Fed Officials Leaning Toward Bigger Is Better on Balance SheetCraig Torres and Liz Capo McCormick
New tools keep fed funds rate less volatile than prior regime
Central bankers still intent on some reduction over time
While nearly all eyes are on the Federal Reserve’s likely decision to raise short-term interest rates next week, investors in the world’s biggest debt market say central bankers have already signaled a major change in another policy tool.
Fed officials have indicated they may make their super-sized balance sheet of bond holdings and $2 trillion in excess reserves created during the last financial crisis a more permanent feature of the way they interact with financial markets.
That would have a lasting impact on the way the central bank manages the short-term policy rate. Before the crisis, the Fed controlled it by intervening in federal fund markets to manage supply and demand of bank reserves. Now, with a huge supply of money created through quantitative easing, the Fed controls the market for its policy rate by paying interest on excess reserves and reverse repurchase agreements in money markets.
Policy makers noted the new system was “relatively simple and efficient to administer” in minutes to their latest meeting in November.
The Fed’s lean toward keeping a large balance sheet and the financial system flush with cash “is a fundamental game changer,” said Subadra Rajappa, head of U.S. interest-rate strategy at Societe Generale SA in New York. “What the Fed has learned over the last seven years is that a lot of reserves does not hurt the system, that it is not inflationary and in some respects it is not operationally intensive.”
Assets on the Fed’s balance have grown roughly five-fold since the financial crisis to $4.4 trillion, which includes $4.2 trillion in securities.
The balance sheet was steady at around 6 percent of nominal gross domestic product from 1998 to 2008. As the crisis intensified in late 2008 and the Fed began flooding the financial system with credit, the ratio began to rise, surging to 15 percent of GDP by the end of that year. The ratio peaked at nearly 26 percent in 2014 and has since shrunk to about 24 percent as total assets have remained stable while GDP has expanded.
A survey of primary dealers in government bonds by the New York Fed last month showed the median expectation for a “change” in the central bank’s policy of reinvesting maturing Treasuries was 20 months ahead. Over the next two years, for example, $617 billion of its debt holdings come due. The November minutes, however, make the case for maintaining a balance sheet “much smaller than at present though likely at least somewhat larger than in the years before the financial crisis.”
“The large balance sheet has become the status quo,” said Lou Crandall, chief economist for Wrightson ICAP LLC in Jersey City, New Jersey. “It is no longer experimental.”
Investors and borrowers stand to reap some benefits from a Fed decision to keep balance sheets large. For one, they don’t have to interpret how the central bank’s runoff of massive amounts of securities would impact long-term interest rates and the economy.
“I would have a very hard time thinking through fed funds futures and what they are telling you if they are selling down the balance sheet or letting it roll off,” said Erik Weisman, chief economist at MFS Investment Management in Boston that manages roughly $425 billion. “It makes it easier.”
For investors and businesses, the Fed’s holdings of Treasuries, mortgage-backed securities and housing-agency debt are tamping down the cost of financing, though estimates on how much vary. By keeping a large stock of debt out of public hands, researchers say that lowers interest rates on Treasuries and a range of other debt securities.
“The current membership of the Federal Open Market Committee seems inclined to use rate hikes rather than portfolio run-offs to tighten for the foreseeable future,” Wrightson’s Crandall said.
That might not sit well with President-elect Donald Trump’s economic team and House Republicans, who say the debt portfolio has hurt the economy by lowering interest rates for big corporations and the government, rather than smaller businesses. Trump’s economic adviser David Malpass said last month the Fed “needs to communicate a plan for downsizing its balance sheet.”
House Financial Services Committee Chairman Jeb Hensarling in June criticized the Fed for directing credit “to favored markets,” such as housing. The Fed owns $1.74 trillion in mortgage-backed securities, a legacy from the crisis when it tried to support housing credit.
“It is way past time for the Fed to commit to a credible, verifiable monetary policy rule to systematically shrink its balance sheet,” Hensarling said.
Some Fed officials, such as Richmond Fed President Jeffrey Lacker, have also expressed discomfort with the holdings because they support credit in a single sector of the economy -- something that looks more like fiscal policy.
The portfolio also poses some risks to the Fed, as the Trump administration’s plans to restructure and possibly privatize Fannie Mae and Freddie Mac could make it less tenable for the central bank to invest in their securities. The Federal Reserve Act doesn’t permit the Fed to use private securities for open-market operations.
Despite the controversy over the balance sheet’s impact on the economy and the Fed’s financial health, there is greater consensus about its ability to reduce volatility in the fed funds market.
When the Fed buys a security, it deposits money in the seller’s bank account. Banks are required to hold a certain amount of reserves against deposits. In the past, they typically dumped excess reserves into the federal funds market to earn a return on them.
In the regime before the financial crisis, the Fed would intervene in the funds markets, sometimes aggressively, to keep the supply and demand for reserves taught and underpin their federal funds rate target. The fed funds market could be volatile as banks bought and sold reserves with frequency.
That system became less effective as reserves ballooned during the financial crisis, so Congress gave the Fed the ability to pay interest to banks on their excess reserves. Once that interest rate came into effect, financial institutions had less incentive to sell in the open market. The interest paid by the Fed -- currently set at 0.5 percent -- stabilizes the fed funds rate. Among the Fed’s new post-crisis tools is also a reverse repo program, which it uses to engineer the floor on its target rate range -- now at 0.25 percent.
“The most robust and effective system” for money markets and reserve management now “is one in which the Fed maintains a larger balance sheet than it did before the crisis,” said Brian Sack, director of global economics for the D. E. Shaw Group and formerly the New York Fed official in charge of achieving the policy target through open market operations.
Sack and another former Fed staffer, Joseph Gagnon, proposed in a 2014 paper a new operating framework for the Fed that included the features of the current system.
“This regime is operationally easier for the Fed to implement, improves how policy decisions are transmitted to markets, and makes the financial system more stable,” Sack said, adding that the minutes signal “the Fed may be heading in that direction.”