The Fed’s Balance Sheet

Matthew Schiffgens:

Hi, I’m Matthew Schiffgens, and I’ll be your host for this podcast on the Fed’s balance sheet. This podcast is the twelfth and final segment of the SF Fed’s 2015 Annual Report, What We’ve Learned…and why it matters. I’ll be talking with Glenn Rudebusch, Executive Vice President and Director of Research at the Federal Reserve Bank of San Francisco. Glenn, welcome.

Glenn Rudebusch:

Thank you, Matthew.

Following the largest financial crisis since the Great Depression, this episode of slow and steady economic recovery has been going on for more than six years. Glenn, during this time, what have we learned about the Fed's balance sheet?

Glenn Rudebusch:

The balance sheet has been an integral part of this episode. We've started, again, with one of the most severe financial crises and recessions that the United States has faced. The Fed has, during that time, stepped up and conducted extraordinary policy action. The balance sheet was crucial in doing that, and I think we've learned a lot about the importance both for liquidity operations and lender of last resort, but also for the quantitative easing, how important it is to have that tool available for the central bank.

Matthew Schiffgens:

So Glenn, can you explain to me, what is the Fed’s balance sheet?

Almost everybody has a balance sheet. Government institutions, commercial businesses, individuals, they all have a balance sheet. A balance sheet is just an accounting of the assets and liabilities. The assets, those are the things you own. The liabilities are the things you owe. You’ve got your assets and liabilities, and the difference between them is your net worth or capital.

The Fed has a balance sheet, and its assets side is pretty simple. The Fed really just owns government securities. The size of the Fed's balance sheet right now is about $4.5 trillion. About 95% of its assets are just in government securities, and shorter and longer term Treasury obligations and mortgage-backed securities from the federally sponsored enterprises or agency. That's on the asset side.

The liability side's a little different. The Fed has currency, primarily, or money, on the liability side. Usually you think of currency as an asset.

Matthew Schiffgens:

Counterintuitive in a sense, right?

Yes, right. You usually think of, "Oh, currency? That's a good thing to have." Well, that currency, if you look on it, it says "Federal Reserve Note." That's actually an obligation of the Federal Reserve, and it's a liability for the Federal Reserve. Currency, or cash or money, represents the bulk of the Fed's liabilities. That might be physical, the kind of currency we see, or this money might be in electronic form. Banks have basically checking accounts with the Fed, and they've got so-called reserves. Those reserves are essentially electronic money that they can use to buy things. The Fed creates those reserves as well, and that's the electronic version of money.

The Fed's balance sheet is assets and liabilities, just like any other balance sheet, and it's very safe assets, these Treasury securities, these government obligations. The liability side, then, the Fed has created cash.

Matthew Schiffgens:

How does the Fed purchase assets on its balance sheet, and where did it get the power to do this?

Glenn Rudebusch:

The Fed was established in 1913 and given this power to create money and to really regulate the money supply by Congress, by law. It works in a fairly simple process. If we want to buy a government security, we would create money. This could be physical money, or we could print it, or we could create this electronic money. We would go out and buy the assets, so our balance sheet would increase. We'd have more liabilities in terms of more money or reserves out there, and more assets in terms of having this government security. If we turn around and sell the government security, then our assets go down and we've also then received this cash, or this money, and we extinguish that. The balance sheet goes up and down as we buy and sell government securities.

Matthew Schiffgens:

And so is this what they mean when they say we have an elastic currency that enables the Fed to shrink or expand the money supply?

Glenn Rudebusch:

Broadly speaking. We're able to increase or decrease the money supply simply by buying and selling government securities.

Matthew Schiffgens:

How does the Fed use its balance sheet to achieve its policy goals?

The Fed's balance sheet has always been integral to its policy setting mechanism, and it's really been used in three different ways in terms of what the Fed was trying to achieve. Really, the Fed was developed in order to use its balance sheet to make emergency loans to firms during financial crises. That was the start of the Federal Reserve. The Federal Reserve's balance sheet would increase as it made these loans. In the financial crisis leading to the Great Recession, the Fed made about $1.5 trillion in this emergency lending. This was collateralized, short-term lending, very secure, but it was important to push that liquidity out into the marketplace. That was an important part of the use of the Fed's balance sheet for a policy purpose.

Matthew Schiffgens:

Historically speaking, this is traditionally what the Fed was created to do in times of financial panics, or runs on the banks, and again stems from the Federal Reserve Act and the powers provided to the Fed by Congress.

Glenn Rudebusch:

Exactly, and we call this the lender of last resort facility of the Fed. It's really true for any central bank. The second part that's adjusting the short-term interest rate. That, too, has traditionally, that conventional monetary policy, has been conducted with the Fed's balance sheet by changing the amount of reserves and the amount of Treasury securities. It affects the supply and demand for short-term liquidity in money markets, and the Fed can set a target for a short-term interest rate. That's traditionally been the federal funds rate. That's conventional monetary policy.

What happened during the financial crisis and the Great Recession is that the Fed lowered short-term interest rates, from about five percent to about zero, and really can't lower those nominal interest rates much lower than zero. Yet, the economy was still underperforming. The recovery was very slow. There were worries about price deflation, and very low inflation in prices and wages, and so the Fed wanted to add more monetary policy stimulus. It couldn't with short-term interest rates, so it used its balance sheet to work on lowering longer-term interest rates. This was the unconventional monetary policy that people talk about.

Matthew Schiffgens:

What people called QE right?

Quantitative easing or QE. This involved buying government securities, on a large scale, and injecting large amounts of liquidity into the system. As you pull the amount of longer-term securities out of the marketplace, that is, you're reducing the supply, that tends to push up the price of those longer-term securities. For a bond, price and yield are inversely related, so as you push up the price of those securities, reducing supply, then the yields fall. You're lowering longer-term interest rates, and that helps stimulate the economy.

Matthew Schiffgens:

That makes it cheaper for American households to borrow money to buy a car or a home?

Exactly. Once you've lowered longer-term interest rates, say by 50 or 100 basis points, probably the effect was on that order of magnitude, you're helping ease financial conditions. Then, of course, that feeds through to the economy where we've seen this boost in auto and light truck purchases because of lower interest rates. Lower mortgage rates have helped revive the housing market, and so forth.

Matthew Schiffgens:

Did QE work?

Yeah, I think our best evidence is that quantitative easing, QE, did help boost the economy. The economic recovery's been slower than we had hoped, but I think that's because the headwinds holding back the recovery have been even stronger than we expected, not so much that QE didn't work. We had QE1, QE2, QE3, but certainly the evidence is that financial conditions eased, that longer-term interest rates fell with the announcement of those QE programs, and that helped support the economy.

Matthew Schiffgens:

In addition to its balance sheet, the Fed also employed forward guidance. Can you tell me what that is?

Glenn Rudebusch:

The Fed has been giving more information, more forward-looking information, about where interest rates are going to be in the future, and so that's forward guidance. This too can also help lower longer-term interest rates. That is, if you were to promise to keep short-term interest rates near zero for a long time, longer than the market expects, then with that announcement, longer-term interest rates would also adjust down and help ease financial conditions right now because of those promises in the future. I think that's also been an important tool of unconventional monetary policy, an important tool of monetary policy stimulus.

I will say that the two tools do help reinforce each other. That is, taking concrete actions in terms of buying these government bonds, these large-scale asset purchases, helps reinforce the commitment for forward guidance. That is, the two reinforce each other. I think if we were to face another downturn, face another recessionary situation, and shorter-term interest rates were near zero, that the Federal Reserve, like other central banks, would consider both further quantitative easing and forward guidance for providing monetary policy stimulus.

Matthew Schiffgens:

With such a large balance sheet pushing down long-term interest rates, how is the Fed able to raise short-term interest rates?

Glenn Rudebusch:

This is an important part of what we think of as the re-normalization of monetary policy. Now that the economic recovery is quite well established, and we're getting closer to meeting our goals on price inflation, the Fed in December of 2015 took a first step, just a small step, of raising short-term interest rates by 25 basis points, or a quarter percentage point. It's able to do that even though there's a lot of liquidity in the system, even though our balance sheet is very large, because it is able to use tools for paying out interest on reserves. That's an important part of why the Fed's been able to raise interest rates.

By paying interest on reserves, we're able to raise the general level of short-term interest rates in money markets in the economy.

Matthew Schiffgens:

Where does the Fed get money to pay interest on excess reserves?

Along with our balance sheet, which gives us this snapshot of assets and liabilities at any point in time, there's also an income statement. Other financial institutions or people or businesses have income statements, what money you're earning and what money you're paying out. The Federal Reserve has a fairly simple income statement. We get a lot of interest income, because we've got this large portfolio of government securities paying interest.

I should say that during the crisis, as we've increased our balance sheet, we've also increased the level of interest income quite dramatically. Something on the order of $80 [billion] to $90 billion on an annual basis has been accruing to the Fed. Each year we turn that over to the US Treasury. Expanding the balance sheet has really been a boon for our payments to the US Treasury. That's not what we're in the business for, we're trying to meet our macroeconomic goals, but that's where the money is coming from for paying interest on reserves.

Interest on reserves is an important tool for us to raise interest rates, but we’re not talking about a large amount of interest expense for the Fed.

Matthew Schiffgens:

Glenn, thanks again for joining us today. Any final thoughts on the Fed’s balance sheet?

As the economy continues to recover, as we return to normal, the Fed's balance sheet will shrink in a fairly straightforward, simple fashion. Again, these are government securities, they will pay off at some point, and the Fed will receive the principal from the treasury, the currency will return to the Fed, and the money supply will decrease. The Fed's balance sheet will just fall in a gradual, fairly predictable fashion over time. It'll not fall to the levels of 2007, of course. The economy has grown since then, so we've got more currency outstanding.

Our best guess is that while currency and the Fed's balance sheet was about 700, 800 billion in 2007, when we re-normalize it somewhere in the next 10 years, say by 2025, the Fed's balance sheet would probably be on the order of $2 trillion, so about three times larger. That's the growth of the economy, and really the growth of currency. That's what we think of in terms of returning to normal, is returning to that normal trend or baseline growth over time.

Ultimately, I think that we've learned that the balance sheet and quantitative easing and these extraordinary monetary policy actions are crucial tools to have in our toolbox, in case we ever are faced by the kind of traumatic economic cataclysm that we were in the Great Recession.