The Other Side of the Fed’s Balance Sheet
In the fretting about the unwinding of the Federal Reserve’s balance sheet, what may be overlooked is its impact on the fractional reserve system.
The financial system is based on “fractional reserves,” the process under which banks make loans by holding a fraction of deposits in currency or at the Federal Reserve. But when the Fed's balance sheet will finally shrink, the current large amount of excess reserves will begin to adjust to a new reality. There are three distinct effects that could occur: monetary base contraction, the revival of the federal funds market and an increase in velocity of money.
Excess reserves are part of the broad money aggregate, known as M1, and represent “near money,” as such funds can be immediately converted into currency. A change of reserves affects money markets and liquidity and thereby assets such as stocks. This is what took place in 1937, when the Fed drained reserves and the monetary base contracted by 15 percent. This had an almost equal negative effect on the S&P 500. This historical example has been well covered by former Fed Chairman Ben Bernanke, and is held up as an exemple of a premature withdrawal of liquidity that caused financial conditions to tighten too quickly.
Monetary Base and S&P 500 in the 1920s and 1930s
Source: Bloomberg, Federal Reserve, Monetary base = M1.
In the 1970s and 1980s, Fed watchers would look for the release of monetary base aggregates every Thursday to see if there was a change in policy stance. Although the Fed is unlikely to return to setting policy by targeting the monetary base, indirectly such process will happen when the drain of excess reserves is managed through reverse repurchases and term deposits.
The Fed sets the (effective) federal funds rate in the middle of the target zone (currently 0.75 percent to 1 percent). A change in excess reserves may affect the federal funds market, driven by supply and demand for Fed funds and borrowed and non-borrowed reserves.
A key impact could be that the effective funds rate might at times “drift” toward the upper or lower end of the Fed’s corridor system, which consists of four interest rates: the interest on excess reserves as a “floor,” the lending rate as “ceiling,” and the reverse repo and term deposit rate to smooth drainage of excess reserves. The plan is to let the balance sheet shrink, and the Fed must control the funds rate in the corridor system.
Prior to the crisis, the funds market was actively traded and often impacted the effective fed funds rate. In the future, a possible revival of the federal funds market may play a greater role how the effective funds rate behaves. If the federal funds market becomes active, that could potentially result in a tighter policy stance when the effective funds rate rises.
The Effective Funds Rate and Funds Market
A third impact could be seen on the velocity of money. It is a complex measure, and was distorted as monetary aggregates lost their relevance to accurately reflect policy, it has reached an all-time low in the post-crisis era. The fall in velocity likely had to do with the effect of advancing demographics that led to larger savings, as well as deleveraging that resulted in swelling deposits, and the buildup of excess reserves sitting idle at the Fed. The velocity of money may pick up when wages and income rise faster, and demand for money experiences a sharper increase. If the recent rise of the employment-to-population ratio is a gauge of rising incomes, the historical relationship suggests a potential change in velocity is near, and that could be compounded by the change in excess reserves.
The Fed’s balance sheet will set in motion a process that entails more than running off Treasuries and mortgages. The complexity of reserves includes several interest rates that may adjust in different directions with impact on banks, deposits, the yield curve, the dollar and stock markets. There are a lot of questions about the unwinding of the balance sheet. These questions may become acute when financial conditions tighten so materially that there is no historical precedent to provide sufficient answers.
Velocity and Employment
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