Practical analysis for investment professionals
26 June 2014

Is It Time for the Fed to Contract Its Balance Sheet?

Posted In: Economics, Fixed Income

The Federal Reserve can keep their balance sheet at the current size (and keep the risk asset party going) or it can position itself to be able to hike rates — but it cannot do both.

Last week, the Fed announced that purchases of agency mortgage-backed securities and US Treasuries would fall to $35 billion per month. If they continue reducing their purchases by $10 billion per month, the incremental purchases should be finished by October.

So what will happen? Their current policy is to reinvest principal runoff and maturities from existing holdings, which means their balance sheet will stay roughly the same size once they stop buying new bonds. As we consider the future of fiscal policy in this country, one of the key questions will be what the Fed is capable of doing.

JP Morgan’s CFO Marianne Lake recently described the impact on the industry, saying, “We should note that a significant portion of the growth in deposits that the industry has experienced has been as a direct result of the Fed’s QE policy and reserve bills. So if you look at JP Morgan, since the end of 2009, the firm’s deposit rate has grown by about $350 billion and we believe a significant portion of that growth has been a direct result [of] QE.” In that same call, she noted that JP Morgan (JPM) has estimated it may experience a deposit outflow as large as $100 billion in the second half of 2015.

How Does QE Work Again?

It’s often mentioned that the Fed buys bonds in asset swaps. This is true. Where many people get confused is that it is not an asset swap for the banks. When the Fed buys bonds, they typically buy them from non-banks. The bonds are removed from circulation and put on the Fed’s balance sheet, while the Fed pays for these bonds with newly created reserves. Now these reserves must be deposited at a bank, so they will show up at a bank as new deposits.

For the bank, these deposits are liabilities and the corresponding assets are the reserves sitting at the Fed earning “interest on reserves” of 0.25%.

So think about this: Every dollar of QE purchases must end up at a bank in the form of a new deposit. This is not a theory, it can be seen by viewing asset and liability data from the Fed’s H8 report. As you might notice, the difference between the deposit over loan excess ties almost exactly with growth in the Fed’s balance sheet.

Deposits Less Loans of All Commercial Banks versus Fed Balance Sheet
Deposits Less Loans of All Commercial Banks versus Fed Balance Sheet

Source: Federal Reserve H8 Report

Comments from Federal Reserve members indicate they are reluctant to cease the reinvestment of principal runoff. I would assume this reluctance stems from their belief not only that the size of the Fed’s balance sheet gives credibility to “forward guidance,” but also that contracting the balance sheet could begin an unwind of various risk asset trades.

Recently, the Fed has introduced two tools to drain reserves from the system: the reverse repo (RRP) and term deposit facilities (TDF). With the TDF, for instance, a bank would have a term deposit (right now one week) with the Fed and earn a few extra basis points (bps) over interest on excess reserves (IOER). The first question is how much compensation would a bank need over the current IOER rate (25bps) to entice them to utilize these tools? Is it 10 basis points? 20? 50? Nobody knows.

Maybe a more fundamental question is this: Is there a big difference to the market in terms of whether they drain reserves by cutting off principal reinvestment or by utilizing RRPs and TDFs? My answer is an unequivocal yes. The goal of RRPs and TDFs is to ensure that enough reserves are removed from the system so that demand will exist to borrow Fed funds. I might be naïve, but I am skeptical that a bank would voluntarily tie up too many reserves only to have to go right back into the market and borrow from someone else.

Meanwhile, if the Fed ceased reinvesting runoff, then reserves would automatically leave the system as bonds paid down and deposits left. Put another way, I have a hard time believe removing reserves temporarily via RRP/TDF will get the overnight markets to a “normalized state.”

Moreover, can the Fed do this in a great enough size to achieve its goal? The most recent TDF auction on 16 June raised a bit over $92 billion, which is insignificant in terms of the Fed’s whole balance sheet.

This is all so important because it is my belief that the Fed cannot raise interest rates with such a large amount of reserves in the system.

Alternative Option: Stop Reinvesting Principal Runoff

The recent year-over-year (YoY) consumer price index data pushing past 2% led some to argue that the Fed should take a more hawkish stance. Much to that group’s dismay, higher inflation projections were not present in the Fed forecasts and Federal Reserve Chairperson Janet Yellen did not seem overly concerned about the spike in her subsequent comments.

Whether or not inflationary pressures are building is debatable. I believe, however, it’s in the Fed’s best interest to start reducing the size of its balance sheet in advance in order to reduce reliance on reserve draining via repos and term deposits. The Fed is currently not in a place where it can raise rates with trillions of dollars of reserves in the system. Thus, if inflationary pressures somehow do arrive, then the Fed has real problems.

The other reason to start taking down the balance sheet is to be proactive in preventing excessive risks in the markets. It’s well documented that the chase for yield continues, and now that even the most esoteric instruments have been bid up, leverage is being employed to hit yield targets.

Shrinking the balance sheet would likely send a shock to carry traders, maybe even similar to last summer’s “taper tantrum,” but it’s probably a healthy thing to do. Opponents of this philosophy might say that such a strategy might risk disrupting one of the only benefits of QE, which is the rise in wealth through rising financial asset prices.

This raises some interesting questions: If you assume risk assets could sell off with a contraction in the balance sheet, would the underlying economy be strong enough to withstand a shock? Would a move sabotage the economy’s momentum and be hurtful in the end? Nobody knows, but there’s a limit to the rise of financial asset prices and excessive risk taking, and leverage buildup has to be considered in terms of the cost-benefit analysis for the Fed. Manmohan Singh of the IMF believes that it could cause great disruptions, but it is all speculation at this point.

It’s more important for the Fed to be in a position to raise rates than it is for the party in risk assets to continue at its current feverish pace. I have real questions about the efficacy of RRPs and TDFs on a large scale, and believe the better option is to “reverse” the purchases through natural runoff. RRPs and TDFs can have some impact, but the “heavy lifting” will be accomplished through runoff and sales. I estimate the average life (time it takes to get half your investment back) of the Fed’s holdings to be about five years, so this wouldn’t be an immediate process. But in my opinion, if the Fed believes inflation and credit creation are starting to take hold then ceasing runoff reinvestment is the optimal choice at this stage of the game.

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About the Author(s)
David Schawel, CFA

David Schawel, CFA, is a portfolio manager for New River Investments in the Raleigh/Durham, North Carolina area. Previously, he managed a $2-billion fixed-income portfolio for Square 1 Financial, which he joined in 2008.

11 thoughts on “Is It Time for the Fed to Contract Its Balance Sheet?”

  1. Anon says:

    They can raise rates by increasing IOER. This is independent of the size of their balance sheet.

  2. Alex says:

    “When the Fed buys bonds, they typically buy them from non-banks.”

    I thought the Fed was buying the bonds exclusively from dealers (which would be banks). Fed cannot force non-banks to sell bonds. So I don’t quite understand the transition mechanism from bonds to deposits.

  3. Tim says:

    Alex: the Fed can never technically force anyone to buy/sell in open market ops. the article is making a somewhat leap in its point on bonds to deposits mechanism. you can see from the graph displayed that there is a lag for fed balance sheet vs. net deposits. the article is basically saying that when the fed buys bonds, it will eventually make its way to a bank’s deposit

    to the author: i’m not as fluent in fixed income, though from one dukie (I’m presuming based on raleigh/durham) to another, could you explain your central point of, “Fed cannot raise interest rates with such a large amount of reserves in the system”? It seems like you’re presuming that the fed is using open market ops to achieve this (vs. direct federal funds rate hike) in this statement? i thought your article brought up some good points, though the language and approach is very high context (vs. low context – seems like NC is rubbing off a bit

  4. Mommin says:

    I think the FED decides what the absolute amount and maturity of bonds it wants to buy and then lets non-banking institutions buy it for them. It doesn’t force these institutions, it places an order with these firms like firm’s other clients.

  5. Tim says:

    Few questions: remind me again why injecting deposits Into the banking system with the corresponding assets parked in reserves is stimulative? Seems to me that if deposits minus loans are growing along with the Feds balance sheet, then the $$ isn’t making its way into the economy. And wouldn’t your chart fail to correlate if loan growth was more robust?

    Why do qe purchases need to go into bank deposits? Can’t a non bank seller of treasuries invest the proceeds in any asset they wish?

    Doesn’t the risk carry trade and subsequent unwind rest solely with the banks since they are the recipients of the qe proceeds?

    Although the data I have is limited, the last time the Fed went on a tightening cycle in 2004, deposit growth more or less continued. Outside of qe unwind, why would the next tightening cycle be any different? Seems to be a consensus view that a surge of deposit outflows is likely when rates rise.

    Thank you

  6. Gunzo Gunzo says:

    It is all a big mess. Inflation or no inflation, the interest rates have no business to be this low. Contrary to popular belief, lack of economic growth should increase the interest rates rather than otherwise. Imagine that a guy is unemployed and and everyone is rushing to lend him money at a low interest rate, now would this not be funny? The same is the case, uncle Sam is broke and unemployed or underemployed and hence must pay higher rate for the loans. Federal reserve is on a collision course; they can neither increase the interest rates nor decrease the balance sheet size.

  7. Engin says:

    You said that
    ” if the Fed ceased reinvesting runoff, then reserves would automatically leave the system as bonds paid down and deposits left.”

    Can you explain this frase ? FED will not take the money of the bonds as cash ?

  8. Mike says:

    Allow me to preface this by stating this is my belief in how it would work. I’ve never read a description of it but I know that money is created and destroyed and this is how I believe it works. Someone will hopefully correct any errors I make. Even if I am basically right I would not be surprised if one or more details are off.

    Much of the so-called “money” in the banking system is created and destroyed by accounting journal entries.

    When the Fed bought the bonds they simply credited the reserve account of the bank holding the demand deposit account of the bond seller and the bank credited the seller’s deposit account.

    If a commercial bank customer pays off an RMBS what will happen is:

    1) As part of clearing the check, the bank will debit (reduce a liability) the customer’s deposit account, decreasing the bank’s demand deposit liabilities. They will credit (reduce an asset) their reserves by an equal amount. Thus both assets and liabilities decrease by the same amount. Demand deposit money shrinks.

    2) Within the Federal Reserve System the check will be cleared and the bank will lose an equal amount of reserves to the Fed (the Federal Reserve Bank with which the commercial bank holds its reserves will debit (reduce a liability) the commercial bank’s reserve account). No corresponding credit to another bank’s reserve account will or can be made and no credit is made to another demand deposit account. Poof, the reserves and demand deposit money are gone. On the asset side the RMBS will be credited (reduce an asset) by the same amount to balance the books. . This is similar to what happens at the demand deposit level when money is destroyed as principal on a loan is repaid to a bank by a retail customer.

    Government bonds are a little more involved but the end result is the same. IMO, the money is not destroyed when the Treasury pays off the bond. That just makes it permanent if the Fed does not go out and buy more assets. The money is destroyed through tax payments and/or the selling of another bond, which provides the money the Treasury needs to pay off the bond. But in a way this is quibbling.

    Why is this? The Treasury account is kept within the Federal Reserve System, not a commercial bank. As a consequence of this:

    1) The Treasury account is not part of the money supply.

    2) Payments to the Treasury destroy demand deposits and reserves as the payment to the Treasury is actually from your bank’s reserves to the Treasury’s deposit account. So within the Federal Reserve system the reserves are “destroyed” by moving from one liability account (reserves) to another Treasury deposit), so accounting-wise it is a reclassification of liabilities with nothing happening on the asset side.

    Normally, this is a temporary phenomenon as the money will be spent back into the economy by the government, including bond payments for publicly held bonds. The Treasury payment causes a commercial bank demand deposit account to be credited and the funds move back out of the Treasury account and are credited to the reserve account of the bank holding the deposit account that received the payment.

    But if the payments go to the Fed the Treasury account money is not credited to any other bank and just goes poof again, unless the Fed turns around and buys an equal amount of bonds again. If they stop these purchases the money and reserves never make it back to the commercial banking system from the Treasury. The offsetting entry to the decrease in Treasury liabilities is an equal adjustment downward (credit) to the bond assets.

    As I said above, this probably isn’t exactly what happens but a key point to remember is that when the Fed receives a payment they don’t go and deposit it anywhere. They just make adjustments to the books. The money comes from nowhere and vanishes just as easily. Money comes out of the commercial banking system and does not re-enter it.

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