## Saturday, March 22, 2008

### How the Fed took the money out of monetary policy

UPDATE: I wrote an expanded, better version of this post, in two parts: Part I and Part II.

The Federal Reserve used to have only a few tools to do its job —that is, until it got the genie out of the bottle. Sometimes quietly, other times conspicuously, the Fed is surely changing the way it creates liquidity.

(Jim Hamilton has been narrating these changes since the summer. Part of this post is my one-stop account. Jim’s posts, which are much better, are here: September 23, December 14, December 16, March 15.)

The central bank has a balance sheet, just like any other bank. As assets, it holds government securities, loans to depository institutions (banks), and other assets. As liabilities, it has currency (the cash in your pockets) and reserve balances. Reserves are deposits that banks keep at the central bank. When a bank needs currency it withdraws from its deposit, effectively turning it into bills and coins that you and I can use.

Until now, macroeconomics textbooks have been telling us that central banks use three tools to control the amount of currency in circulation. Looking at them from an accounting perspective will help us understand what the Federal Reserve has been up to recently:

1) Open market operation. This is an outright purchase of government securities from banks. When conducting this operation, the central bank increases its assets and credits banks’ reserve balances. Eventually, banks withdraw from their reserves at the central bank and turn them into cash. So an open market operation amounts to withdrawing government securities from the economy and replacing them with cash. The central bank can also reduce the amount of cash in circulation, by doing just the opposite: selling government securities and absorbing cash. By far, an open market operation is the best-know of the central bank’s tools.
This is a simplified version of the U.S. Federal Reserve’s balance sheet on August 15, 2007:

 Federal Reserve's balance sheet, $millions (Aug. 15, 2007) Assets US government securities 789,601 Repurchase agreements 24,000 Reverse repurchase agreements -31,941 Direct loans 264 Other assets 37,058 Liabilities Currency in circulation 813,085 Reserve balances 5,897 Source: Federal Reserve, H.4.1 release. (For the moment, regard “repurchase agreements” as government securities.) Suppose that on August 16, 2007, the Fed pumped$1,000 million in the system through an open market operation. The Fed’s balance sheet would experience the following changes, once banks have withdrawn the new funds from their reserve accounts:

 Changes in the Fed's balance sheet after a $1,000M open market operation Assets US government securities +1,000 Repurchase agreements 0 Reverse repurchase agreements 0 Direct loans 0 Other assets 0 Liabilities Currency in circulation +1,000 Reserve balances 0 2) Direct loan. This tool is usually referred to as the “discount window.” The central bank simply lends money to a bank. The borrower must pledge collateral with a value that exceeds that of the direct loan. The central bank increases its balance of loans, and simultaneously credits the reserves of the borrowing bank. Then the bank withdraws from its reserves, effectively turning them into currency in circulation. Asking for a direct loan usually means that the bank was not able to obtain liquidity in the inter-bank market. Moreover, borrowers are also subject to scrutiny by the central bank, and watched by other banks. And the interest rate charged for direct loans is higher than the inter-bank rate. For those reasons, the discount window is used rarely and in small amounts. 3) Reserve requirements. Banks are required to keep a certain amount of reserves at the central bank. If the central bank increases that requirement, banks are forced to withdraw currency from the economy and put it in their reserve account. The central bank can also do the opposite, i.e. increase the amount of currency in circulation by lowering the reserve requirement. This tool is the least often used. Normally banks obtain liquidity for their daily operations in the inter-bank market, where they borrow from and lend to each other at the going interest rate. Last summer some U.S. banks started experiencing losses from their portfolios of mortgages and securitized mortgages. Nobody knew which banks would suffer losses in the future, or how large they could be. So banks starting growing wary of lending to each other, and it became more expensive—or just plain impossible—to raise as much liquidity as needed. The Fed stepped in to help. Instead of providing liquidity through outright open market operations, it increased the use of an operation that is more frequently used, yet less well known: repurchase agreements. These are short-term loans, usually overnight, extended by the Fed to banks. As collateral, banks transfer high-quality securities to the central bank for the duration of the loan. At expiration, the loan is repaid and the bank takes back its securities. From an accounting perspective, the repo increases the central bank’s assets and potential currency in circulation, much like an open market operation does. This, for example, is what happened between August 8 and August 15. Soon after, the Fed decided that it didn’t want to increase the potential amount of liquidity in the system, which affects short-term interest rates and inflation. So it offset the repurchase agreements by selling some of its own government securities (or letting them expire without purchasing more), and thus withdrawing cash from the system. So the repos didn’t have any bottom-line effect on liquidity: they merely changed the composition of the Fed’s assets and provided temporary cash to the borrowing banks. This is why Jim Hamilton writes that the Fed has been doing monetary policy using the asset side of the balance sheet. Another way to see it is that the Fed has been conducting money-less monetary policy, because its actions barely affect the monetary base (reserves plus currency in circulation). Here’s how a repurchase agreement would change the Fed’s balance sheet, after offsetting it with an open market operation:  Changes in the Fed's balance sheet after a$1,000M repurchase agreement, offset by an open market operation Assets US government securities -1,000 Repurchase agreements +1,000 Reverse repurchase agreements 0 Direct loans 0 Other assets 0 Liabilities Currency in circulation 0 (-1,000 + 1,000) Reserve balances 0

After doing this for months, and aware that banks were not getting as much liquidity as they wanted, in December the Fed unveiled the Term Auction Facility (TAF). As its name suggests, this is an auction for a limited amount of Fed’s loans. Just like a repo, loans through the new facility require borrowers to use assets as collateral to the Fed for the duration of the loan. But the TAF represents an improvement with respect to repos in their capacity to provide liquidity. First, it lowers the bar for the type of assets that the Fed accepts, which are the same as those for the discount window. Second, it is more targeted than repos: the bidding system ensures that the limited loans go to the banks that value them most.

By themselves, TAF loans would increase both assets and liabilities of the Fed, just like open market operations and repos. But, once again, the Fed partially offset those loans by selling securities and withdrawing cash from the system. Here’s the simplified balance sheet on December 26 and August 15:

 Federal Reserve's balance sheet, $millions Assets Aug. 15, 2007 Dec. 26, 2007 US government securities 789,601 754,612 Repurchase agreements 24,000 42,500 Reverse repurchase agreements -31,941 -40,542 Term Auction Facility loans 0 20,000 Direct loans 264 4,535 Other assets 37,058 52,869 Liabilities Currency in circulation 813,085 829,193 Reserve balances 5,897 4,781 Source: Federal Reserve, H.4.1 release. The balance of TAF loans grew from$20bn to $60bn between December 26 and March 12. Still, all these liquidity venues are available only to members of the Federal Reserve system, which I have been calling “banks” and whose proper name is “depository institutions.” There is another set of financial intermediaries and investors, such as Bear Stearns or Lehman Brothers. They have been as affected by the liquidity crisis as much as banks have, but don’t have direct access to neither the discount window nor TAF. So the Fed has announced two new facilities for those institutions. The first one is the Term Securities Lending Facility (TSLF), to open on March 27. At this new window, all primary dealers -all banks and brokers that trade in government securities with the Fed- are allowed to borrow up to$200bn of government securities for 28 days. The minimum quality of the assets seems to be the same as those for than for the TAF (they include federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS). But in contrast with TAF this new facility lends government securities, not cash. Through the TSLF the Federal Reserve will be temporarily swapping safe government securities for risky assets. This is how these loans would look like on the balance sheet:

 Changes in the Fed's balance sheet after a $1,000M TSLF loan Assets US government securities -1,000 Repurchase agreements 0 Reverse repurchase agreements 0 Direct loans 0 TSLF loan +1,000 Other assets 0 Liabilities Currency in circulation 0 Reserve balances 0 The second institution is the Primary Dealer Credit Facility (PDCF), which started operating on March 17. This venue provides overnight cash loans to all primary dealers, at the discount window interest rate, and accepts even riskier the same type of collateral. they accept all collateral eligible for repos, plus investment-grade corporate securities, municipal securities, MBS and asset-backed securities. With the PDCF, all primary dealers have de facto access to the discount window, from which only depository institutions could borrow before. The loan will increase the monetary base (read the PDCF FAQ). To offset the increase, the Fed will utilize "a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements, redemptions of Treasury securities, and changes in the sizes of conventional RP transactions." Here's what a PDCF loan looks like, after it has been offset:  Changes in the Fed's balance sheet after a$1,000M PDCF loan, offset by an open market operation Assets US government securities -1,000 Repurchase agreements 0 Reverse repurchase agreements 0 Direct loans 0 PDCF loan +1,000 TSLF loan 0 Other assets 0 Liabilities Currency in circulation -1,000 + 1,000 Reserve balances 0

In fact, the Federal Reserve has included PDCF as a sub-entry within "Other loans" in the balance sheet, next to the discount window loans, because PDCF and discount window are in fact one and the same facility.

Unlike the TAF, neither TSLF nor PDCF will increase the assets of the Fed. It will temporarily decrease balances of government securities, and increase those of sketchy securities. And because participant institutions don’t have Fed reserves, TSLF loans don’t affect the monetary base. These two venues circumvent the necessity to conduct open market operations so that the monetary base doesn’t change.

Here’s the balance Fed again, in December and after the PDCF opened:

 Federal Reserve's balance sheet, $millions Assets Dec. 26, 2007 Mar. 19, 2008 US government securities 754,612 660,484 Repurchase agreements 42,500 62,000 Reverse repurchase agreements -40,542 -46,143 Term Auction Facility loans 20,000 80,000 Primary Dealers Credit Facility 0 28,800 Direct loans 4,535 125 Other assets 52,869 36,603 Liabilities Currency in circulation 829,193 818,362 Reserve balances 4,781 3,507 Source: Federal Reserve, H.4.1 release. With its new tools, the Fed has provided liquidity without printing much money. It has temporarily absorbed risky and illiquid securities, and supplied government securities, which are risk-free. So instead of monetary policy, in the sense we traditionally have thought about it, the Fed has become a risk-absorber (temporarily, we hope). Or, to put it less kindly, a pawnbroker. Will these new tools make it to the textbooks? It’s hard to tell whether the particular facilities (TAF, TSLF, etc.) will survive. I think that some unified, generalized form of credit to non-depository institutions will stay. But I’ll have to write about that another time. Addendum: Somebody asked me how the Fed conducts an "offsetting" open market operation when the Fed extends a TAF loan. This table summarizes it:  Changes in the Fed's balance sheet after a$1,000M TAF loan with an offsetting open market operation Assets US government securities -1,000 Repurchase agreements 0 Reverse repurchase agreements 0 Teerm Auction Facility loans +1,000 Direct loans 0 Other assets 0 Liabilities Currency in circulation (-1,000 + 1,000) Reserve balances 0

The Fed extends the loan, which is an asset for the lender, and credits the bank's reserve account. (In the table I assume that the borrower withdraws the funds from the reserve account, so they're turned into currency in circulation.) The collateral doesn't show up in the balance sheet, because the Fed does not take ownership of it. At the same time, the Fed sells $1,000M worth of government securities, absorbing that same amount of cash from the banking system. Subscribe to EconWeekly (Clicking that button gives$0.10 to Francisco. Join tipjoy! How does tipping work?)

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Anonymous said...

Excellent summary.

In the current circumstance the US Feb has indeed accepted the risk. But will the risk be realised and will the electorate pay for this?

The circumstance is much different: Lets have luch vs. Let me buy you lunch

Nemo said...

Thanks for the summary.

Regarding the TSLF, you write:

Borrowers must pledge collateral for these loans, but the minimum quality of the assets is even lower than for the TAF (it includes federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS).

Are you sure? According to the TAF FAQ, the TAF accepts the same collateral as the discount window. According to the discount window FAQ, a wide variety of collateral is already accepted, including both agency and non-agency asset-backed securities, etc.

My understanding is that the TSLF and PDCF do not expand the collateral being accepted, but they do essentially extend the discount window to non-depository institutions. This, and not the collateral, is their truly novel (and frankly somewhat disturbing) feature.

Francisco said...

Nemo:

Thanks for the correction. Yes, the New York Fed's page is somewhat more explicit about the collateral that is acceptable at the discount window. They say:

In 1999, the Federal Reserve expanded the range of acceptable collateral to include such items as investment-grade certificates of deposit and AAA-rated commercial mortgage-backed securities. Other acceptable collateral consists of U.S. Treasury securities, state and local government securities, collateralized mortgage obligations (AAA), consumer loans, commercial and agricultural loans, and certain mortgage notes on one-to-four-family residences.

This seems to be the same type of collateral as that allowed at the TSLF. And, as you say, TAF requires the same collateral as the discount window.

JefB said...

I guess PDCF does increase the level of reserves and the assets of the Fed and thus monetary base (see Fed FAQ on PDCF: http://www.ny.frb.org/markets/pdcf_faq.html). It is cash-for-bonds to primary deaers who normally only get cash on the initiative of the FOMC trading desk through open-market operations.

TSLF is bonds-for-bonds, which is the reason TSLF does not lead to an increase in the monetary base. Prmimary dealers get Treasury Bills for riskier paper under the TSLF.

Francisco said...

jefb:
You're right about both, as far as I can tell. The PDCF extends cash loans, whereas the TSFL extends Treasury loans (swaps Treasurys for other securities).
The Fed can (and will) offset the PDCF loans with open market operations though.

Anonymous said...

Excellent review of the Fed's new tools. There are some reserve banks that use Credit Reserve Ratio (CRR) as a tool for monetary policy. What are the merits & demerits of using CRR as monetary policy tool?

Flow5 said...

Should be required reading for most Fed watcher's.

(1) Friedman's "high powered money" (MO) is not a base [sic] for the expansion of the money supply.

(2) "have been calling “banks” and whose proper name is “depository institutions.” There is ANOTHER set of FINANCIAL INTERMEDIARIES (other than depository institutions) and investors, such as Bear Stearns or Lehman Brothers". NEVER are the member commercial banks (depository insitutions) financial intermediaries in the lending process. THIS IS THE MOST PERVASIVE ERROR IN ECONOMICS.

From a systems viewpoint, member commercial banks as contrasted to financial intermediaries never loan out, and can’t loan out, existing deposits (saved or otherwise); including existing transaction deposits, or time deposits or the owner’s equity or any liability item.

When MCBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions), and every person, except the commercial and the Reserve Banks; they acquire title to earning assets, by initially, the creation of an equal volume of new money-transaction deposits.