Brian P Sack: Managing the Federal Reserve's balance sheet
Remarks by Mr Brian P Sack, Executive Vice President of the Markets Group of the Federal
Reserve Bank of New York, at the 2010 Chartered Financial Analyst (CFA) Institute Fixed
Income Management Conference, Newport Beach, California, 4 October 2010.
* * *
It is a pleasure to be here today to discuss the management of the Federal Reserve's
balance sheet. The Federal Reserve currently holds more than $2 trillion of securities in its
portfolio, making it a key participant in U.S. fixed-income markets. Moreover, the portfolio is
managed in a manner that differs from any other market participant, as the Federal Open
Market Committee (FOMC) has adjusted the size and composition of the portfolio with the
intention of achieving its monetary policy objectives of full employment and price stability.
Thus, it is important for market participants to understand the balance sheet decisions of the
FOMC and the implementation of those decisions to fully assess the implications for
fixedincome markets.
The evolution of the balance sheet going forward will depend on how the economic outlook
unfolds. The current forecasts of FOMC members show the economy moving in the right
direction, with a sustained recovery in GDP, a gradual reduction in the unemployment rate
over time, and an increase in inflation towards the level that FOMC members see as
desirable over the intermediate term. However, the anticipated recovery is relatively tepid
and thus delivers only slow progress toward meeting the Federal Reserve's dual mandate.
Indeed, according to their most recently published forecasts, most FOMC members expect
the unemployment rate to remain above 8.25 percent through 2011 and the inflation rate to
remain below its mandate-consistent level through 2012. In addition, the economy remains
vulnerable to downside surprises that could take both output and inflation further away from
the FOMC's objectives.
The sluggish outlook for the economy and the risks that surround that outlook have raised
the possibility of further monetary policy accommodation. The most recent FOMC statement
indicated that the Committee "is prepared to provide additional accommodation if needed to
support the economic recovery and to return inflation, over time, to levels consistent with its
mandate."
The FOMC has several policy tools that it could use to achieve more accommodative
financial conditions, as Chairman Bernanke discussed in his speech at the Jackson Hole
symposium in August. My remarks today will focus on one of those options - changing the
size of the Federal Reserve's holdings of securities. In particular, I will review the FOMC's
recent decision to keep the size of those security holdings at their current level, and I will
discuss some of the issues to be considered in any decision on whether to expand them
further. As always, the views I express are my own and do not represent those of the FOMC
or the Federal Reserve System.
Decision to reinvest maturing asset holdings
The initial decisions by the FOMC to expand the Federal Reserve's holdings of securities
came at the height of the financial crisis. Before that time, the Federal Reserve maintained a
relatively simple portfolio of between $700 billion and $800 billion of Treasury securities - an
amount largely determined by the volume of dollar currency that was in circulation. In late
November 2008, in the face of tightening financial conditions and a deep downturn in
economic activity, the Federal Reserve announced that it would purchase up to $600 billion
of agency debt and agency mortgage-backed securities (MBS). In March 2009, it expanded
the program to include cumulative purchases of up to $1.75 trillion of agency debt, agency
MBS, and longer-term Treasury securities. The use of the balance sheet in this manner was
spurred in part by the inability to ease further using the traditional policy instrument, as the
federal funds rate effectively reached the zero lower bound in late 2008.
The asset purchases were carried out from December 2008 through March 2010 by the
Trading Desk (the Desk) at the Federal Reserve Bank of New York, resulting in a significant
expansion of the Federal Reserve's portfolio. As the settlement of those purchases
progressed, the amount of domestic securities held in the System Open Market Account
(SOMA) reached a peak of $2.1 trillion in June 2010. From that point, the portfolio began to
shrink because the agency debt and agency MBS held in the SOMA were being allowed to
run off without reinvestment as they matured or were prepaid.
Against that backdrop, an important policy decision regarding the Federal Reserve's portfolio
was made at the August FOMC meeting, when the Committee decided to halt this run-off
and instead hold the size of the SOMA portfolio steady. To achieve this, the FOMC directed
the Desk to purchase longer-term Treasury securities as needed to offset any principal
payments realized on our holdings of agency debt and agency MBS.1
That was not just a symbolic policy decision, but instead involved a meaningful shift in the
path of the balance sheet. At the time of the meeting, the Desk was projecting that about
$340 billion of the Federal Reserve's MBS holdings would be paid down from that time to the
end of 2011. In addition, another $55 billion of agency debt holdings would mature over that
period. Thus, the total portfolio was expected to shrink by nearly $400 billion by the end of
2011. The reinvestment decision therefore amounted to a sizable program to purchase
longer-term Treasury securities.
The effect of asset purchases on the economy remains a point of ongoing debate, with some
uncertainty about the channels through which such purchases operate and the magnitude of
those effects. My own perspective is aligned with the view expressed by Chairman Bernanke
in Jackson Hole - that the effects arise primarily through a portfolio balance channel.2 Under
that view, our asset holdings keep longer-term interest rates lower than otherwise by
reducing the aggregate amount of risk that the private markets have to bear. In particular, by
purchasing longer-term securities, the Federal Reserve removes duration risk from the
market, which should help to reduce the term premium that investors demand for holding
longer-term securities. That effect should in turn boost other asset prices, as those investors
displaced by the Fed's purchases would likely seek to hold alternative types of securities.
Some research studies have estimated that the effects of the earlier expansion of our
securities holdings by just over $1.5 trillion lowered longer-term Treasury yields by about
50 basis points through this portfolio balance channel.3 These effects on Treasury yields
appear to have been transmitted into lower rates on private credit instruments and higher
asset prices more broadly.
1
Reflecting the long-standing practice of the Desk, principal payments on our holdings of Treasury securities
were already being fully reinvested at Treasury auctions.
2
The Fed's asset purchases initially had an additional and important effect on mortgage rates by improving the
functioning of the MBS market. As I have noted in earlier speeches, the use of the central bank's balance
sheet can be particularly effective when focused on markets in which liquidity and market functioning have
become impaired. The focus here is whether, in addition to those effects, the size and composition of the
Fed's balance sheet have a lasting impact on financial conditions in well-functioning and relatively liquid
markets.
3
See, for example, Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack, "Large-Scale Asset
Purchases by the Federal Reserve: Did They Work?" Federal Reserve Bank of New York Staff Report
no. 441, March 2010. Several private-sector firms have estimated yield effects of similar magnitude. In
addition, a working paper by James Hamilton and Jing Wu, "The Effectiveness of Alternative Monetary Policy
Tools in a Zero Lower Bound Environment," finds that changes in the Federal Reserve's asset holdings
produce considerable yield effects.
BIS Review 128/2010
Under this view, the FOMC's influence on financial conditions is associated with the size and
composition of its securities portfolio. This perspective provides a clear rationale for the
reinvestment decision made at the August FOMC meeting. The decline in the size of the
Federal Reserve's portfolio that would have occurred in the absence of the reinvestment
program would have amounted to a passive tightening in the stance of monetary policy, as
the portfolio balance effect would have gradually reversed. Moreover, the extent of this
tightening was increasing in response to the weakening of the economy, as lower
longerterm yields were leading to more rapid repayment of MBS. This perverse effect was seen by
the FOMC as working against its efforts to reach its dual mandate.
In effect, the policy approach that was implemented before the August meeting acted to mute
the amplitude of movements in longer-term interest rates. As rates declined in response to a
weakening of the economy, the Federal Reserve's MBS holdings would decline more rapidly,
effectively adding to the supply of duration held by the market.4 This increase in the duration
held by the market would tend to damp the decline in yields. With the change in strategy at
its August meeting, the FOMC no longer lets its aggregate duration holdings flow back into
the market. This approach allows long-term interest rates to adjust fully to a weakening of the
economy, which should act to better stabilize the economy.
Implementing the reinvestment policy
So far, I have focused on the FOMC's August policy decision; however, you may also be
interested in the details of how the Desk has actually implemented the reinvestment policy.
The instructions from the FOMC to the Desk, from both the August FOMC statement and the
directive that was adopted at that meeting, were to keep the total face value of domestic
securities held in the SOMA portfolio near their level at that time. The published size of the
securities portfolio just ahead of the August meeting was $2.054 trillion, so the Desk adopted
this level as the target for the portfolio. This is a notable development by itself, as the
directive from the FOMC now involved two targeted variables - the target range for the
federal funds rate, and the target size for its asset holdings.
To implement this directive, the Desk has been purchasing Treasury securities on a monthly
schedule. In particular, we announce a plan around the middle of each month for the
purchase operations to take place through the middle of the following month, once we know
the principal repayments that will be received over that period.5 We are running at a pace of
$27 billion in purchases this month, and we expect that pace to bump up to around
$30 billion for the next several months. Looking further ahead, we currently project that the
cumulative amount of principal payments on agency debt and agency MBS through 2011 will
be somewhat higher than the estimates provided at the August FOMC meeting.
I should note that the directive to the Desk is expressed in terms of the overall size of the
portfolio. However, under the portfolio balance model described above, the effect on markets
will be tied to the amount of duration risk that such purchases encompass. Thus, the
composition of purchases across maturities will be quite important in governing the effects on
financial conditions.
The strategy that the Desk has employed for the reinvestment program is to follow the
pattern of purchases that was implemented in the earlier Treasury purchase program. The
purchases will be concentrated in nominal Treasury securities with remaining maturities
between 2 and 10 years, but with some purchases also occurring outside this segment. The
average duration of the securities purchased is expected to be just over 5 years, although
the exact realized outcome will depend on the offers that we receive in our operations. Under
this approach, the purchases will remove a considerable amount of duration from the market
relative to what the market would have held without reinvestments by the Federal Reserve.
The reinvestment strategy, of course, also involves a reallocation of our portfolio from agency
debt and MBS into Treasury securities. The FOMC's decision to reallocate was based on a
variety of factors. However, one crucial consideration was whether purchasing Treasury
securities would have an effect on longer-term interest rates comparable with that of
purchasing MBS. My view was that the effects would be similar, because purchasing
longerterm Treasury securities removes as much duration risk from the market as purchasing
current-coupon MBS.6
The two approaches differ, however, in that purchasing MBS also removes prepayment risk
from the market. If the market were to begin having trouble digesting that prepayment risk,
the spread between MBS rates and Treasury yields could widen. A significant widening of
MBS spreads to Treasuries, whether due to this or other factors, could affect policymakers'
decisions about which assets to purchase. The Chairman's speech in Jackson Hole and the
August FOMC minutes both indicated that reinvesting in MBS rather than Treasury securities
might become desirable if market conditions were to change.
Balance sheet expansion as a policy option
As you can see, the decision to simply keep the balance sheet unchanged involved a
number of considerations and choices. Let me now turn to the possibility that the FOMC
could go a step further and expand the balance sheet beyond its current levels.
This policy option has been the subject of intense focus among market participants.
Chairman Bernanke has indicated that any decision about expanding the balance sheet
would depend on the FOMC's assessment of the costs and benefits involved. Of course, that
assessment is difficult to calibrate. Federal Reserve Bank of New York President William
Dudley discussed many of the relevant issues in his speech last Friday.7
In terms of the benefits, balance sheet expansion appears to push financial conditions in the
right direction, in that it puts downward pressure on longer-term real interest rates and makes
broader financial conditions more accommodative. One can reach that judgment based on
the empirical evidence from the earlier round of asset purchases, as mentioned before. In
addition, the market responses to more recent news about the balance sheet also lean in this
direction. The market response to the reinvestment decision at the August FOMC meeting
seemed largely in line with the estimated effects from the earlier round of asset purchases,
once we account for the size of the surprise and the anticipatory pricing that occurred ahead
of its announcement. And the increased expectations for balance sheet expansion in
response to the September FOMC statement also generated a sizable market response.
To be sure, I think it is fair to say that this is an imperfect policy tool. Even under the
estimates noted earlier, the Federal Reserve had to increase its securities holdings
considerably to induce the estimated 50 basis point response of longer-term rates. In
addition, there is a large degree of uncertainty surrounding the estimates of these effects,
given our limited experience with this instrument. Lastly, it is reasonable to assume that the
effects of balance sheet expansion would diminish at some point, especially if yields were to
move to extremely low levels. Nevertheless, the tool appears to be working, and it is not
clear that we have yet reached a point of diminishing effects.
Some observers have argued that balance sheet changes, even if they influence longer-term
interest rates, will not affect the economy because the transmission mechanism is broken.
This point is overstated in my view. It is true that certain aspects of the transmission
mechanism are clogged because of the credit constraints facing some households and
businesses, and it is true that monetary policy cannot directly target those parties that are the
most constrained. Nevertheless, balance sheet policy can still lower longer-term borrowing
costs for many households and businesses, and it adds to household wealth by keeping
asset prices higher than they otherwise would be. It seems highly unlikely that the economy
is completely insensitive to borrowing costs and wealth, or to other changes in broad
financial conditions.
In terms of the costs of balance sheet expansion, the assessment is perhaps even more
complicated. I will not attempt a comprehensive discussion of all of the potential costs of
balance sheet expansion, as that assessment falls to the FOMC. However, as manager of
the SOMA, I will speak about two of the potential operational challenges involved - one
associated with implementing additional asset purchases, and one associated with exiting
from them.
On the implementation of a program, an important operational consideration is whether
Federal Reserve purchases would strain the functioning of financial markets and cause an
erosion of market liquidity. This consideration would be particularly relevant if the FOMC
decided that a fairly sizable program was needed to have a meaningful effect on financial
conditions and the economy. This issue was present during the first asset purchase program,
especially when the pace of weekly purchases reached a peak of about $40 billion in the
middle of last year. The pace of those purchases at times put pressure on liquidity in the
MBS market, leading the Desk to take mitigating actions when possible.8
In the current circumstances, there would seem to be room for the Federal Reserve to
expand its holdings of Treasury securities without creating difficulties for market functioning.
The SOMA currently holds about 12 percent of the outstanding stock of Treasury coupon
securities - a smaller share than it held before the financial crisis. Moreover, the supply of
Treasury securities will remain ample, as the Treasury is expected to issue around
$1.2 trillion of securities over the next year.
Any purchase program that the FOMC decides upon, whether aimed at Treasury securities
or MBS, would be designed to support market functioning as much as possible while still
achieving the program's economic objectives. The deep liquidity of these markets has
considerable value to our economy, and we should take whatever steps possible to leave
this liquidity intact.
The second operational challenge I mentioned comes at the other end of the program - the
exit. In particular, it is important to consider whether balance sheet expansion would
complicate the eventual exit of the Federal Reserve from its accommodative policy stance.
I am confident that our ability to exit will not be compromised by any further expansion of the
balance sheet. The exit strategy that is ultimately implemented will have to take into account
the size and structure of the balance sheet at that time. However, in all potential
circumstances the Federal Reserve should be able to tighten financial conditions to a
sufficient degree when appropriate. The ability to pay interest on reserves, in combination
with the ability to drain reserves as needed, will give us sufficient control of short-term
interest rates. On that front, it is worth noting that both of the Fed's reserve draining tools
- the reverse repurchase program and the term deposit facility - are already operational, and
their capacity to drain reserves will continue to expand. In addition, the Federal Reserve
could always sell assets to reduce the size of its balance sheet if it desired.
Designing a purchase program
If the FOMC were to move forward with an expansion of the balance sheet, it would
presumably want to take into consideration the perspective gained from the asset purchases
conducted from late 2008 to early 2010. The FOMC would have to decide the extent to which
a new purchase program would follow the approach from the earlier round of purchases.
An alternative approach would be to design a purchase program that shares more of the
features of the FOMC's adjustment of the federal funds rate in normal times. After all,
adjustments to the balance sheet are in many respects a substitute for changes in the federal
funds rate. Both instruments attempt to influence broader financial conditions in order to
achieve a desired economic outcome. However, the way in which the FOMC implemented
asset purchases differed in important ways from the manner in which it has historically
adjusted the federal funds rate. With this contrast in mind, I raise a set of policy questions
that could be considered in designing a purchase program.
First, should the balance sheet be adjusted in relatively continuous but smaller steps, or in
infrequent but large increments? The earlier round of asset purchases involved the latter
approach, which caused the market response to be concentrated in several days on which
significant announcements were made. That might have been appropriate in circumstances
when substantial and front-loaded policy surprises had benefits, but different approaches
may be warranted in other circumstances. Indeed, it contrasts with the manner in which the
FOMC has historically adjusted the federal funds rate, which has typically involved
incremental changes to the policy instrument.
Second, how responsive should the balance sheet be to economic conditions? Historically,
the FOMC has determined the federal funds target rate based on the Committee's
assessment of the outlook for economic growth and inflation. If changes in the balance sheet
are now acting as a substitute for changes in the federal funds rate, then one might expect
balance sheet decisions to also be governed to a large extent by the evolution of the FOMC's
economic forecasts. The earlier purchase program, in contrast, did not demonstrate much
responsiveness to changes in economic or financial conditions. Indeed, the execution of the
program largely involved confirming the expectations that were put in place by the two early
announcements.
Third, how persistent should movements in the balance sheet be? An important feature of
traditional monetary policy is that movements in the federal funds rate are not quickly
reversed, which makes them more influential on broader financial conditions. A change that
was expected to be transitory would instead move conditions very little. For similar reasons,
one could argue that movements in the balance sheet should have some persistence in
order to be more effective.
Fourth, to what extent should the FOMC communicate about the likely path of the balance
sheet? The FOMC often communicates about the path of the federal funds rate or provides
other forward-looking information that allows market participants to anticipate that path. This
anticipation of policy actions is beneficial, as it brings forward their effects and thus helps to
stabilize the economy. For the same reason, providing information about the likely course of
the balance sheet could be desirable. In fact, such communication might be particularly
important in the current circumstances, because financial market participants have no history
from which to judge the FOMC's approach and anticipate its actions.
Fifth, how much flexibility should the FOMC retain to change its policy approach? The
original asset purchase programs specified the amount and distribution of purchases well in
advance.9 However, the FOMC would be learning about the costs and benefits of its balance
sheet changes as it implemented a new program. This might call for some flexibility to be
incorporated into the program, providing some discretion to change course as market
conditions evolve and as more is learned about the instrument.
Conclusion
I hope that my remarks today have offered some insight into the recent balance sheet
programs undertaken by the Federal Reserve. Adjustments to the size of the Federal
Reserve's securities holdings are a new policy instrument for the FOMC. That presents
challenges, both to policymakers in terms of determining how to use the instrument and to
market participants in terms of anticipating that usage and understanding its effects. Given
these challenges, I believe it is important for the Federal Reserve to communicate effectively
about the factors affecting its balance sheet decisions and the implementation of those
decisions.
In my view, the evidence suggests that the expansion of the securities portfolio to date has
helped to foster more accommodative financial conditions, and further expansion would likely
provide additional accommodation. Of course, whether the FOMC decides to take such a
step will be determined by its assessment of whether the benefits of additional policy
stimulus outweigh the perceived costs of expanding the balance sheet.