One of the most esoteric aspects of Federal Reserve policy has proven to be the U.S. central bank’s most powerful weapon in fighting the coronavirus economic fallout: the balance sheet.
But even though it’s hard to find a dictionary that translates what central bankers say into everyday English, this isn’t a topic to ignore. While most consumers focus on how the Fed impacts borrowing costs, this wonky term has major implications for the U.S. economy, the stock market, monetary policy and your pocketbook.
Here’s everything you need to know about the Fed’s balance sheet, including what it is, why it’s important and even why it’s been back in the news lately.
The basics of the Fed’s balance sheet
You probably have an idea of the different types of debts you may owe, such as student loans, credit cards or a mortgage. In accounting terms, those are considered liabilities. In contrast, the things you own — stocks, bonds or a house, for example — are considered assets.
The U.S. central bank, too, keeps track of its assets and liabilities. It publishes this data in a weekly financial statement known as “the balance sheet.” (More officially, it’s the Fed’s H.4.1 statement).
U.S. paper currency, as well as money that commercial banks hold in accounts at the Fed, are counted as a liability. Assets, on the other hand, are things that the Fed has purchased, such as Treasurys.
What does the balance sheet have to do with the Fed’s coronavirus response?
To help understand why the Fed’s assets have become an important part of its recession-fighting toolkit, a history lesson from the 2008 financial crisis is needed.
In November 2008, then-Fed Chairman Ben Bernanke faced a financial panic. The Fed reduced interest rates to virtually zero, but that still wasn’t enough to jump start an economy suffering its worst turmoil since the Great Depression.
To inject more life into the financial system, the Fed turned to unconventional and unprecedented measures: It started buying long-term Treasurys, debt and mortgage-backed securities to “increase the availability of credit” for home purchases and prop up the economy, according to a Fed statement from 2008.
These purchases were dubbed “quantitative easing,” or QE, by financial experts. The Fed, however, prefers “large-scale asset purchases,” says Joe Pavel, senior media relations specialist at the board of governors of the Fed.
Fast-forward to October 2017: The Fed started gradually selling off those holdings because the economy had since healed from the last recession. The Fed concluded this process Aug. 1.
When the Fed announced it would start buying massive amounts of bonds, including “subprime” mortgage securities and other forms of distressed debt, it listed them as “assets” on its balance sheet.
This caused the balance sheet to balloon. In Aug. 2007, before the financial crisis hit, the Fed’s balance sheet totaled about $870 billion. By Jan. 2015, after those large-scale asset purchases had occurred, its balance sheet swelled to $4.5 trillion. That’s more than a five-fold increase.
By the time the Fed finished its normalization process, the balance sheet totaled $3.78 trillion.
Before these measures, people weren’t interested in the Fed’s finances, says Kenneth Kuttner, a professor of economics at Williams College who has researched unconventional monetary policy.
“It was the most boring thing in the world — like watching paint dry,” Kuttner says. “Quantitative easing changed all that.”
Why did the Fed turn to QE?
To know why the Fed took such drastic measures to revive the economy, it’s important to remember the goal of the central bank: ensuring stable prices and maximum employment.
Traditionally, the Fed influences the pace of economic growth by adjusting its key short-term interest rate known as the federal funds rate, which determines how much it costs banks to borrow and lend to each other overnight.
Cheaper borrowing costs gives consumers and businesses an incentive to spend money and invest, propelling economic growth forward. But if the economy grows too quickly, the Fed can raise interest rates to try to prevent it from overheating, which also makes it more attractive to save.
But as the financial crisis worsened, interest rates were slashed to virtually zero and the Fed still hadn’t seen the economy revived. Thus, it decided to do more.
That’s when it started to buy Treasurys and mortgage-backed securities. The Fed typically has control over short-term interest rates, but those securities are used as the benchmark for borrowing at the longer end of the curve. Ultimately, the Fed’s efforts pushed down long-term borrowing.
The Fed would then add those securities onto its balance sheet and put cash of an equal amount into the financial system. It ultimately did this by increasing the supply of bank reserves.
Firms would then use the cash from the sales to boost lending and reinvest in their businesses, according to the Fed’s reasoning.
When the Fed announced these unconventional measures, it said it would reduce its holdings back to the normal, pre-crisis level once the economy started to recover. That process came to be known as “normalization.”
What consumers should watch for
There’s just one problem: The asset purchases were so unprecedented that Wall Street investors worried that the economy may suffer harm and grow more slowly if the Fed reduced its holdings too aggressively. That’s because it takes money out of the financial system. And just as interest rates typically fall when reserve supplies increase, the central bank risks lifting borrowing costs as it decreases reserves.
As a result, some have claimed that the balance sheet normalization process amounts to policy tightening. Thus, it’s often been dubbed “quantitative tightening.”
It was the fear that “maybe monetary policy is a bit more contractionary than indicated by the fed funds rate,” Kuttner says.
The process was also evidently fraught with unknowns.
It’s like “going into a forest that hasn’t been mapped before,” says Mark Hamrick, Bankrate’s senior economic analyst. The Fed “wasn’t sure what they’d find on the way in, and getting out of the woods is similarly fraught with unknowns.”
What did the balance sheet have to do with the repo market?
That became apparent in September — but not for the reason you might be thinking. The normalization process didn’t exactly slow down the economy as experts feared, but it played a role in an extremely technical, short-term disruption.
The Fed had previously stated that the balance sheet would end up being much larger than it was pre-crisis. That’s because banks keep much more cash in accounts at the U.S. central bank — often referred to as “reserves.” But when the Fed started selling off its balance sheet holdings, bank reserves subsequently declined. Officials thought they chose an optimum level, but then Sept. 16 came along.
That’s when a large amount of cash started pouring in and out of a complicated corner of the marketplace: the repo market. It subsequently created a funding shortage that drove up interest rates past the Fed’s target range.
A “repo” is a shorter word for “repurchase agreements,” and the repo market is a place where parties go to exchange cash for securities. Trillions of dollars in debt are financed here, including U.S. government debt.
Economists still don’t know what exactly caused the funding shortfall or why it happened. Part of it was the timing. Corporate tax payments came due, sucking cash out of the system, right as new Treasury debt was offered up to the marketplace.
“The banks had less excess reserves to lend,” says Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “If we look back in hindsight, it was the case that the Fed reigned in the balance sheet too much.”
As a result, the Fed started injecting cash as soon as Sept. 17 to pull down interest rates. It’s also been conducting overnight lending operations. But on Oct. 4, it made a big announcement: It would start “organically” growing the balance sheet again, at an initial pace of $60 billion each month — mainly shorter-term Treasury bills, a “moderately aggressive” package, Ma says.
“The Fed looks like it’s erring on the side of providing extra comfort to the markets that it does have this under control,” Ma says. “I would still consider it more technical in nature and not indicative of bigger strains in the economy or the markets that the Fed is not able to address.”
How is the Fed using its balance sheet in response to the coronavirus crisis?
The Fed planned to step away from its repo operations by the second quarter of 2020. At the time, the only aspect of Fed policy that was causing the balance sheet to grow. But the coronavirus pandemic, which has left more than 26 million Americans unemployed and firms shuttered across the globe, put a damper on those plans.
As a result, the Fed has taken some extraordinary measures to contain the economic fallout — some came from the 2008 crisis-era playbook, and others went well beyond.
Most notably to do with the balance sheet, the Fed has instituted an unlimited bond-buying program. It’s also increased those repo market operations, pledging to inject a trillion dollars a week, in some cases, if firms indeed need it.
The Fed has also created new emergency lending programs, some that are scooping up municipal bonds and corporate debt. Though the Fed isn’t technically allowed to buy non-government backed debt, it can get around those requirements through section 13(3) of the Federal Reserve Act of 1913.
In emergency situations, the Fed can create a facility designed to buy those special types of debt and then lend to it. That special facility then goes on the Fed’s balance sheet.
In response to the coronavirus crisis, the Fed’s balance sheet has swelled to more than $6.57 trillion — a first for the U.S. central bank. Experts say the balance sheet could balloon even more, with some forecasts predicting it could reach as high as $10 trillion.
But is this QE?
The Fed has been hesitant to call these emergency measures quantitative easing, despite its size and scope. Records of the Fed’s March meeting show that the operations aren’t designed to push down long-term interest rates, but rather to ensure that markets are functioning properly.
All of this could lead to lower long-term rates down the road, including the Fed’s repo operations, Ma says, whether that’s through the mortgage market or to other Treasury markets out on the yield curve.
It also underscores that the Fed’s messaging is going to be important moving forward, Ma says.
What next steps should consumers take?
All of this volatility and uncertainty surrounding the depth and the breadth of the coronavirus recession, as well as the Fed’s responses, underscores the importance of building an emergency savings fund, Hamrick says. Experts recommend storing about six months of expenses in a fund, which could offset an emergency such as losing your job, but still be enough to complement what you’d receive in unemployment benefits.
But the biggest bottom line of all? Embrace the unconventional.
“Consumers, investors, savers and borrowers should think about this (quantitative easing) as one of the two main tools in the central bank’s toolbox to help adjust the strength of the U.S. economy,” Hamrick says. “It remains to be seen how the Fed will learn how best to employ it and whether there are unintended negative consequences from having invented and deployed it.”
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