Download The essential How will the Fed`s balance sheet return to normal?

# 03
March 2017
Achevé de rédiger le 27 février2017
2 How will the Fed’s balance sheet return
The essential
to normal?
BASTIEN DRUT, Strategy and Economic Research
Since the fed funds hike in December
2016 (the second of this cycle) and
with encouraging signs on inflation,
the balance sheet normalisation
has become a hot topic, for FOMC
members and market players. This is
a source of worry for some, given the
dollar amounts involved.
In response to the Great Recession of 2008/2009 and the weak growth that
ensued, the Fed launched several operations to purchase massive amounts
of assets financed by money creation. These transactions are also known as
«Quantitative Easing» (QE). The size of the Fed’s balance sheet rose from under
$900 bn in late 2007 to about $4.5 trillion today. In its assets column, the Fed
owns $2.46 trillion in U.S. Treasury securities and $1.75 trillion in MortgageBacked Securities (MBS).
Although the last QE3 purchases took place in late 2014, the Fed has kept
the size of these US Treasury and MBS holdings unchanged, reinvesting the
securities as they reach maturity. Treasury securities the Fed holds started to
mature in earnest in 2016. $200 bn will reach maturity in 2017, and nearly $430
bn in 2018. The amounts involved are therefore very large, because net issues
of long-term U.S. Treasuries in 2016 was $392 bn.
Overall the market expects that the end
of reinvestment of maturing Fed-held
securities will take place gradually and in a
limited fashion. In the years that preceded
the crisis, the Fed held almost as much in
Treasury securities on the asset side of its
balance sheet as currency in circulation on
the liability side, and held no mortgagebacked securities. In the event that the Fed
returns to its pre-Great Recession balance
sheet, its goal should be to stop reinvesting
maturing MBS so that it ultimately holds
none at all. Furthermore, the continuing
growth of currency in circulation makes the
need for a reduction in Treasury holdings
relatively modest and non-urgent.
In September 2014, the Fed published its «Policy Normalisation Principles
and Plans». The key points were as follows:
••First, raise the fed funds rates.
••Next, reduce securities holdings in a gradual and predictable fashion by
ceasing to reinvest the repaid principal of maturing securities.
••Ultimately, the Fed “will hold no more securities than necessary to
implement monetary policy efficiently and effectively, and that it will
hold primarily Treasury securities, thereby minimising the effect of Fed
holdings on the allocation of credit across sectors of the economy”.
Only after the first rise in the fed funds rate, in December 2015, did the FOMC’s
communication about the balance sheet change, to indicate that the Fed
intended to continue its reinvestment policy «until normalisation of the level of
the federal funds rate is well under way», which is subject to interpretation.
Since the second fed funds increase, in December 2016, and encouraging
signs regarding inflation, the topic of the balance sheet’s normalisation
has started to be discussed more and more. Several FOMC members have
made statements on this matter since the start of 2017:
••Patrick Harker, President of the Philadelphia Fed and voting in 2017, declared
in early January that the Fed might end the reinvestment of maturing securities
once the fed funds rate has reached 1%.
English version
Graph n°
23
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
The Survey of Primary Dealers
Autres conducted by the New York Fed among the leading
dealers of Treasuries provides
very
signs about market expectations
Liquidité CT
auxinteresting
institutions financières
when it comes to the Fed’s
balance
normalisation policy. During the survey
Liquidité
CT auxsheet
emprunteurs/investisseurs
MBS
conducted before the 20 January
FOMC, the market expects on average that
Titres du Trésor
the Fed will alter its balance
sheet policy when the fed funds rate reaches
Source : Datastream, Recherche Amundi
1.50% (compared to 0.75% today), which the market believes will happen at the
2006
500
What are the market’s
expectations with respect to balance sheet
0
policy?
2004
2500
••Janet Yellen, Chair of the Board of Governors, explained in testimony to
2000
Congress that
the balance sheet would be reduced gradually, when the Fed
1500
«is confident 1000
that the economy is on the right path.»
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4000
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(in$bn)
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2003
5000
••Lael Brainard,
a member of the Board of Governors, said on 17 January
4500
that the Fed4000
would need to consider to cease reinvestments sooner than
expected if fiscal
3500 stimulus measures were to cause slack in the economy to
erode faster. 3000
1
2005
French
version
••Eric Rosengren, President
of the Boston
Fed, indicated that the Fed should
consider reduce the size of its balance sheet, saying in particular: «There are
Fed : actifs (en Mds$)
n°1
some benefits to actually tightening
not just on short rates but also possibly
on long rates.»
Others
ST liquidity to sound financial institutions
ST liquidity directly to borrowers and investors
MBS & GSE debt
US Treasuries
Source: Datastream, Amundi Research
Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry
2500
The fact that these
2500excess reserves are paid by the Fed at a rate that matches
the upper bound of the fed funds target (currently 0.75%) while the fed funds
2000
target range is2000
expected to be raised gradually in the coming quarters
constitutes an issue as: 1) the Fed’s interest expenses will rise rapidly and
1500
1500
they might weigh
on the Fed’s profits and 2) some politicians will criticize a
situation where1000
the Fed would “subside” the banks while the latter would not
1000
lend enough the real economy according to them.
201
201
201
201
201
201
2015
2015
2016
2016
2017
2017
2000
2000
1500
1500
1000
1000
2019
2019
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2021
2015
2015
2017
2017
2011
2011
2013
2013
2007
2007
2009
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2003
2003
2005
2005
2001
2001
1999
1999
1997
1997
00
USTreasuries
Treasuriesheld
heldby
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in circulation
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Source:Datastream,
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Source:
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of Primary
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Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry
>4501
>4501 bn
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4001
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3501
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Probabilité
If the Fed returns to its pre-crisis balance sheet configuration, its goal would
45%
45% security holdings in line with the amount of currency
be to bring its Treasury
40%
in circulation, but if40%
the supply of currency in circulation were to continue to
35%
grow at the average
pace of the last five years (+7.3% per year), it would be
35%
expected to reach30%
slightly more than $2.1 trillion by the end of 2021, which
30%
is ultimately not so
far from the current $2.46 trillion in Treasury holdings.
25%
25%
Under these conditions,
is there an urgent need to decrease holdings
20%
20%
of Treasuries? The
answer
is “no”, and if the decision not to reinvest
15%
15%
maturing Treasuries
was
made,
it would only be temporary and the
10%
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amplitude relatively
limited.
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3001
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3000 bn
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titres
de la
la Fed
Fed fin
fin 2019?
titres de
2021
2021
2019
2019
2017
2017
2015
2015
2013
2013
2011
2011
2009
2009
2007
2007
2005
2005
2003
2003
2001
2001
1999
1999
00
The «Policy Normalisation
Principles and Plans» indicates that ultimately, the
Fed will no longer be holding securities beyond what is needed to implement
its monetary policy efficiently and effectively, and that it will hold primarily
du
parat
du Trésor
Trésor détenus
détenus
Treasury securities. It mayTitres
be instructive
to look
the Fed balance sheet’s
Titres
la Fed
Monnaie
Monnaie en
en circulation
circulation
structure before the Great Recession
of
2008/2009. In the years that preceded
Monnaie
en
(simulation)
en circulation
circulation
the crisis, the Fed held almost
as much
in Treasury
securities on the asset side
Monnaie
of its balance sheet
as
currency
in
circulation
on
the
liabilities side, and held
Source
Amundi
Source :: Datastream,
Datastream, Recherche
Recherche Amundi
no Mortgage-Backed Securities. Returning to this configuration would indicate
that the Fed’s goal should be to stop reinvesting maturing MortgageBacked Securities so that it ultimately holds none at all. This will remove
Enquête
Primary
où
Dealers:
où sera
sera le portefeuille de
Enquête
Primary Dealers:
some support from
the mortgage
loan market.
n°4
n°4
3000 Mds
Mds
<< 3000
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incirculation
circulationvs
vsUS
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heldby
bythe
the
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the
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(inFed
$bn)(in $bn)
Fed
(in
$bn)
500
500
What is the end goal for the balance sheet?
1997
1997
Source:Datastream,
Datastream,Amundi
AmundiResearch
Research
Source:
Probability
500
500
2012
2012
2013
2013
2014
2014
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Others
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balances
Reserve
Deposits other
other than
thanreserves
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Deposits
Reverserepurchase
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Reverse
Currency in
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Since December 2008, theRéserves
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banques
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banquesto use the interest rate on bank
Réserves
Dépôts
autres
que
autres Since
que réserves
réserves
reserves as a tool of monetary
policy.
then, the Fed communicates on a
Dépôts
Reverse
agreements
Reverse
repurchase
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fed funds target range (and
not onrepurchase
an unique
target rate) in which it wants the
circulation
en
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Monnaie
effective fed funds rate toMonnaie
be anden
whose
upper end corresponds to the rate
::Datastream,
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at which excessSource
reserves
are remunerated:
the IOER rate, the Interest rate On
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other assets that do not pay at least the rate of interest on excess reserves:
this should raiseMonnaie
short-term
market interest
However,
en
vs
du
vs titres
titresrates.
du Trésor
Monnaie
en circulation
circulation
détenusas
paronly banks hold
n°3
n°3
reserves, market rates are generally
below
the$)IOER rate.
la
(en
la Fed
Fed
(en Mds
Mds
2009
2009
2010
2010
2011
2011
5000
5000
4500
4500
4000
4000
3500
3500
3000
3000
2500
2500
2000
2000
1500
1500
1000
1000
500
500
00
2017
2017
2014
2014
2015
2015
2016
2016
2013
2013
2011
2011
2012
2012
2009
2009
2010
2010
2007
2007
2008
2008
Fed:
liabilities
(in
$bn)
Fed:liabilities
liabilities
(in
$bn)
Fed:
(in
$bn)
2006
2006
2007
2007
2008
2008
1500
1500
The Fed’s substantial
expansion during its phases of QE coincided with a steep
1000
1000
rise in the bank’s 500
excess reserves (see the box below on “the mechanics of QE”).
500
The thing is the existence
of these very high excess reserves complicates the
00
management of the fed funds rate by the Fed (the fed funds rate is the overnight
rate at which banks lend reserves to each other).
2
2003
2003
2004
2004
2005
2005
2500
2500
Source:
Amundi
Source: NY
NY Fed,
Fed, Recherche
Recherche Amundi
201
201
201
201
201
201
Source:Datastream,
Datastream,Amundi
AmundiResearch
Research
Source:
What problems
may arise from having too large a balance sheet?
2000
2000
5%
0%
0%
200
200
201
201
201
201
# 03
end of H1 2018. We should note that two primary dealers of the 21 surveyed do
Fed
Mds$)
passif (en
(enpolicy
Mds$)to end. For the most part,
n°2the
Fed :: passif
n°2
not expect the US Treasuries reinvestment
primary dealers believe that reinvestments will cease only gradually: no sudden
5000
5000
end to the reinvestments.
They believe that the average probability that the
4500still be more than $3.5 trillion at the end of 2019 is 71%,
balance sheet 4500
will
4000
4000
which indicates
that the expected balance sheet reduction is relatively
3500
3500
modest.
3000
3000
2005
2005
2006
2006
200
200
200
200
200
200
Others
Others
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liquidityto
tosound
soundfinancial
financialinstitutions
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2003
2003
2004
2004
200
200
200
200
200
200
201
201
201
201
201
201
201
201
201
201
201
201
201
201
200
200
201
201
200
200
200
200
200
200
200
200
200
200
200
200
March 2017
Autres
Autres
Liquidité
aux institutions
institutions financières
Liquidité CT
CT aux
Liquidité
aux emprunteurs/investisseurs
emprunteurs/investisseurs
Liquidité CT
CT aux
MBS
MBS
Titres
Titres du
du Trésor
Trésor
24
# 03
March 2017
> T he quantitative easing mechanism
The Fed’s QE has consisted in purchases of securities (Treasuries, MBS, agency bonds)
financed by central bank money created for this purpose. These securities have shown up
on the asset side of the Fed’s balance sheet, while the increase in bank reserves has shown
up in the Fed’s liabilities for an equivalent amount. QE has thus mechanically expanded
the Fed’s balance sheet.
Did banks sell Treasuries to the Fed? If the banks had sold their own Treasuries to the Fed,
their balance sheet would not have expanded, and QE’s only impact would have been a shift
in the breakdown of their assets (from Treasuries to the reserves held with the Fed). However,
a look at the breakdown of holdings of US Treasuries shows that US banks have been
net buyers of them during QE phases. In reality, the banks, who are the only ones holding
accounts with the Fed, have actually served as an intermediary. Let’s take the example of an
investor who sells securities to the Fed through a bank. In this case, the investors’ transaction
is first recognised in the bank’s liabilities, and the bank’s sale of securities to the Fed leads to
an increase in the bank’s excess reserves in its assets and an equivalent increase in deposits
in its liabilities. So QE operations have not caused just the Fed’s balance sheet to expand
but also US banks’ balance sheets.
What about the reinvestment of maturing Treasuries? The Fed reinvests the amounts
from maturing securities directly on the primary market with the US Treasury, without the use
of intermediaries. The reinvestments are split among the Treasury auctions held the day of
maturities (prorated to the volume of each of the auctions held that day).
When the Fed ultimately decides to no longer reinvest the securities it holds, other
investors will take over and their bank deposits will decline, which will lead to a decline
in banks’ excess reserves.
25
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March 2017
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MO JI – Hong Kong, Stéphane Taillepied – Paris
Support
–P
ia Berger
Research, Strategy and Analysis – Paris
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