Why the Fed Is So Wound Up

There is endless talk about the Fed exiting from the QE-induced asset bubble on its balance sheet. We will show what the Fed can and cannot do to unwind its balance sheet. First some background data from its balance sheet in terms of assets and liabilities. The balance sheet is a wonderful tool for understanding what can happen, what can’t happen, and the corner the Fed has painted itself into.

A Snapshot of Key Part of the Fed’s Balance Sheet

Below are graphs of four key lines of the Fed balance sheet. The figures showing the graphs are scrollable and interactive. The Fed’s balance sheet reached $4.4 trillion last week shown in Figure 1. Source of all figures is FRED.

Figure 1. Assets: All Federal Reserve Banks – Total Assets, Eliminations from Consolidation, Millions of Dollars, Not Seasonally Adjusted (WALCL).

The amount that the primary dealers have on deposit in their reserve accounts with the Fed is shown in Figure 2.

Figure 2. Liabilities: Reserve Balances with Federal Reserve Banks, Billions of Dollars, Not Seasonally Adjusted (WRESBAL).

We show currency in circulation in Figure 3.

Figure 3. Liabilities: Currency in Circulation, Billions of Dollars, Not Seasonally Adjusted (WCURCIR).

Figure 4. Liabilities: Deposits with F.R. Banks, Other than Reserve Balances – U.S. Treasury, General Account, Millions of Dollars, Not Seasonally Adjusted (WLTGAL)

Money (Debt) Mechanics

Almost all the assets on the Fed’s balance sheet (Figure 1) are Treasuries and Mortgage-Backed Securities. All are forms of debt that have a fixed term or maturity. The longest duration is the 30-year bond. If the Fed acquired no additional assets and did not replace or roll over maturing assets, in 30 years it would have no assets in theory. Could this happen? What about liabilities?

Lets assume that a $1 billion (B) Treasury bond matures this month. That means the Treasury Department has to pay the Fed $1 B. Ignoring for now the question of where it gets this money from, one of two things can happen. The Treasury may have $1 B in its account with the Fed (Figure 4). To the Fed this appears as a liability (money it owes the Treasury). So the Treasury cancels the maturing paper and the Fed wipes out $1 B of what it owes the Treasury. Assets reduce by $1 B and liabilities reduce by $1 B and the balance sheet is happy (in balance).

But what if the Treasury account is at zero? The Fed could lend the Treasury $1 B. But it never lends without receiving equivalent collateral. So the Treasury would have to issue $1 B in new securities to the Fed.

Following this in steps, the balance sheet assets go down by $1 B as the original note matures; the liabilities go down by $1 B in the Treasury account driving it negative. The Treasury gives $1 B in new assets to the Fed in return for a $1 B credit to its reserve account raising its balance by $1 B and back to zero. The Fed registers the $1 B new note received under assets raising them by $1 B back to the level they started at. In the end the balance sheet is unchanged. What is changed is that the $1 B maturing asset has been rolled over and replaced by a $1 B new asset of new duration, say a 10-year note.

But this contravenes the Fed’s intention of allowing its balance sheet to shrink. This means the Treasury actually has to come up with $1 B in the case where its account with the Fed is zero. This is not a problem for the Treasury since it raises tens of billions every month in auctions of new paper (debt). It deposits with the Fed, this $1 B of money that it has raised from participants in the economy. So $1 B of currency moves from the economy into the Fed. It doesn’t remain as an entry in the Treasury’s account, however, because the Treasury is not actually making a deposit that creates a liability for the Fed but is paying off an obligation (a maturing Treasury). The Fed takes the currency deposited and moves it into its vault. It still needs to register a $1 B decrease on the liability side of its balance sheet and does this by reducing the currency in circulation (Figure 3) by $1B.

Getting Real

In the example we gave in the last section, every dollar the Fed reduces its balance sheet by is ultimately a dollar taken out of the economy. Money actually has a price independent of its nominal value and that is the interest rate that you as a participant in the economy have to pay to borrow more for that new car, house or factory. As long as money is plentiful, it is relatively cheap. When it become scarce, its goes up in price. This means you might not be able to afford to borrow as much as you would like or need. Or you may have to forgo another expenditure to acquire it. How this plays out is in interest rates – the cost of money – rising and the economy slowing down.

A parallel issue is liquidity – how much money there is in the economy to keep it running. By taking money out of the economy, there isn’t enough money to keep the economy operating at its optimal rate. It slows down.

This is the Fed’s dilemma. Any move to reduce the size of its balance sheet will have a negative effect on economic growth.

There is a cushion that the Fed may be able to use and that is shown in Figure 2 – excess reserves of the big banks. This is roughly $2.7 trillion (T) that the banks have on deposit with the Fed doing nothing but earning a small amount of interest. Even though this is money that is in the private sector, it is not effectively in the economy. (For economic geeks, this is the reason the velocity of all measures of money that include these reserves are low – they simply aren’t moving).

Should the economy change such that it can absorb these reserves by providing the big banks inducement to invest them, then the Fed’s job becomes easier. The only way a bank can use its reserves for economic activity is to withdraw them from its account. This can only be done in the form of currency.¬† Say bank GS wants to withdraw $1 B from its reserve account. GS sends an armoured car to its local Fed branch and picks up $1 B of new Federal Reserve Notes (FRN – otherwise known as dollars). The Fed then increases the currency in circulation account by $1 B since an FRN is a debt instrument and as such is a liability to the Fed. It reduces the GS reserve account by $1 B and its balance sheet is happy.

But remember that the reserve accounts total $2.7 T. As this money moves out of the Fed, the Fed can allow its balance sheet to shrink in a controlled manner without the amount of money in circulation changing and damaging the economy. This is the fairy tale ending the Fed is hoping for. And there are good reasons why the Fed can’t have it as we shall show.

Getting Real Real

In The Dilemma of the Impatient Trader we presented an argument of why it will cost the Fed to act. In short, if a market participant needs to act quickly and/or in significant volume, he will affect the market price so much as to create a net loss in value on the trade for himself after the market returns to equilibrium. It happens on both sides of the market – buying and selling. The volume of QE buying has forced down interest rates¬† – which was the Fed’s intent – but also forced up the price of the assets purchased. The reverse will likely happen when the Fed has to unwind quickly and in quantity to intervene in a market crisis.

A possible scenario involves a situation where the $2.7 T in reserves moves into the real economy in a short period of time, tripling the currency in circulation. This would be highly inflationary. The Fed’s only tool to fight this is to sell assets to mop up excess currency in circulation, raising interest rates and causing bond prices to plummet in the process. It would lose, perhaps quite significantly on such an action since the value of the assets on its balance sheet would suffer a loss. The net loss taking into account the losses on the purchase and now the sale would result in assets being exhausted while significant liabilities remain. This makes for a very unhappy balance sheet.

Now accountants have a solution for this. They have a third component on the balance sheet called shareholder equity or some such thing. This is an entry on the liability side of the sheet that is the number required to make the two sides balance. When it is positive – assets exceed liabilities – the company is profitable and the shareholders have a positive investment value in the company. When it is negative, the company is bankrupt. The Fed is increasingly at risk of bankrupting itself. In fact there may be no way to avoid it. Fortunately it is too big to fail so the Government will bail it out. Pay up sucker.

In summary, the Fed may not be able to exit when or at the speed it might want to. It may simply run out of ammo. If it tries N exit, it will pay a hefty price. Bubbles are easy to blow. Have you ever known one to deflate gracefully on demand?

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