Shrinking the Fed balance sheet

[William F Hummel]

The Fed announced it will begin down-sizing its balance sheet later this year.  It will do so by retiring maturing securities instead of rolling them over  Assets currently total $4,422 billion. Most of that is Treasury securities - $2,465 billion and mortgage-backed securities $1,779 billion. Treasuries will be retired a rate of $30 billion per month and MBS at a rate $20 billion per month. Although MBS will take longer to retire, It seems likely they will all go.

 

Regarding the final size of the balance sheet, the Fed said “no more securities than necessary to implement monetary policy, appreciably below that seen in recent years but larger than before the financial crisis.” That clearly implies a regime of excess reserves, with the Fed controlling the interbank lending rate on reserves by paying interest on excess reserves (IOER) and using overnight reverse repos to set a corridor for the upper and lower rates

 

The Fed is required to hold enough Treasuries to cover the currency in circulation which now totals about $1,556 billion. I am guessing the Fed will target about $250 billion for aggregate reserves in the banking system. Treasuries on the Fed’s balance sheet would thus total about $1,800 billion initially. That will require a reduction of about $660 billion from its current level.

.William

[lante...@gmail.com]

Regarding: " No more securities than necessary to implement monetary policy, appreciately below that seen in recent years but larger than before the financial crisis".

That is very revealing and helpful to moving forward. It is confronting the problem of how much reserves is necessary. Now the US Treasury must address the same problem. It is going to be interesting.

Signature:    My compliments and best wishes.

[John Hermann]

  Thanks for this information William.  What is the mechanism
for retiring securities held by the Fed in its assets portfolio?
Can it simply write them off, or does it need to come to some
sort of  an arrangement with Treasury?  In theory the Treasury
would pay the monetary value of maturing securities and any
residual interest to the holder.  But perhaps this is unnecessary
in regard to the Fed?    - John

On 16/06/2017 3:45 AM, William F Hummel wrote:

The Fed announced it will begin down-sizing its balance sheet later this year.  It will do so by retiring maturing securities instead of rolling them over  Assets currently total $4,422 billion. Most of that is Treasury securities - $2,465 billion and mortgage-backed securities $1,779 billion. Treasuries will be retired a rate of $30 billion per month and MBS at a rate $20 billion per month. Although MBS will take longer to retire, It seems likely they will all go.

Regarding the final size of the balance sheet, the Fed said “no more securities than necessary to implement monetary policy, appreciably below that seen in recent years but larger than before the financial crisis.” That clearly implies a regime of excess reserves, with the Fed controlling the interbank lending rate on reserves by paying interest on excess reserves (IOER) and using overnight reverse repos to set a corridor for the upper and lower rates.

[William F Hummel]

The shrinkage plan will start at $6 billion per month and increase every third month by $6 billion per month until it reaches $30 billion per month. That will retire $180 billion in the first year and $360 billion in the second year for a total of $540 billion. If the objective is to retire $660 billion as I have assumed, the remaining $120 billion could be retired in four months of the third year.

Normally the Treasury sells new securities to the Fed to acquire the funds needed to redeem maturing Treasury securities in the Fed’s portfolio, in effect rolling over its debt. This is allowed as long as the balance in the Treasury account at the Fed does not increase by the sale of securities to the Fed. So there must be a simultaneous redemption and sale of securities in the process. No doubt the Fed and Treasury have a simple solution to this, but I don’t know the details.

However for the Feds portfolio of Treasuries to shrink, the sale of new securities to the Fed would not take place. Then how does the Treasury acquire the funds it needs to redeem its maturing securities in the Fed’s portfolio? I assume it satisfies the need by including an extra amount when it sells securities in the open market to cover its estimated budget deficit.  In this way the Fed’s liabilities in bank reserves decrease equally with its assets in Treasury securities. 

William   

 

[Joe Leote]

This Fred graph shows 153 billion of federal funds in the Treasury General Account (TGA) as of June 14, 2017:

https://fred.stlouisfed.org/series/WTREGEN

This article shows a graph:

http://www.investopedia.com/insights/how-will-fed-reduce-balance-sheet/

with this description "(Fed) Balance sheet run-off starting Q4 2017 at $10bn per month. Cap raised by $10bn each quarter until it reaches $50bn a month."

Also according to the article, "For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month," the Fed said.

So for maturing Treasuries running off its balance sheet Fed will debit (reduce) the TGA balance. Treasury could run down the TGA for some time but at some point would apparently have to sell securities to banks and non-banks to keep a positive (credit) balance in its TGA.

Also according to the article, "With regards to its agency debt and Mortgage-Backed Securities (MBS), the Fed laid out a similar plan where it will begin tapering $4 billion a month until it reaches $20 billion."

I assume the agencies will have a similar concern raising funds in markets to keep a positive federal funds balance as Fed lets the agency and MBS securities run-off.

Joe

[John Hermann]

On 18/06/2017 1:16 AM, William F Hummel wrote:

However for the Feds portfolio of Treasuries to shrink, the sale of new securities to the Fed would not take place. Then how does the Treasury acquire the funds it needs to redeem its maturing securities in the Fed’s portfolio? I assume it satisfies the need by including an extra amount when it sells securities in the open market to cover its estimated budget deficit.  In this way the Fed’s liabilities in bank reserves decrease equally with its assets in Treasury securities.

OK William, that makes sense, and I have noted that Joe concurs that this
is how it would work.  The overall process (i.e. involving Treasury) is the
equivalent of the Fed selling some of its stock of securities back to the
private sector.  This means that over the longer term we would see $660
billion in reserves removed from the banking system.  Correct?
  - John

[lante...@gmail.com]

Regarding: ' This means that over the longer term we would see $660 billion in reserves removed from the banking system ' . Finally, we get to the nitty-gritty. The goal was to remove those excess reserves. Sounds encouraging.

Signature:    My compliments and best wishes.

[Steve Conover (TX)]

William, 

First of all, many thanks to you for your patient mentorship, going back twenty years in my case. You have made a huge difference, and no doubt you'll keep going strong. I look forward to that.

I've been more of a lurker here than a participant, and I still have a (small?) gap in understanding. Here's the question: What is the financial risk of NOT shrinking the Fed's balance sheet -- the risk of simply letting the bond boneyard sit there undisturbed? (...as opposed to the political risk, which does not interest me much any more.)

Thanks, as usual, and best wishes.

Steve

On Sat, Jun 17, 2017 at 11:46 AM, William F Hummel <wfhu...@gmail.com> wrote:

[William F Hummel]

     John, in order to redeem the maturing securities in the Fed’s SOMA, the Treasury must acquire funds equal in amount to the principal and interest due on them. On balance it does so by selling securities in the open market in excess of what is needed to cover the budget deficit.That reduces aggregate reserves in the banking system, replacing them with securities of equal value. The liquidity of the aggregate bank is reduced by that amount

When the Treasury redeems maturing securities at the Fed, those securities simply disappear from SOMA, thereby shrinking Fed assets. The funds it receives reduce its liabilities,

​(

base money outstanding

​)​

​as recorded on

 its balance sheet. The Fed does not transact directly with the banking system in this scenario.

William                          ,, 

[William F Hummel]

Correcting an error on my previous post:

John, in order to redeem the maturing securities in the Fed’s SOMA, the Treasury must acquire funds equal in amount to the principal and interest due on them. On balance it does so by selling securities in the open market in excess of what is needed to cover the budget deficit.That reduces aggregate reserves in the banking system,

When the Treasury redeems maturing securities at the Fed, those securities simply disappear from SOMA, thereby shrinking Fed assets. The funds it receives reduce its liabilities (base money outstanding) as recorded on its balance sheet. The Fed does not transact directly with the banking system in this scenario.

[John Hermann]

On 19/06/2017 12:58 AM, William F Hummel wrote:

John, in order to redeem the maturing securities in the Fed’s SOMA, the Treasury must acquire funds equal in amount to the principal and interest due on them. On balance it does so by selling securities in the open market in excess of what is needed to cover the budget deficit.That reduces aggregate reserves in the banking system, replacing them with securities of equal value. The liquidity of the aggregate bank is reduced by that amount

William,  this is a repetition of what you said previously, which I have already
agreed with.   I am unsure why you felt a need to repeat it.

When the Treasury redeems maturing securities at the Fed, those securities simply disappear from SOMA, thereby shrinking Fed assets. The funds it receives reduce its liabilities,

​(

base money outstanding

​)​

​as recorded on

 its balance sheet.

Obviously so.

The Fed does not transact directly with the banking system in this scenario.

Obviously not.  Which is why I used the word "equivalent".

I would make the point that, instead of this complicated interaction involving both
the Fed and Treasury, it would seem to be much simpler for the Fed to simply sell
some of its Treasuries.

I realize that it would have a harder time trying to sell its MBS assets, in which
case the mechanism described for retiring these assets - involving the Treasury -
is appropriate.

- John

[William F Hummel]

On Sun, Jun 18, 2017 at 9:11 AM, John Hermann <her...@chariot.net.au> wrote:

I would make the point that, instead of this complicated interaction involving both the Fed and Treasury, it would seem to be much simpler for the Fed to simply sell some of its Treasuries.

​The Fed could do that too. but it cannot avoid dealing with the Treasury on maturing securities.

​

 

I realize that it would have a harder time trying to sell its MBS assets, in which case the mechanism described for retiring these assets - involving the Treasury is appropriate.

 

​The counter-party for the​ ​MBS  are GSEs like Fannie Mae and Freddy Mac or investment banks.

-