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Feb 1, 2009 7:08 pm


Is the Fed Reining Back?



James Hamilton at Econbrowser observed two weeks ago a recent decline in total Federal Reserve assets. Thus, as reported in the Fed’s H.4.1 Release, Fed assets, after peaking at over $2.3 trillion in mid-December, have fallen by nearly $300 billion to $2.0 trillion. Hamilton presents a nice graphical display of this apparent reversal.

Yet the monetary base has fallen hardly at all. As of January 14, according to the Fed’s H.3 Release, it had climbed to $1.75 trillion, 2.9 percent higher than two weeks before, which translates into an annual growth rate of over 100 percent. The Fed reports changes in the base only every other week, but you can estimate the base weekly from the Fed’s balance sheet (I will explain how below, in the last paragraph), and as of January 21, the base was still at $1.70 trillion.

So how is this possible? Hamilton observes that the decline in Fed assets is mostly concentrated in lending to banks through the new Term Auction Facility. But Fed borrowing from the Treasury has declined even further: from around half a trillion to only around $245 billion. Most of this borrowing is through a special Supplementary Financing Account, which involves issuing Treasury securities specifically for this purpose, but this account is now being worked down. So only $200 billion remains in these special Treasury deposits at the Fed, while an additional $45 billion is in regular Treasury deposits at the Fed (up from only $4.5 billion a year and a half ago).

When you couple that with an additional $150 billion plus decline in the Fed’s holding of foreign currencies in its reciprocal swaps with foreign central banks, it explains why the base can continue to grow. Part of the fall in Fed assets represents a decline in dollars that the Fed has loaned abroad and that are not counted in the base. And while domestic assets have also declined somewhat, that decline was more than offset by the Treasury releasing into the economy part of its base-money holdings (that took the form of deposits at the Fed).


The Mysterious Currency Swaps

I explained in a post back in October how the Fed’s enormous Treasury borrowings could cause its balance sheet to grow larger than the monetary base. By borrowing this money in order to relend it, the Fed, in addition to creating fiat money, has in essence become a large, government intermediary—just like Fannie and Freddie. This completely new aspect of the Fed will only expand if it gets the power to issue its own bonds, borrowing on the domestic market in its own name, as Ben Bernanke wishes.

What I didn’t realize at the time is that this Treasury borrowing is closely tied to the Fed’s currency swaps. The Fed coordinates its swaps with the Treasury’s Exchange Stabilization Fund, which bears any resulting exchange-rate risk. Thus, it was no coincidence that, just as the amount of foreign currency holdings mushroomed on the asset side of the Fed’s balance sheet, the Treasury initiated its Supplementary Financing Account on the liability side.

Although holdings of foreign currency are incorporated into the weekly totals of the Fed’s “Other assets,” the breakdown by country is only available monthly from the Fed in a statistical supplement to the online Federal Reserve Bulletin, and then for the currency swaps only in a footnote. Although you can find some good discussions of currency swaps online here, here, and here, they remain one of the least transparent of all the Fed’s recent machinations. But the bottom line: as the currency swaps unwind, reducing “Other assets” on the Fed’s balance sheet, the Treasury’s Supplementary Financing Account declines on the liability side.


Impact on M1, M2, and MZM

The unprecedented increase of the monetary base over the last several months is finally showing up in the broader monetary measures. The Fed’s latest H.6 Release reports that M1 grew at the seasonally adjusted annual rate of 40 percent over the last three months of 2008, whereas M2 grew at nearly 20 percent over the same period. Thus, M1 at the end of December was 17 percent higher than a year prior, and M2 was 9.5 percent higher. The St. Louis Fed puts MZM growth at 25 percent over the three months up to the beginning of December, with its level 13 percent higher than a year prior. These match the highest growth rates seen over the last quarter century. In other words, bank lending is responding to the base increase. Whether you think this is good or bad news in the long run, it certainly contradicts the ultra-Keynesians, such as Paul Krugman, who have been touting a liquidity trap that makes monetary policy impotent and portends severe deflation. As I have emphasized before, neither a short-run lag in the growth of the broader monetary aggregates nor a one-shot increase in base money demand constitute a genuine liquidity trap.

On the other hand, the Fed’s paying interest on reserves has severely compromised the effectiveness of monetary policy. Consider the extreme case. Suppose the interest rate on Treasuries and bank reserves is exactly the same. Not only does this entirely eliminate any seigniorage. But then open market operations are merely exchanging one form of government debt for another. The two differ slightly in minor details: Treasuries can be held by the general public whereas deposits at the Fed cannot; deposits at the Fed can be redeemed directly for currency whereas Treasuries cannot. Nonetheless, if both pay the same interest, open market operations should be approximately neutral in their economic impact. Any increase in bank reserves should be offset by a decline in bank Treasury portfolios, with little change in overall bank lending or the broader monetary aggregates.

So the power of open market operations now hinges on the interest differential between reserves and Treasuries. In short, the Fed has undermined monetary policy at a moment it may have been most needed, creating a self-fulfilling Keynesian prophecy. This is just another aspect of the problems arising from this incredible Fed blunder that I have blogged about before here and here.


Recent Changes in the Fed’s Balance Sheet

Looking at the Fed’s balance sheet, you will discover that its holdings of securities (Treasury and Federal agency, which includes GSE’s) through traditional open market operations has actually declined from nearly $800 billion a year and a half ago, before the current crisis, to around $500 billion today. And the current total includes the $140 billion of securities temporarily lent to dealers through the new overnight and term securities lending facilities, as well as the $6 billion worth of mortgage-backed securities that the Fed has just started buying.

Traditional discounts are up from about a quarter of a billion dollars a year and a half ago to around $60 billion. But the big growth is in the Term Auction Facility, which didn’t exist a year and a half ago, and currently has loaned out over $400 billion. This facility is basically a modified discount window. Discounts set the interest rate and allow banks to determine the amount the Fed loans, whereas the Term Auction Facility sets the amount to be loaned and allows banks to determine the interest rate (through auction). The Fed has also extended “discounts” to securities dealers ($30 billion), money market funds ($15 billion), and AIG ($40 billion).

The other big item on the Fed’s balance sheet is assets denominated in foreign currencies (discussed above), which peaked at $650 billion, and is now down to around half a trillion. Remaining items that bring the Fed’s assets up to a total of $2.0 trillion include commercial paper ($350 billion), assets relating to the Bear Stearns bailout ($27 billion—given the exotic name Maiden Lane in the accounts), more assets relating to AIG and its subsidiaries ($47 billion under the names of Maiden Lane II and Maiden Lane III), and all the other miscellaneous items that have conventionally shown up on the Fed’s balance sheet.

The three Maiden Lanes along with the Commercial Paper Funding Facility and the Money Market Investor Funding Facility (the last of which has acquired no assets so far) are LLCs (limited liability corporations) set up under the New York Fed. Created for complex legal reasons to conduct these particular bailouts, think of them as the Fed’s very own Structured Investment Vehicles (SIVs). In addition to using Fed created money to acquire assets, they can also raise funds (i.e, have outstanding liabilities) in their own names, although so far they have done very little of that.


Interpreting the Fed’s H.4.1 Release

The H.4.1 Release seems to present the Fed’s balance sheet twice. The first time is in section 1, under the heading “Factors Affecting Reserve Balances of Depository Institutions.” Then after a lot of detail about specific Fed facilities, including the LLCs already discussed, you find section 8, “Consolidated Statement of Condition of All Federal Reserve Banks.” But only section 8 is the actual Fed balance sheet.

The reason section 1 looks like the Fed balance sheet is because it consolidates the Fed accounts with the monetary accounts of the Treasury. Bear in mind, that in the U.S., for historical reasons, the central bank is not the only institution issuing fiat money. The Treasury issues coins, which are also part of the monetary base. So to get a full picture of the factors affecting the monetary base, you have to combine the two accounts. If you want to see this done in a straightforward, logical way, consult Appendix B (pp. 797-98) of Milton Friedman and Anna Jacobson Schwartz’s classic, The Monetary History of the United States, 1867-1960 (1963).

Unfortunately the Fed, again as a historical holdover, presents the weekly consolidation in a very confusing fashion, the details of which are not worth going through even if you wouldn’t be totally bored by them. But I will note a few terminological anomalies. In section1, “Treasury currency outstanding” represents the value of coins, and “Currency in circulation” represents the total of Federal Reserve notes and coins outside both the Fed and the Treasury. But it includes all vault cash held by private banks as reserves. Thus, it differs from the Currency reported in the H.6 Release as a component of M1 (which excludes vault cash) as well as the Federal Reserve notes reported in the Fed’s actual balance sheet (which excludes Treasury coin but includes Federal Reserve notes in Treasury vaults).

Everybody follow that? Well, it doesn’t matter. Here is the important point. To get a weekly total of the monetary base from the Fed’s H.4.1 Release, go to section 1 and add up the following items: “Currency in circulation,” “Reserve balances with Federal Reserve Banks,” “Required clearing balances,” and “Other” under “Deposits with F.R. Banks.” Have fun!


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