The Fed s Balance Sheet: Implications for Exit Strategy and Financial Stability

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1 The Fed s Balance Sheet: Implications for Exit Strategy and Financial Stability Jeremy Stein NABE/AEA Panel on: Monetary Policy Normalization: Graceful Exit or Bumpy Ride? January 3, 2015

2 Fed s Balance Sheet (Very Roughly) $4.5 T of assets (mostly Treasuries and MBS). $1.3 T of currency. Remainder (aside from Treasury account) financed with reserves and reverse repo (RRP). Reserves pay 25 bp. Banks, GSEs and FHLBs can deposit with Fed; only banks get interest. RRP currently pays 5 bp. Currently about 140 counterparties participate. 94 money funds, GSEs plus some FHLBs, 18 banks, 22 primary dealers.

3 Why is Fed Funds < IOR? Funds rate has recently been in range of 7 13 bp. Think of banks arbitrage condition: Fed funds = IOR cost of doing arbitrage. Costs include FDIC assessment for domestic banks, and shadow value of leverage constraint. The tighter the leverage constraint binds, the larger the equilibrium wedge.

4 Foreign Banks and IOR Arbitrage Big FBO reserve holders include Deutsche, UBS, Bank of China, Mitsubishi. If done through uninsured branch, don t have to pay FDIC assessment.

5 What is Right Mix of Reserves and RRP? Can ask as a monetary policy implementation question. Want to raise rates, how much slippage (in mean and variance) are you willing to tolerate between IOR and money market rates? More RRP less slippage. E.g.: Strong floor: set RRP = IOR 5 bp, full allotment. But in the end, there a lots of combinations that will work to get rates up, some cleaner than others. More interesting as a financial stability question. Can doing more RRP help Fed on its fin stab goals? Or is it potentially destabilizing in a crisis?

6 Fed s Current Approach will use an overnight RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate. Overnight facility is currently capped at $300B. Fed is experimenting with term RRP as well. Why the aversion to RRP? Generalized conservatism? Fear that money funds will run to RRP in a crisis, causing a squeeze for other borrowers. Discomfort with monetary policy being so reliant on money market funds.

7 What Would Milton Friedman Say? If Fed seeks to fund itself as cheaply as possible, doesn t this have good normative properties? Sell your liabilities to those who value it most. Banks are glutted with reserves, have to be paid extra to hold them. Meanwhile, money funds are relatively hungry for short term safe assets.

8 A Brief Crisis Narrative Too much maturity transformation by banks and shadow banks. Households and corporates wanted safe assets; had huge deposits in MMFs. MMFs couldn t find enough T bills, bought repo and ABCP issued by Bear and Lehman. Lots of rules now that hope to rein this bad behavior in. LCR; NSFR; leverage ratio; liquidity based capital surcharges; FSB work on margin requirements for SFTs. How will these rules fare when yield curve normalizes and it is much cheaper to borrow at the very short end? Need to ask: why does private sector do so much maturity transformation? Because it pays. Because public sector has not produced much in the way of the most highly valued very short maturity bills.

9 Evidence on Crowding Out From Greenwood Hanson Stein (2014): Significant money premiums on short maturity T bills. On the order of 40 bp for 2 to 4 week bills. These premiums shrink when bill supply increases. Can get exogenous variation in bill supply using tax calendar. E.g. bill supply falls sharply after April 15. Financial CP issuance falls when bill supply increases. Carlson et al (2014) Similar results for time deposits, ABCP.

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12 Fed vs. Treasury as Supplier of Short Term Safe Assets? Treasury may be more natural for accommodating long term secular demand. Fed may be better suited to dealing with highfrequency demand shifts. Fed doesn t need to worry about failed auctions.

13 RRP Design Issues Should be capped so that supply doesn t expand elastically in a stress scenario. But need not be unconditionally capped at fixed quantity. Instead, could let quantity find its natural level in normal times, then impose cap such that quantity never grows by more than X% in a short interval. Could restrict counterparties to be government only MMFs. Then no issue of running away from private firms in a stress scenario. And less concern about supporting an undesirable business model.

14 Other Fed Balance Sheet Tools Term deposit facility Banks deposit for eight days at 29 basis points. Meant to drain overnight reserves. But doesn t eliminate bank balance sheet bloat. Segregated balance accounts Like RRP, an attempt to approximate Fed bills. A potential drawback is that these accounts may still count towards bank FDIC assessments and leverage ratio.