. Under that view, the large-scale asset purchases provide stimulus to the economy primarily by supplying reserves to the banking system, in which case the stimulative effects could be unwound by draining the reserves using any of the tools available. My own perspective differs. In my view, the effects of the asset purchases arise primarily from the removal of duration and prepayment risk from the markets, based on the portfolio-balance effects discussed earlier. Those effects would not be unwound by draining reserves with reverse repos or term deposits.
This is an important consideration for anyone who believes that the portfolio-balance effects could turn out to be too powerful. Some market observers have expressed concerns that the large holdings of liquid assets “on the sidelines” are pushing up risky asset prices excessively as investors attempt to invest those funds. Taking out the excess reserves using the two instruments I discussed will not, by itself, reduce the amount of liquid assets and hence will not undo those effects.
Nevertheless, as long as the FOMC has control of short-term interest rates, it will be able to achieve the desired outcome for broader financial conditions. In particular, the FOMC could always raise short-term interest rates further than would otherwise be the case to offset the stimulus provided by the remaining portfolio balance effects coming from the LSAPs. This type of response is built into the current policymaking process, as any remaining portfolio-balance effects would presumably be factored into the FOMC’s assumptions about how financial conditions are likely to evolve, affecting the FOMC’s economic forecast and the policy decisions based on that forecast. In some sense, this approach places more of the burden on hiking short-term interest rates to tighten financial conditions when the time comes.
An alternative approach would be to reverse a portion of the portfolio-balance effects through asset sales. Asset sales would put the portfolio risk back into the market at a faster pace than redemptions alone, forcing risk premiums to adjust more quickly in order to entice investors to hold that risk. The result would be to put upward pressure on Treasury yields and MBS rates independent of any changes in the expected path of short-term interest rates, so that less of the burden of financial tightening would fall on the short-term interest rate. As described in the minutes of the last FOMC meeting, FOMC participants discussed the possible role of asset sales in their policy strategy going forward and expressed a range of views. My comments are intended only to lay out what I see as the conceptual difference between the effects of asset sales and short-term reserve draining operations.
Overall, the large-scale asset purchases that the Federal Reserve has employed seem to have had their desired effects in terms of reducing longer-term interest rates. These purchases have been an important part of the policy response that the FOMC put in place to foster a sustained economic recovery. Moreover, that conclusion is reassuring for the future, as it suggests that central banks will still have effective policy options should the zero bound threaten again.
However, these asset purchases have ongoing implications for the balance sheet that may require adjustments along other dimensions, such as the implementation of reverse repos, term deposits, asset sales, or other measures. The size, likelihood, and timing of the appropriate adjustments will only become apparent over time, as they will depend on the evolution of the economy and financial markets. They will also depend importantly on the effectiveness of interest on reserves for controlling short-term interest rates in a high reserve environment—a policy regime that has not been fully tested in U.S. markets and that will have to be evaluated in real time.
However, at this point we can at least identify what the policy issues are and evaluate how this set of tools addresses them. I have tried to provide you with my own perspectives on the effects that the Fed’s expanded balance sheet has had on financial markets and the key issues that we face in managing this balance sheet going forward. Hopefully these views will be of some use in assessing and evaluating the future decisions of policymakers and in predicting how financial markets may respond.