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24Modern approach to Federal Reserve's balance sheet management Denisov I. (Russian Federation) Современный подход к управлению балансом Федерального резерва Денисов И. С. (Российская Федерация)
Денисов Иван Сергеевич /Denisov Ivan - магистрант, кафедра макроэкономического регулирования, Финансовый университет при Правительстве Российской Федерации, г. Москва
Abstract: the article discusses changes that were made in the asset-liability structure of the Federal Reserve during the several last years. The main problems of the current balance sheet structure are stated as well as consequences of any realization of the risks. In addition, a possible solution to the problem is offered.
Аннотация: в данной статье обсуждаются изменения в структуре активов и пассивов Федерального Резерва США в течение последних лет. Описываются основные проблемы сложившейся структуры баланса и возможные последствия реализации рисков, а также предлагается возможное решение.
Keywords: mortgage-backed securities, quantitative easing (QE), interest rate risk, liquidity risk, exit strategy. Ключевые слова: ценные бумаги, обеспеченные ипотечными займами, количественное смягчение, риск процентной ставки, риск ликвидности, стратегия выхода.
In response to the financial crisis that began in 2007 and the subsequent recession, the Federal Reserve (or the Fed) has been employing a variety of nontraditional monetary policy tools. The use of these tools has significantly affected the size and composition of the Federal Reserve's balance sheet, as well as its earnings.1
At the start of the financial crisis, the Federal Reserve's balance sheet began to expand at a faster pace, largely because of an increase of lending through the liquidity and credit facilities that were established at that time. These extensions of credit expanded the asset side of the balance sheet.
The intent of the asset purchases is to stimulate economic activity and help the Federal Reserve to foster its dual objectives of maximum employment and stable prices. Chung et al. (2011)2 provide some estimates of the macroeconomic effect of the asset purchases, which would likely result in higher tax revenue, and this effect would likely be substantially larger than any fluctuation in remittances by the Federal Reserve.
From the liabilities side it's interesting to consider the volume of commercial bank deposits at the Fed in nominal U.S.dollar terms. In the period 1951 to 2007, there is a remarkable fact that financial institution deposits at the Fed remained almost constant in nominal terms while the economy and financial system expanded enormously during those 55 years. But during 2008-2009 years the volume of bank reserves in the Fed increased more than 100 times.3
After the financial crisis in 2008 the Fed instituted several rounds of additional securities purchases known as quantitative easing (QE). Under its QE policies, the Fed purchased longer-term securities in an effort to push longer-term interest rates down and, ultimately, further stimulate borrowing. The Fed engaged in three successive rounds of QE since 2008, and each had its own unique characteristics.
1. QE1 (December 2008). In December 2008, the Fed started buying longer-term Treasury securities as well as the debt and the mortgage-backed securities (MBS) of Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs). The Fed announced it would purchase up to $100 billion of the GSEs' debt and up to $500 billion of their MBS from both banks and the GSEs themselves.
2. QE2 (November 2010). In November 2010, the Fed announced that it would purchase $75 billion per month of longer-termed Treasuries, for a total of $600 billion. These purchases were to be concentrated in Treasury securities with maturities of two to 10 years, though the Fed also intended to purchase some shorter-term and some longer-term securities.
QE3 (September 2012). In September 2012, the Fed announced its third round of easing, now referred to as QE3. Under QE3, the Fed's combined securities purchases (long-term Treasuries, GSE debt, and MBS) were increased to approximately $85 billion per month. Unlike its counterparts, QE3 was an open-ended commitment. Rather than commit to purchasing a fixed amount of securities by a certain date, the Fed declared that it would make purchases until it decided that the labor market had sufficiently improved. On October 29, 2014, the FOMC announced that it had decided to conclude its asset purchase program, and that it would maintain its existing policy of reinvesting principal payments from its holdings of agency debt and MBS in agency MBS and of rolling over maturing Treasury securities at auction4
'Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, Daniel W. Quinn, and Alexander H. Boote The Federal Reserve's Balance Sheet and Earnings: A primer and projections.
2Chung, Hess, Laforte, Jean- Philippe, Reifschneider, David, and Williams, John C. 2011. «HaveWe Underestimated the Likelihood and Severity of Zero Lower Bound Events?» Federal ReserveBank of San Francisco Working Paper 2011- 01, January.
3Taylor, John, 2009, «The Need to Return to a Monetary Framework».
4 Board of Governors of the Federal Reserve System, Quarterly Report on Federal Reserve Balance Sheet Developments, November 2014.
At the end of March 2015 the Federal Reserve holds approximately $2.5 trillion in U.S. Treasury securities, and $1.7 trillion in GSE securities. According to Richard Fisher, president of the Dallas Federal Reserve Bank, the Fed now holds more than 30 percent of the stock of outstanding MBS and nearly 25 percent of outstanding Treasuries5.
The main risks of this modern balance sheet management of the Federal Reserve could be identified as following.
1. Interest rate risk. Any increase in interest rates may lead to very high losses for the Fed as a consequence of a fall of UST and MBS market values. Taking into account very low «capital to assets» ratio the losses could quickly exceed the Fed's capital.
2. Spread and default risk (for MBS). Not only an overall increase in interest rates but a decrease in the market value of MBS particularly could lead to losses. For instance, a decrease in house prices or any other external event leading to defaults on MBS could appear especially costly for the Fed.
3. Liquidity risk. As far as the excess reserves of commercial banks are short-termed but UST and MBS are mostly long-termed, a significant liquidity gap is in place.
In case of a realization of any from above-mentioned risks the Fed suffers two major consequences: financial losses and a deficiency of funds.
Financial losses are important mostly due to the fact that they diminish or even nullify the yearly remittances of Fed's profits to the Treasury which are currently around 80-97 bln dollars. That would only increase the current budget deficit of U.S.
The failure to remit funds to the Treasury is not necessarily a problem because of the Fed's special status. Just as the Fed can withstand losses on paper, neither Treasury nor Congress would be required to do anything if the Fed failed to remit funds. However, continued large losses could become a problem if Treasury had to start supporting the Fed instead of the other way around. This scenario would be much worse if it occurred during a period of high inflation, because the Fed's ability to create base money would be constrained.
Despite the potential losses the Fed does not face the same insolvency problem that confronts commercial banks. For instance, its newly acquired risky assets could cause the Fed to experience a type of balance-sheet insolvency if those assets dropped in value. But this fact alone means virtually nothing. There is no regulator, for instance, that can step in and shut down the Fed because its net worth is negative.
Even if the Fed were to suffer such large losses that it could no longer use its assets to meet its obligations, it could still create more base money to meet its obligations. The main limiting factor to this solution - issuing more money to meet its obligations - is the (unknown) level of inflation the public will tolerate. Ultimately, if the Fed's excessive money creation causes too much inflation, people would not want to use the U.S. dollar.
Thus, the most immediate risk from the Fed's policies is the liquidity risk i.e. that banks could use those newly created excess reserves too quickly. Banks now have an additional $2.75 trillion in excess reserves, which means that they can create up to approximately $27,5 trillion in new money. In other words, banks now have the power to create more than twice the amount of money currently in the U.S. economy, thus heightening the risk of future inflation. As the economy improves, the Fed may have to pay higher interest rates on these reserves to keep banks from dramatically increasing their lending. Paying higher rates, all else being constant, would exacerbate any «losses» suffered by the Fed.
Additionally, to minimize the losses from increasing interest rates and decreasing prices of securities, the Fed may seek for an indirect support from the Treasury. The support should be aimed to increase the prices of UST and the main instrument to achieve the aim is to decrease the U.S. budget deficit.
So from our point of view the best plan of combined actions from the Fed and the Treasury should be:
1. To announce a sound exit strategy to sell the accumulated securities (f.i. 40 bln per month);
2. To synchronize the announcement and sales of the securities with a new budget approved by the Treasury with decreased budget deficit or, and it's more desirable, budget surplus.
The second point of the action plan is vital because it decreases the supply of UST and thus supports the low interest rates.
The Fed may still suffer some «losses» on these securities sales, but the danger of future inflation and political pressure outweigh the consequences of these losses. In fact, the longer it holds on to these securities, the greater the danger the Fed will not be able to control future inflation. At some point, the Fed will have to sell securities to try to slow down inflation, and if it does so after interest rates start rising, the losses on its securities sales will most likely be worse than they would be now. Such a situation would only magnify the Treasury's fiscal problems, thus adding to the political pressure on the Fed. As bad as the QE policies may have been, letting Congress direct monetary policy operations would surely be worse.
References
1. Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, Daniel W. Quinn, and Alexander H. Boote The Federal
Reserve's Balance Sheet and Earnings: A primer and projections.
5 Richard W. Fisher, «Forward Guidance», remarks before the Asia Society Hong Kong Center, Federal Reserve Bank of Dallas, April 4, 2014, http://www.dallasfed.org/news/speeches/fisher/2014/fs140404.cfm (accessed June 30, 2014).
2. Chung, Hess, Laforte, Jean-Philippe, Reifschneider, David, and Williams, John C. 2011. «Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?» Federal Reserve Bank of San Francisco Working Paper 2011-01, January.
3. Taylor, John «The Need to Return to a Monetary Framework». 2009.
4. Board of Governors of the Federal Reserve System, Quarterly Report on Federal Reserve Balance Sheet Developments, November 2014.
5. Richard W. Fisher, «Forward Guidance», remarks before the Asia Society Hong Kong Center, Federal Reserve Bank of Dallas, April 4, 2014. [Electronic resource]. Available at: http: //www.dallasfed.org/news/speeches/fisher/2014/fs140404.cfm (accessed June 30, 2014).
