Federal Reserve's Balance Sheet Research Articles

Assessment of Dealer Capacity to Intermediate in Treasury and Agency MBS Markets

We provide an assessment of broker-dealers’ current and future capacity to support the smooth functioning of the Treasury and agency MBS markets, considering increases in Treasury issuance and continued Federal Reserve balance sheet normalization. Drawing on regulatory data analysis, recent research, and experiences with fixed income market functioning, we focus on two types of constraints that are most relevant for dealers’ intermediation activities: regulatory constraints—specifically the minimum Supplementary Leverage Ratio (SLR) requirement at the Bank Holding Company (BHC) level—and internal risk limits—specifically Value at Risk (VaR) limits at the trading-desk level for each dealer.

A tale of two tightenings

Balance sheet policy is now a prominent facet of monetary policy. Based on the U.S. experience between 2017 and 2019, Smith and Valcarcel (2023) show the first period of quantitative tightening (QT1) was markedly different from earlier balance sheet expansions. This paper provides evidence the Federal Reserve's second balance sheet unwind effort that began in January 2022 (QT2) is strikingly different from QT1. We find substantial announcement effects during QT2 for various treasury yields and interest rate spreads, which are largely absent from QT1. At the time of this writing—by February 2023—both episodes have experienced a similar percent reduction in reserve balances. Yet, QT2 shows a stronger market response upon implementation. Not only are the underlying financial conditions different across the two periods, but the conduct of monetary policy in 2022 seems to be different as well. A clearer signaling mechanism for the expectations channel of monetary transmission takes place during QT2 than was apparent during QT1. The liquidity effects that seemed to be so important during QT1 have been largely attenuated during the second episode of balance sheet tightening.

The Effects of CBDC on the Federal Reserve's Balance Sheet

We propose a parsimonious framework to understand how the issuance of central bank digital currency (CBDC) might affect the financial system, the Federal Reserve's balance sheet, and the implementation of monetary policy. We show that there is a wide range of outcomes on the financial system and the Federal Reserve's balance sheet that could reasonably occur following CBDC issuance. Our analysis highlights that the potential effects on the financial sector depend critically on how the Fed manages its balance sheet. In particular, CBDC could in principle put substantial upward pressure on the spread of the federal funds rate and other wholesale funding rates over the interest rate on reserves unless the Fed expanded its balance sheet to accommodate CBDC issuance.

Gross capital inflows, the U.S. economy, and the response of the Federal Reserve

In recent years, there has been a surge in capital inflows to the United States' treasury and corporate bond markets from other countries. How do these inflows affect economic activity in the United States? Does the Federal Reserve respond to such shocks? To address these important issues, we employ a sign-identified structural vector autoregressive (SVAR) model to see the effects of these types of capital inflows. Our results suggest that the U.S. economy and the Federal Reserve's balance sheet respond differently to shocks to these inflows. In particular, gross inflows to U.S. treasuries are contractionary while inflows to corporate debt are expansionary. Moreover, the Federal Reserve shrinks its balance sheet in response to shocks to gross capital inflows to U.S. treasury securities with little to no response to inflows to corporate securities. Interestingly, we find that the bulk of the Fed's response to both shocks is systematic. In this manner, the Federal Reserve's response to these shocks played only a minor role in the evolution of macroeconomic aggregates following such shocks.

Market Reactions to the Federal Reserve's Balance Sheet Normalization Plans

ABSTRACT: This paper focuses on interpreting the stock market's reactions to Federal Reserve announcements about its balance sheet normalization plans, applying the methodology developed with Francesco Bianchi and Sai Ma. The results indicate that the stock market declines after announcements, suggesting perceived inflexibility in statements about balance sheet normalization, but many of the large reactions to these announcements can be ascribed to forces that move the stock market but not the broader economy.

Panel on Shrinking the Federal Reserve Balance Sheet

Panel on Shrinking the Federal Reserve Balance Sheet

Substitutability between Balance Sheet Reductions and Policy Rate Hikes: Some Illustrations and a Discussion

This note explores the substitutability between policy rate hikes and reductions in the size of the Federal Reserve's balance sheet for the removal of policy accommodation. We do so using a version of the FRB/US model augmented to incorporate the effects of changes in the Federal Reserve's asset holdings on term premiums.

The Effects of Federal Reserve's Quantitative Easing and Balance Sheet Normalization Policies on Long-Term Interest Rates

The Effects of Federal Reserve's Quantitative Easing and Balance Sheet Normalization Policies on Long-Term Interest Rates

What's in a name? Purchases and Sales of Financial Assets As a Monetary Policy Instrument

Large-scale asset purchases are now a conventional tool for monetary policymakers. In August 2019, Federal Reserve balance sheet expansion began for the first time since December 2015, with the federal funds rate away from the zero lower bound (ZLB). The Federal Reserve expanded the balance sheet by $400 billion by the end of 2019. This paper studies active balance sheet management by the Federal Reserve with the federal funds rate away from and at the ZLB. Purchases and sales of financial assets allow the Federal Reserve to simultaneously stabilize financial markets, thus moderate long-term interest rates, and pursue the dual mandate. At the ZLB, active financial asset portfolio management alleviates the effects of the constraint on the federal funds rate.

Monetary Policy Implementation: Making Better and More Consistent Use of the Federal Reserve's Balance Sheet

Since December 2015, the Federal Reserve has operated a new “floor system” in which it brings about desired changes in its targeted federal funds rate by managing the interest rate it pays on bank reserves and other short‐term liabilities. The design of this new system reflects the tendency of Fed officials to view monetary policy as affecting the economy through Keynesian” interest rate channels. From this Keynesian perspective, policy actions that change the size of the balance sheet are seen as tools for influencing credit market conditions that operate in addition to and independently of the Fed's monetary policy stance.The alternative monetarist framework proposed by the author views monetary policy and its effects as operating through the interaction between money supply and demand. Use of this framework makes clear that, even under a floor system, monetary policy actions designed to affect the aggregate price level and the rate of inflation must be accompanied sooner or later by traditional open market operations that have implications for the size and composition of the Fed's balance sheet.Use of the monetarist framework also underscores the likelihood that the Fed, by paying interest on reserves, has unknowingly contributed to the restrictiveness of its own monetary policies since the financial crisis, a period during which inflation has run consistently below target. More generally, the monetarist framework downplays the importance of the zero lower interest rate bound and suggests that monetary policy could be conducted more effectively by adopting and adhering to a consistent, rule‐like manner during good times and bad.

Poole Rules: Implementing Monetary Policy Using Multiple Instruments

This paper identifies zero lower bound risk as key rationale for a monetary policymaker to actively manage the size and composition of its holdings of domestic debt. This is true at all times, including when the zero lower bound does not currently bind. It then provides a simple, optimal rule for the quantity and maturity composition of asset purchases. Using a unique dataset, estimates of the Federal Reserve's balance sheet response function since 2008 are presented. Balance sheet policymaking could be improved by responding more actively to economic growth.

Fiscal Implications of the Federal Reserve's Balance Sheet Normalization

The paper surveys the recent literature on the fiscal implications of central bank balance sheets, with a special focus on political economy issues. It then presents the results of simulations that describe the effects of different scenarios for the Federal Reserve's longer-run balance sheet on its earnings remittances to the U.S. Treasury and, more broadly, on the government's overall fiscal position. We find that reducing longer-run reserve balances from $2.3 trillion (roughly the current amount) to $1 trillion reduces the likelihood of posting a quarterly net loss in the future from 30 percent to under 5 percent. Further reducing longer-run reserve balances from $1 trillion to pre-crisis levels has little effect on the likelihood of net losses.

Fiscal Implications of the Federal Reserve's Balance Sheet Normalization

Fiscal Implications of the Federal Reserve's Balance Sheet Normalization

ECB tapering: beware of global consequences

▀ The ECB's scaling back of its QE programme in 2018 could be more disruptive to global financial markets than the Federal Reserve's ongoing balance sheet unwinding. ECB bond purchases led Eurozone private investors to inject a massive amount of funds into global debt markets over the last few years. As the ECB reduces its stimulus, Eurozone investors will gradually pare back the build‐up of their foreign debt exposures. The full unwinding of ECB QE will see investors rebalance toward domestic debt securities. ▀ We expect Eurozone investors to continue injecting funds into global debt markets as the ECB proceeds to wind down its QE, but they will do so at a much slower pace. Based on our projections, European purchases of foreign debt securities this year will total €200 billion – down by half from the average €400 billion over the last three years. Such a large reduction raises the risk of disruption in some markets. ▀ How did we get here? Spillovers from the ECB's QE were much more pronounced than during Fed's. European private investors that sold bonds to the ECB during its QE programme faced a commensurate shortage of domestic debt assets. In contrast to the US experience, ECB buying far exceeded new domestic issuance, inducing private investors to sharply increase purchases of overseas debt securities. ▀ Ultimately, we expect European investors to seek to restore the share of domestic debt securities in their portfolios to a level in line with the historical norm, after the proportion of their domestic debt holdings fell by 7pp since the programme began. The rebalancing is likely to start in earnest once the ECB stops buying (and eventually starts selling) securities. As a result, the global debt issuance boom is likely to lose steam, given the extent to which it has relied on the support of European investors.

Monetary Policy at the Zero Lower Bound: Information in the Federal Reserve's Balance Sheet

We examine the impact of the actual purchases of Treasury securities by the Federal Reserve on the Treasury yields. Using structural stability tests we find significant breaks in the relation between these variables. We find that in the zero lower bound period following the first phase of quantitative easing, May 2010 to December 2015, the actual purchases of Treasury securities by the Federal Reserve are positively related to changes in Treasury yields. This effect is driven primarily by the positive relation of the Treasury purchases with the bond risk premium, but they are also positively related to the expected inflation rate and the real rate of interest. The evidence is consistent with the liquidity channel hypothesis as put forward by Krishnamurthy and Vissing-Jorgensen (2011), since the Federal Reserve's Treasury purchases also strongly predict a lower corporate yield spread. Using a macro-finance term structure model we provide counterfactual estimates of the Treasury yields in the zero lower bound period.

The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates

In an effort to promote more accommodative financial conditions following the financial crisis of 2008 and the ensuing recession, and at a time when the conventional monetary policy tool--the federal funds rate--was at its effective lower bound, the Federal Reserve conducted large-scale asset purchases (LSAPs) and a maturity extension program (MEP). By increasing the amount of longer-term Treasury securities and agency MBS on the Federal Reserve's balance sheet, and thereby reducing the amount of longer-term Treasury securities and agency MBS that the public would have held otherwise, these purchase programs put downward pressure on longer-term interest rates. This note outlines a way to estimate by how much Federal Reserve securities holdings resulting from these purchase programs reduce longer-term interest rates. In particular, we estimate the term premium effect (TPE) on the 10-year Treasury yield. Currently, our model suggests that the cumulative effect of the Federal Reserve's LSAPs and MEP results in a reduction in the 10-year Treasury yield term premium of about 100 basis points. By the end of 2017, the term premium will be held down by about 85 basis points. The slight narrowing of the TPE reflects the average maturity of the Federal Reserve's portfolio declining and the cessation of reinvestments drawing nearer.

Confidence Interval Projections of the Federal Reserve Balance Sheet and Income

In response to the financial crisis of 2008 and the subsequent recession, the Federal Reserve employed large-scale asset purchases (LSAPs) and a maturity extension program (MEP) with the purpose of reducing longer-term interest rates, and thereby promoting more accommodative financial conditions at a time when the conventional monetary policy tool, the federal funds rate, was at its effective lower bound. In this note, we presented the implications for the Federal Reserve's balance sheet and income arising from a range of future potential macroeconomic outcomes.

Has Fed's Policy Hurt the World Economy?

In an attempt to rescue the U.S. financial market and to stimulate the economy, the Federal Reserve introduced a number of non-conventional monetary policy tools. Termed as and aimed at lowering both the short-term and the long-term interest rates and thereby boosting the consumption and investment demand and, in turn, stimulating the economy, this policy had the effect of altering both the size and composition of the Federal Reserve's balance sheet. These nonconventional policy tools were thought to be necessary when conventional policy tool, such as, the federal funds rate target had almost reached zero. These policy tools were implemented in the forms of: (a) lending to financial institutions, (b) providing liquidity to key credit markets, and (c) purchasing longer-term securities. There have been several studies on the impact of the recent U.S. monetary policy. But these studies mainly focus on its effect on the interest rate, the commodity prices, and the exchange rates. None of these studies have examined the impact of U.S. monetary policy on a specific country, a specific group of countries, or the world economy. Also, these studies do not use a general equilibrium model that takes into account both the goods market and the money market equilibrium condition. We develop a general equilibrium model of income, in which the domestic real GDP is a function of domestic currency's exchange rate and the foreign monetary base. We, then, apply the model on a panel data on the United States and the BRICS countries to see if U.S. credit easing has any effect on BRICS countries' real GDP. Our study finds that the recent U.S. monetary policy of credit (quantitative) easing has an adverse effect on BRICS countries' real GDP. This finding seems intuitive, because, the increase in the U.S. money supply caused by its pursuance of the credit easing policy will lower the interest rate in the U.S. increasing the relative prospective rate of return on investment in the United States. This increased relative rate of return causes increased capital flow into the U.S. from abroad including the BRICS countries. The capital outflows, in turn, lower the investment and, consequently the real GDP in BRICS countries. Also, the random effect is negative for Brazil and Russia, while it is positive for China, India, and South Africa, suggesting that the U.S. monetary policy has a greater negative impact on the real GDP of Brazil and Russia than on that of other BRICS countries. The policy implication of our finding is that an easy monetary policy, such as, quantitative easing does lower the interest rate and increase domestic investment and thereby stimulate the economy. Therefore, some of the policy measures the BRICS countries can take to insulate their economies from a negative impact of the U.S. monetary policy is to implement a similar (easy) monetary policy in their own countries or exercise a direct control on capital outflow.

Quantity Theory of Money Redux? Will Inflation be the Legacy of Quantitative Easing?

Since the onset of the Federal Reserve's unconventional programme of large-scale asset purchases, known as quantitative easing (QE), some economists and financial practitioners have feared that the consequent buildup of the Fed's balance sheet could lead to a large expansion of the money supply, and that such an increase could cause a sharp rise in inflation. So far fears about induced inflation have not been validated. This article examines the basis for the original concerns about inflation in terms of the classic quantity theory of money, which holds that inflation occurs when the money supply expands more rapidly than warranted by increases in real production. The article first reviews the US experience and shows that whereas rapid money growth might have been a plausible explanation of inflation in the 1960s through the early 1980s, subsequent data have not supported such an explanation. It then shows that the quantity theory of money has not really been put to the test after the Great Recession, because a sharp increase in banks’ excess reserves and corresponding sharp decline in the ‘money multiplier’ has meant that the rise in the Federal Reserve's balance sheet has not translated into increased money available to the public in the usual fashion. The most likely aftermath of quantitative easing remains one of benign price behaviour. However, if nascent inflationary conditions materialise, the Federal Reserve will need to manage adroitly the large amounts of banks’ excess reserves that have accumulated as a consequence of QE in order to limit inflationary pressures.

Unconventional Monetary Policy Measures and Inflation Expectations

The record increase in the size of the Federal Reserve's balance sheet after the financial crisis ignited fears among some people that high inflation would inevitably follow. We investigated whether those fears were supported in survey or market measures of inflation expectations around the time that large-scale asset purchases were announced. Nothing suggests that the Fed's new policy tools have been perceived by professional forecasters or financial markets as harbingers of hyperinflation.