Tuesday, November 10, 2009

The Challenge With the Fed's Balance Sheet

The bloated size of the Fed's balance sheet in the post-Lehman period has become the subject of concerns of varying intensity, as it represents a potential inflation flashpoint when the economic recovery starts gaining traction. The dramatic increase in the Fed's balance sheet is, of course, the direct result of the unprecedented amount of liquidity that needed to be injected into the banking system in order to prevent a complete meltdown of the financial structure since September 2008.

The injection of that liquidity has been delivered via a combination of a number of special lending facilities and outright purchases of different kinds of securities. While in the early phase of such liquidity injections, the vehicle of choice was mostly the array of special lending facilities established by the Fed late last year and early 2009, in the last seven months or so, the mix has shifted heavily away from such programs and in favor of outright purchases of securities. As of November 4, 2009, approximately 75% of the Fed's total balance sheet consisted of securities held outright (vs. about 1/3 in March), while the remaining 25% consisted of the various special liquidity facilities.

The downtrend in the size of the Fed's special liquidity facilities reflects the easing of the most acute phase of the seizing up of credit market conditions late last year, and, therefore, the quiet winding down of programs like the TAF (Term Auction Facility), the Primary Dealer Credit Facility, the Commercial Paper Funding Facility, etc. However, this trend has been fully offset by the Fed;s stepping up of two key programs of purchasing securities outright: $300 billion of Treasuries (the program was just completed at the end of October), and the still ongoing massive program to purchase a total of $1.25 trillion of agency mortgage-backed securities and $175 billion of agency debt (both of which are expected to be completed by the end of the first quarter of 2010). The net result of that shift among the Fed's various programs has had no discernible effect on the total size of the central bank's balance sheet, which actually remains in the vicinity of $2.2 trillion- essentially close to its peak reached since the fourth quarter of 2008.

The gradual winding down of the special liquidity facilities can, on the face of it, be viewed as a positive development, reflecting the relative restoration of normalcy in credit market conditions. However, this is the easier part of the Fed's challenge ahead to ultimately withdraw the massive amount of liquidity injected into the financial system during the peak of the crisis. The tougher part of the Fed's job is still ahead, which remains the eventual unwinding of a portfolio of holdings consisting, to a very considerable degree, of mortgage-backed and other non-Treasury securities.

With the mortgage-backed securities market still scarred by its near-apocalyptic experience of the last two years, the Fed's hands are tied in terms of its ability to resell those securities back into the market any time soon. So, the stage is set for the Fed to remain the proud owner of well over a trillion of low-quality securities over an extended period, mostly counting on the slow runoff of these holdings over a multi-year horizon.

As a result, when the time comes for the Fed to move decisively to start draining the excess liquidity, actively dumping its bloated portfolio of outright holding is unlikely to be a viable component of its exit strategy. Instead, in implementing the latter, the emphasis will need to be more on both conventional (reverse Repurchase Agreements) and more recently introduced tools (interest paid on bank reserves).

Anthony Karydakis