Brian P Sack: The SOMA portfolio at $2.654 trillion
Remarks by Mr Brian P Sack, Executive Vice President of the Federal Reserve Bank of New
York, before the Money Marketeers of New York University, New York, 20 July 2011.
* * *
Thank you for inviting me here tonight to give these remarks. These events organized by the
Money Marketeers provide an excellent venue to talk about the Federal Reserve's
involvement in financial markets, given the focus and expertise of your group. As you know,
the Federal Reserve recently completed its second round of large-scale asset purchases,
known inside the Fed as LSAP2 and to everyone else in the world as QE2. With the program
now in the books, I thought it would be a good time to look back and assess the experience
with LSAP2. Specifically, I will discuss the effectiveness of the program relative to its stated
objectives, and I will describe some the operational challenges that we faced in implementing
it. Lastly, I will touch on several issues related to the potential evolution of the Federal
Reserve's balance sheet going forward. As always, my comments do not necessarily reflect
the views of the Federal Open Market Committee (FOMC) or any other members of the
Federal Reserve System.
LSAP2 and the Federal Reserve's balance sheet
Let me start with a few facts. The FOMC decided at its November 2010 meeting to expand
the amount of domestic securities held in the System Open Market Account (SOMA) portfolio
by $600 billion by purchasing longer-term Treasury securities through the end of June 2011.
Those purchases were in addition to ones already being made to reinvest the principal
payments from SOMA holdings of agency debt and agency mortgage-backed securities
(MBS) into longer-term Treasury securities. The purchase program was implemented by the
Open Market Trading Desk (Desk) at the Federal Reserve Bank of New York.
To be sure, it was a busy period for the Desk. Over the life of the program, we conducted
140 outright purchase operations to meet the directive set out by the FOMC. That meant that
we were active on nearly every day possible over that period. In those operations, the Desk
bought $767 billion of Treasury securities, which included the $600 billion expansion of the
portfolio and $167 billion of reinvestments. Our operations ranged in size from just over
$1 billion to around $9 billion, with an average size of about $5.5 billion.
Those operations brought the amount of domestic assets held in the SOMA portfolio to
$2.654 trillion. The current directive from the FOMC instructs the Desk to continue to reinvest
the principal payments on all domestic assets held in SOMA into Treasury securities. Thus,
the amount of assets held in the SOMA will remain at that level until the FOMC decides to
change the directive.
Of course, the portfolio at these levels is unusually large. In the absence of the asset
purchase programs, the size of the SOMA portfolio would be around $1 trillion, as required to
meet currency demand and other factors. Thus, the Federal Reserve has about $1.6 trillion
of additional assets in the portfolio as a result of its asset purchase programs.
The SOMA portfolio also has different characteristics than it would have had in the absence
of the asset purchase programs. Most notably, the overall duration of the SOMA portfolio at
the end of June was over 41⁄2 years, compared to its historical range of between two and
three years.
Together, the larger amount and longer tenor of our securities holdings result in a
considerable amount of duration risk in the SOMA portfolio, meaning that the market value of
the portfolio is sensitive to movements in interest rates. One measure of this risk that is
familiar to market participants is the concept of "10-year equivalents," or the amount of
10-year notes that would produce the same degree of overall interest rate risk. At this time,
we have about $1.5 trillion of ten-year equivalents in the SOMA portfolio, which is about
$1 trillion above the amount that we would have under our traditional portfolio approach. The
majority of this additional risk came from the expansion of the balance sheet, but the
extension of its average duration also contributed significantly.1
Transferring this additional duration risk to the Federal Reserve's portfolio, and hence out of
the portfolios of market participants, was one channel through which the asset purchase
program was intended to have its effect on financial conditions. This "portfolio balance"
channel has been discussed by Chairman Bernanke on several occasions.2 This view
associates the amount of policy stimulus with the stock of assets, or more precisely with the
amount of duration risk, that the Federal Reserve takes onto its balance sheet.
Policy achievements of LSAP2
The purpose of the asset purchase program was to help the Federal Reserve achieve the
economic objectives of full employment and stable prices that it was given by Congress. I
believe that the program delivered what could have been expected from it. In particular, let
me highlight its success along two dimensions.
First, the LSAP2 program made broad financial conditions more accommodative. This
conclusion can be drawn from the behavior of financial markets from late August 2010 to the
program's implementation date in November 2010 - a period during which market
participants moved from seeing such a program as a remote possibility to expecting it with
near certainty.3 Asset price movements over this period included a decline in real interest
rates, a narrowing of risks spreads, an increase in equity prices, and a decline in the dollar
- exactly the pattern that one would expect to be generated from additional monetary policy
accommodation. These changes likely supported economic growth and the creation of
employment relative to what would have been realized in the absence of the program.4
Second, the LSAP2 program appears to have raised inflation expectations from unusually
low levels and reduced the threat of deflation. The downside risks to inflation had become
quite threatening by last summer. Breakeven inflation rates had moved to levels that were
well below those consistent with the FOMC's mandate, even for forward measures covering
periods beginning several years ahead. In addition, the pricing of deflation risk, as computed
by looking at Treasury inflation-protected securities with different amounts of accrued
inflation, reflecting fairly substantial odds of deflation over the next several years.5 Since that
1
Estimates of the contribution of additional risk coming from the increased size of the portfolio range from
60 percent to 80 percent, while estimates of the impact of its longer duration range from 20 percent to
40 percent.
2
See, for example, Chairman Ben S. Bernanke (2010), "The Economic Outlook and Monetary Policy",
remarks at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming,
August 27.
3
One would expect market prices to incorporate nearly all of the effects of the programs in advance rather than
during the actual implementation of the program. Thus, the period before the November implementation is the
most relevant period for assessing the program's effects.
4
For example, see Chung et al (2011), "Have We Underestimated the Likelihood and Severity of Zero
Lower Bound Events" and Vice Chairman Janet Yellen (2011), "The Federal Reserve's Asset Purchase
Program", remarks at the Allied Social Science Associations Annual Meeting, Denver, Colorado, January 8.
5
TIPS are designed with a floor of zero on the cumulative inflation adjustment that they can realize over the life
of the security. Thus, the prices of securities that are similar to each other in most ways but have different
amounts of accrued inflation can be used to derive a measure of the value of this floor, which can then be
translated into the probability of deflation.
time, though, breakeven inflation rates have risen back to levels more consistent with the
FOMC's mandate, and the perceived risk of deflation has diminished notably.
One criticism that has been directed at the LSAP2 program is that it was unable to restore
vigorous growth to the economy. I think this is a reasonable observation but not a strong
criticism. It is true that the support to growth provided by the asset purchases appears to
have been countered by other factors that have continued to weigh on growth. However, the
LSAP2 program was never described as such a potent policy tool that it could ensure a
return to robust growth and rapid progress toward full employment in all circumstances.6
Despite its limits, the expansion of the balance sheet was seen by the FOMC as the best
policy tool available at the time, given the constraint on traditional monetary policy easing
from the zero bound on interest rates. The willingness of the FOMC to use this tool is
indicative of a central bank that takes its dual mandate seriously and does what it can to
deliver on it. The disappointing pace of recovery that has been realized since then suggests
that the additional policy accommodation provided by the LSAP2 program was appropriate.
Operational success of LSAP2
Let me now switch from the policy objectives of the LSAP2 program to its implementation by
the Desk. The FOMC set the broad parameters of the asset purchase program based in part
on input from the Desk on our capacity to conduct operations and the market's capacity to
absorb them. In particular, we wanted to complete the asset purchases in a timely manner,
but we also wanted to ensure that the pace of purchases was not so rapid as to disrupt the
functioning and liquidity of the Treasury market. In the end, I believe the program struck a
good balance between these two considerations. I would like to recognize the staff on the
Desk for their valuable input to the operational design of the program, as well as the effective
implementation of the program over the last eight months.
Our presence in the market was sizable. Over the course of the program, our purchases ran
at about the same pace as the total net Treasury supply coming to the market. Moreover,
with the completion of the program, the SOMA portfolio holds about 18 percent of the
outstanding stock of Treasury securities. Our share of the market is even higher at
intermediate maturities, where our purchases were concentrated.
Part of the challenge to the Desk was to structure our operations in a manner that would
allow the market to absorb such a large volume of purchases. Several features of the
program's design may have helped to promote robust participation by market participants,
including the decisions to relax the 35 percent limit on SOMA holdings of individual issues
and to include recently issued securities in the range of eligible issues in nearly every
operation. These features allowed our counterparties to offer us a wide range of securities at
each operation. In the end, dealers participated aggressively, with an average offer-to-cover
ratio of over 3.5. Moreover, we managed to execute these purchases at prices that were, on
average, at or very near the indicative quotes on these securities that we collect as a pricing
reference.
In addition to focusing on the performance of our operations, we have also monitored
measures of liquidity in the Treasury market. The market seems to be functioning well
despite our sizable presence. Measures such as bid-ask spreads, quote depth, and trading
volumes have held relatively steady at favorable levels over the life of the program. Indeed,
there are no signs that trading activity has been notably impaired for Treasury coupon
securities, even in those issues for which our holdings are particularly high.7 Moreover, the
market has not encountered any meaningful problems with delivery and settlement of
Treasury securities.8
Lastly, I should note that the market seems to have adjusted fairly well so far to the end of
the purchase program. The pace of the Desk's purchases fell back sharply at the end of
June, as we moved from expanding the portfolio to simply reinvesting principal payments. In
particular, our purchases slowed from an average pace of about $100 billion per month
through June to an anticipated pace of about $15 billion per month going forward. We do not
expect this adjustment to our purchases to produce significant upward pressure on interest
rates or a tightening of broader financial conditions, given our view that the effects of the
program arise primarily from the stock of our holdings rather than the flow of our purchases.
While there has been considerable volatility in Treasury yields over the past several weeks,
we attribute those movements primarily to incoming economic data and to broader risk
events. However, we will continue to watch the markets and assess their adjustment to the
end of the purchase program.
Future evolution of the SOMA portfolio
While I am sure you are happy to hear more about our actions to date, I realize that you may
be even more interested in the evolution of the SOMA portfolio going forward. Just to be
clear, I will not be saying anything about the likelihood of prospective policy actions beyond
what has been conveyed in FOMC communications. However, I would like to make a few
points about the portfolio under those prospective actions.
As noted earlier, the current directive from the FOMC is to reinvest principal payments on the
securities we hold in order to maintain the level of domestic assets in the SOMA portfolio.
This approach can be interpreted as keeping monetary policy on hold. Indeed, one can
generally think of the stance of monetary policy in terms of two tools - the level of the federal
funds rate, and the amount and type of assets held on the Federal Reserve's balance sheet.
The FOMC has decided to keep both of these tools basically unchanged for now.
Given the considerable amount of uncertainty about the course of the economy, market
participants have observed that the next policy action by the FOMC could be in either
direction. If economic developments lead the FOMC to seek additional policy
accommodation, it has several policy options open to it that would involve the SOMA
portfolio, as noted by Chairman Bernanke in his testimony last week. One option is to expand
the balance sheet further through additional asset purchases, with the just-completed
purchase program presenting one possible approach. Another option involves shifting the
composition of the SOMA portfolio rather than expanding its size. As noted earlier, a sizable
portion of the additional risk that the SOMA portfolio has assumed to date came from a
lengthening of its maturity, suggesting that the composition of the portfolio can be used as an
important variable for affecting the degree of policy stimulus. Lastly, the Chairman mentioned
that the FOMC could give guidance on the likely path of its asset holdings, as the effect on
financial conditions presumably depends on the period of time for which the assets are
expected to be held.
Alternatively, economic developments could instead lead to a policy change in the direction
of normalization. The FOMC minutes released last week provided valuable information on
the sequence of steps that might be followed in that case. The minutes indicated that the
removal of policy accommodation was expected to begin with a decision to stop reinvesting
some or all of the principal payments on assets held in the SOMA. If all asset classes in the
SOMA were allowed to run off, the portfolio would decline by about $250 billion per year on
average over the first several years.
Under the interpretation of the policy stance noted earlier, this shrinkage of the balance sheet
would amount to a tightening of policy.9 However, one should realize that this step
represents a relatively gradual and limited policy tightening. Indeed, using the mapping that
has been discussed by Chairman Bernanke, this path for the balance sheet would, in terms
of its effects on the economy, be roughly equivalent to raising the federal funds rate by just
over 25 basis point per year over the course of several years.
The minutes also described asset sales as part of the strategy, indicating that this step would
likely occur relatively late in the normalization process. From the perspective of the balance
sheet and the stance of monetary policy, sales accomplish the same thing as redemptions,
as they also shrink the balance sheet over time. The minutes indicated that such sales are
likely to be gradual and predictable, which makes them even more similar in nature to
redemptions.
Together, the combination of asset redemptions and asset sales, once underway, should put
the size of the portfolio on a path to a more normal level over several years. Thus, they
represent an important part of the normalization of the policy stance. However, if the
approach follows the gradual and predictable path described by the minutes, one can think of
this adjustment as a relatively passive part of the policy tightening. In these circumstances,
adjustments to the federal funds rate would generally be the active policy instrument,
responding as needed to economic developments.10
The sequence of policy steps described in the minutes indicates how the size of the SOMA
portfolio is likely to be normalized. However, simply reducing the size of the portfolio would
still leave its duration at historically elevated levels. The FOMC might decide it was happy
with this outcome, or it could decide at some stage to renormalize the duration of the portfolio
as well. Depending on the precise timing of the steps that will occur in the exit sequence,
there will likely be opportunities to do so. For example, there is a good chance that the Desk
will still be selling MBS at the time when the SOMA portfolio gets back to its normal size.11 In
such circumstances, the Federal Reserve would have to then engage in sizable Treasury
purchases to offset the ongoing sales of MBS and to expand the SOMA portfolio as needed
to meet currency demand and other factors. This period of Treasury purchases would allow
the FOMC to rebuild its Treasury portfolio with the maturity structure that it sees as optimal.
Prospects for SOMA income
The path of the balance sheet that is realized, along with the evolution of the term structure
of interest rates, will determine the stream of income that will be realized from the SOMA
portfolio.12 It is important to note that this income is not the objective of the asset purchase
programs. The income from the SOMA portfolio is instead a byproduct of policy decisions
taken by the FOMC to promote its economic mandate of full employment and price stability.
However, because there seems to be considerable interest in the income produced by the
portfolio, let me touch on it briefly.
Given the uncertainty about how the balance sheet and interest rates may evolve, there is a
wide range of outcomes for the income stream from the SOMA portfolio.13 At this point, if
interest rates and the balance sheet were to unfold in the manner that appears to be
expected by market participants, the asset purchase programs should produce a substantial
amount of cumulative income. The SOMA Annual Report for 2010 presents some projections
for the portfolio income under an illustrative set of assumptions for the evolution of interest
rates and the balance sheet.14 Under that projection, the portfolio produces about $500 billion
of cumulative income over the period from 2009 to 2018, which is about $90 billion in excess
of what we project would have been realized in the absence of asset purchases.
Of course, the realized stream of income could differ substantially from these projections,
depending on how interest rates and the balance sheet evolve. In any event, it is worth
repeating that the realized income is much less important than the economic outcomes that
are achieved from the programs.
Conclusion
I hope these comments have provided you with some insights into how the SOMA portfolio
has been managed to date and some perspectives on its evolution going forward. In general,
the Federal Reserve will continue to have a meaningful presence in the Treasury market and
in the agency debt and agency MBS markets for a number of years. However, with effective
communications about potential balance sheet actions and careful implementation of any
such actions by the Desk, the markets should be able to adjust to the evolution of the SOMA
portfolio without considerable problems.
Thank you.