Brian P Sack: Implementing the Federal Reserve's asset purchase
program
Remarks by Mr Brian P Sack, Executive Vice President of the Federal Reserve Bank of
New York, at the Global Interdependence Center Central Banking Series Event,
Philadelphia, 9 February 2011.
* * *
It is a pleasure to be back in my hometown of Philadelphia and to be invited to speak tonight
at this event hosted by the Global Interdependence Center (GIC) and the Federal Reserve
Bank of Philadelphia. The GIC has an impressive history of promoting public dialogue about
monetary policy and other topics, and it is a privilege to be able to participate in that process.
Tonight I will focus my comments on the implementation of the recent monetary policy
decisions of the Federal Reserve and the associated implications for its balance sheet. As
always, the views I will express are my own and do not represent those of the Federal Open
Market Committee (FOMC) or the Federal Reserve System.
Unconventional policy decisions
In the second half of 2010, the FOMC made two important policy decisions about the size
and composition of the Federal Reserve's balance sheet. In August, it decided to begin
reinvesting the principal payments from its holdings of agency debt and mortgage-backed
securities into longer-term Treasury securities, thereby keeping the amount of domestic
assets held in the System Open Market Account (SOMA) portfolio unchanged at about
$2 trillion. In November, the FOMC announced that it intended to expand the SOMA portfolio
by purchasing an additional $600 billion of longer-term Treasury securities through the end of
the second quarter of 2011, bringing the intended level of domestic securities holdings to
$2.6 trillion.
Those decisions were aimed at providing more monetary policy stimulus to the economy.
The FOMC saw the additional stimulus as warranted because it viewed the progress toward
its mandated objectives of full employment and price stability as disappointingly slow.1 In
effect, the Committee was using the size and composition of its balance sheet as a policy
instrument, given that it had already employed its traditional means of easing monetary
policy - decreasing short-term interest rates - to the fullest extent possible. Federal Reserve
Chairman Bernanke has noted that the intention of asset purchases is similar to that
associated with changes in short-term interest rates, in that they are meant to affect
economic activity by influencing broader financial conditions.2
But while the intention of the recent policy decisions may be similar to traditional monetary
policy adjustments, the implementation of them is not. These policy decisions involve what
are presumably some of the largest and most rapid portfolio adjustments that have ever
taken place by any single financial market participant. To put it in perspective, note that these
recent policy decisions involve the Federal Reserve purchasing, over an eight-month period,
more Treasury securities than the amount currently held by the entire U.S. commercial
banking system.
It is therefore no small task to determine how to implement these purchases in an effective
and responsible manner. That task falls to the Open Market Trading Desk (the Desk) at the
Federal Reserve Bank of New York. Let me describe how the Desk has conducted those
purchases and some of the issues that we have taken into consideration during the process.
Implementing Treasury purchase operations
A good place to start is with the distinction between the roles of the FOMC and the Desk.
The FOMC is responsible for making monetary policy decisions, while the Desk is
responsible for implementing those policy actions on behalf of the FOMC. Thus, decisions
about the broad parameters of any asset purchase program, including the amount of
securities to be purchased and the duration of those securities, reside with the FOMC, as
those are the parameters that will govern the overall impact on financial conditions and,
ultimately, on the economy.
The role of the Desk is to determine how best to carry out the purchase programs within
those broad parameters. In doing so, the Desk seeks to meet the policy intentions of the
FOMC, while taking into consideration two other objectives. The first objective is to obtain the
securities at competitive and appropriate prices for the Federal Reserve, as doing so will
ultimately benefit the U.S. taxpayer. The second objective is to minimize any negative effects
that the purchases might have on the functioning of financial markets. As I noted in a speech
in October 2010, the liquidity and efficiency of the Treasury market provide tremendous
benefits to our economy, and the Desk was intent on designing a purchase program that
would not diminish those benefits in any meaningful way.3
To achieve these objectives, the Desk relies on a system in which it purchases securities
through reverse auctions with a set of established counterparties called the primary dealers.4
The securities that are eligible for each operation and an indication of the total size of the
operation are announced in advance.5 Dealers then submit offers to sell those securities,
either for their own accounts or on behalf of their customers, over a 45-minute period on the
morning of the operation. Those offers are assessed by the Desk based on two criteria: their
proximity to market prices at that time, and an internal methodology for comparing the
relative value of the securities at the offered prices.6 This process occurs over a proprietary
trading system called Fedtrade under the oversight of Desk staff, and the results are typically
finalized and published within a few minutes of the close of the operation.
With this infrastructure, the Desk has been able to purchase large volumes of securities in a
rapid manner, as required by the policy decisions made by the FOMC. Indeed, over the
period since the FOMC's decision to expand the SOMA portfolio, the Desk has purchased
about $300 billion of Treasury securities.7 That total includes about $220 billion of purchases
out of the intended $600 billion expansion of the portfolio, and another $80 billion of
purchases associated with the reinvestment of principal payments on agency debt and
mortgage-backed securities.8 In terms of the monthly pace, the purchases so far have been
3
See Brian Sack. 2010. "Managing the Federal Reserve's Balance Sheet." Remarks at the 2010 CFA Institute
Fixed Income Management Conference, Newport Beach, California, October 4.
4
The list of primary dealers.
5
This information is included in a monthly purchase schedule published by the Desk.
6
The methodology for comparing the relative value of the securities at the offered prices is based on a spline
fitted through the prices of Treasury securities.
7
These changes are measured since the November schedule published by the Desk, which was the first
schedule of operations to come out after the FOMC decision. All data on policy operations are through Friday,
February 4, 2011.
8
The purchases associated with these two components are combined in the monthly schedule. To arrive at the
totals reported in the text, we allocate the purchases so far this month proportionally across the two
components.
running at about $105 billion per month, consisting of roughly $75 billion in new investments
and $30 billion of reinvestments. To meet this pace, the Desk has been operating in the
market on nearly every available day.9
The operations to date have gone well. Participation by the dealers has been strong, with an
average offer-to-cover ratio of about 3.5, and the accepted offers have been allocated across
a number of dealers and a wide range of securities. Given the robust participation in the
operations, the Desk has received competitive and appropriate prices for the securities
obtained.10
Moreover, our purchases do not appear to be causing significant strains on the liquidity or
functioning of the Treasury market. It is unusual for the market to have such a large,
persistent, and one-sided participant, and we had to worry about how it would adjust to our
presence. However, the available evidence suggests that market liquidity is decent at this
time. Measures of liquidity, such as trading volumes, bid-ask spreads, or quote sizes,
worsened in December, but that pattern appears to have been driven by year-end effects
rather than our presence in the market. These measures have recovered since the year-end,
moving back toward the levels observed before the start of the purchases.
In addition, we do not see signs that the market is facing unusual scarcity of particular
Treasury securities. To monitor this, we look at the number of issues trading on special in the
repo market and at the amount and composition of the securities that the market borrows
from our securities lending facility. Both measures have increased some, but we do not see
their current levels as indicating notable strains. Moreover, it does not appear that these
patterns are more acute in securities for which the SOMA portfolio holds a larger proportion
of the supply.
Our success at purchasing such large volumes of securities without causing significant
market strains reflects some of the operational decisions that were made in the design of the
program. One key issue was determining an appropriate speed for purchasing assets. The
pace of purchases under the announced plan reflected a judgment by the Desk that it could
purchase as much as $100 billion to $125 billion per month without significantly disrupting
the functioning and liquidity of the Treasury market. So far, that appears to be the case,
given the evidence just described.11
Another important aspect of the operations is the flexibility in terms of the securities that we
purchase. As noted earlier, our selection of the specific offers to accept at a given operation
depends on our assessment of their relative attractiveness. This process should support
market functioning. In particular, it allows the market to determine which securities it is willing
to sell on the most favorable terms for us. If a particular security is scarce in the market, we
will presumably not be shown offers at attractive terms, and hence we will not end up
removing additional supply of that security.
9
The Desk tends to avoid conducting operations on days that coincide with FOMC announcements and on
days that are known to have lighter liquidity conditions.
10
The Desk has begun publishing additional information from its operations, including information about the
prices paid for each security, on a monthly basis. In addition, under the Dodd-Frank Wall Street Reform and
Consumer Protection Act, the Federal Reserve will publish additional information about its open market
operations, including the individual securities purchased, the transaction prices and the counterparty, with a
two-year lag for all transactions subsequent to the legislation.
11
Implementing the program over an eight-month period would not be expected to significantly reduce the speed
or magnitude of its effects on financial conditions and, ultimately, on the real economy under the view that the
program's effects arise from the expected stock of our holdings rather than the flow of our purchases. Under
this view, financial conditions react immediately to the announcement of the program, bringing forward its
effects on financial conditions. This view provides policymakers with some flexibility regarding the amount of
time to implement the total amount of purchases.
The flexibility of this procedure can be seen in the patterns of our purchases over time.
Earlier in the program, we ended up purchasing a large concentration of off-the-run
securities, including bonds that were issued 15 to 25 years ago. Given their age, these bonds
are generally less liquid and less valuable to market participants, and hence dealers were
willing to sell them to us at cheaper prices relative to other securities. At more recent
operations, however, we have received a greater share of offers to sell more recently issued
Treasury securities, including on-the-run issues, and our purchases have shifted accordingly.
This suggests that older, off-the-run securities may have become harder for dealers to
obtain, and that they have increasingly found it appealing to offer more recent issues, which
are available in greater supply and are generally more liquid. Our procedure allows this shift
to take place, as long as the more recent issues are offered to us on generally favorable
terms.
Overall, the Desk has endeavored to implement the FOMC's policy decisions in a manner
that ensures competitive and appropriate prices for the securities obtained and that
maintains the efficient functioning of financial markets. I believe that we have managed to
accomplish these objectives with our operations to date.
Market developments during the purchase programs
Of course, the operational objectives discussed above do not speak to the broader policy
objectives of the asset purchase programs. The policy decisions made by the FOMC in
August and November were intended to influence financial conditions in a manner that would
support the economic recovery and return employment and inflation, over time, to levels
consistent with the FOMC's objectives. One way that this might occur is through a portfolio
balance channel.12 Under this view, removing duration risk from the market would tend to
keep longer-term real interest rates lower than they otherwise would be and would
encourage investors to move into other types of assets, thereby making broader financial
conditions more accommodative.
These intended effects were apparent in financial markets from mid-August to early
November, when investors increasingly anticipated the Federal Reserve's decision to expand
its balance sheet. Over that period, longer-term real interest rates declined, breakeven
inflation rates moved up toward more normal levels, equity prices rose notably and risk
spreads on many credit instruments narrowed. This configuration of asset price movements
is the pattern that is typically associated with additional monetary policy easing.
Since early November, one of the notable developments in financial markets has been the
sharp increase in longer-term interest rates. At first glance, this change may seem at odds
with the portfolio balance channel. However, it is important to understand the factors that led
to the increase in interest rates in the current circumstances.
The upward movement in longer-term interest rates in large part reflects the greater optimism
among investors about the outlook for economic growth. Investors revised up their baseline
forecasts for the economy and reduced the perceived downside risks that they see around
that outlook. This shift in the outlook led the market to price in the possibility of earlier
increases in short-term interest rates and to scale back the size of asset purchases that they
expect from the Federal Reserve. Both of those developments contributed to the significant
rise in yields.
In contrast, the rise in yields does not appear to be driven by the concerns expressed by
some that the asset purchase program would unleash a considerable rise in U.S. inflation
and inflation expectations to levels well above those consistent with the Federal Reserve's
mandate. Such an outcome would be detrimental to the economic outlook, leading to
downward pressure on risky asset prices and a substantial weakening in the value of the
dollar. However, what has taken place in U.S. markets to date does not resemble this
outcome. Indeed, over the period since the November FOMC meeting, longer-term inflation
expectations have remained at levels consistent with the Federal Reserve's mandate, risky
asset prices have advanced and the dollar has held its ground.
Overall, the broad improvement in financial conditions since last summer has been an
important and encouraging development. Risky asset prices such as equities have risen at a
rapid pace, and credit spreads and measures of credit availability have continued to ease.
These changes have been driven to a large extent by the improvement in the economic
outlook and, in turn, will help to promote the economic recovery going forward.
The decisions taken in the second half of 2010 affecting the size of the Federal Reserve's
portfolio have provided support to that process. To be sure, economic fundamentals will
ultimately exert the strongest force on financial conditions, as can be seen by the rise in
Treasury yields even as the Federal Reserve expanded its balance sheet. But the Federal
Reserve's balance sheet actions have helped to make broader financial conditions more
accommodative.
Characteristics of the SOMA portfolio
The set of asset purchase programs launched by the Federal Reserve, including those
initiated at the peak of the financial crisis and the more recent actions, have changed some
of the basic characteristics of the SOMA portfolio. I thought it would be useful to review those
changes and to discuss their implications for the conduct of monetary policy.
The most obvious effect of the purchase programs has been on the size of the SOMA
portfolio. If the intended asset purchases announced in November are completed, the size of
the domestic portfolio will reach approximately $2.6 trillion by mid-year - considerably larger
than the $1 trillion portfolio that would be in place in the absence of the asset purchase
programs.
In addition, the purchase programs have affected the duration of the portfolio. The securities
that have been purchased by the Desk since November have had an average duration of
about 5.5 years. With those purchases and the adjustments from the earlier purchase
programs, the duration of the overall SOMA portfolio has reached about 4.5 years, which is
somewhat higher than the typical level of between 2 and 3 years that was observed before
the financial crisis.
This combination of its larger size and longer duration results in a greater amount of interest
rate risk embedded in the SOMA portfolio.13 Of course, under the view that the asset
purchase programs operate through a portfolio balance channel, this is precisely how the
programs have an effect on the economy - by transferring risk away from private investors
and onto the Fed's books.
The risks to the portfolio arise because the characteristics of the assets that have been
purchased differ from those of the liabilities that have been created by those purchases. The
assets held in the SOMA portfolio have fixed coupon rates that reflect longer-term interest
rates. However, the purchases of those assets create reserves in the banking system, and
the Federal Reserve pays interest on those reserves at a short-term interest rate that it
controls. The interest paid on reserves can be thought of as the "funding cost" of the
portfolio.
Today, because short-term interest rates are low relative to longer-term interest rates, this
mismatch produces a very elevated stream of net income. In particular, the SOMA portfolio
has a weighted average coupon yield of about 3.5 percent, which, if applied to a $2.6 trillion
portfolio, produces about $90 billion of income at an annualized rate.14 In contrast, the
annualized funding cost of the portfolio at this time is only around $4 billion. This cost is
relatively low because of the near-zero level of the interest rate paid on reserves. In addition,
the private sector holds nearly $1 trillion of currency, which are liabilities of the Federal
Reserve that bear no interest.15 Thus, the SOMA portfolio should produce a considerable
amount of net income over the near term.16
Beyond the near term, though, the income that will be produced by the SOMA portfolio is
uncertain. If short-term interest rates were to rise, the funding cost of the portfolio would
increase relative to the fairly steady yield earned on the assets held, reducing the amount of
net income from the portfolio. In addition, if longer-term yields were to shift higher, the
Federal Reserve could realize capital losses if it were to begin selling assets.
However, even if interest rates did move up abruptly and the SOMA portfolio experienced
realized losses, it would have no meaningful operational consequences for the Federal
Reserve's ability to implement monetary policy. These losses would not impair the FOMC's
ability to control short-term interest rates by paying interest on reserves or by draining
reserves as needed. Accordingly, the Federal Reserve would continue to operate in the
same manner that it otherwise would have in pursuing its economic mandate.
What would be affected by unexpectedly large realized losses on the SOMA portfolio would
be our remittances to the Treasury. All Federal Reserve earnings in excess of those needed
to cover operating costs, pay dividends and maintain necessary capital levels are remitted to
the U.S. Treasury on a weekly basis. Accordingly, any change to the income on the SOMA
portfolio directly affects the amount of funds that the Federal Reserve remits to the Treasury.
The unusually large amount of portfolio income realized of late has boosted those
remittances considerably. If portfolio income were to decline going forward, whether toward
more normal levels or toward unusually low levels, the amount of those remittances would
adjust lower.17
Ensuring our ability to remove policy accommodation
While the potential risks around the SOMA portfolio will not hamper the implementation of
monetary policy, the size and duration of the portfolio will have to be taken into account when
considering the appropriate policy strategy. In that regard, it is worth noting that, even as the
14
The weighted average coupon rate is closer to 4 percent. However, to get to the reported income stream on
these assets, we have to adjust for the amortization of any premium that we paid at our operations. I am
referring to this adjusted measure as the average coupon yield.
15
Factors other than currency held also affect the amount of reserves in the financial system, as reported in the
Federal Reserve's H.4.1 Statistical Release.
16
Indeed, the SOMA portfolio has already produced a large flow of income for the Federal Reserve for these
same reasons. Over 2009 and 2010, the SOMA portfolio produced $46 billion and $76 billion of interest
income, respectively, while the interest expense on reserve balances was $2 billion and $3 billion,
respectively, in those years. Over the preceding 10 years, the average SOMA income was about $30 billion.
The excess income in recent years has already been remitted to the Treasury.
17
In the most extreme case, the Federal Reserve would have to cease remittances to the Treasury for a time. Of
course, one might also want to take into consideration the additional tax revenue to the government that could
be generated by the more robust economic recovery supported by the asset purchase programs.
Federal Reserve has been expanding its balance sheet, it has not lost any momentum in the
preparation of its exit tools.
When the FOMC eventually determines that the time to begin reducing policy
accommodation has come, the critical tool will be the ability to pay interest on reserves. As
has been discussed on many occasions, paying interest on reserves will allow the FOMC to
control the cost of short-term credit even with an enlarged Federal Reserve balance sheet.
In addition, we continue to make considerable progress increasing our capacity to drain
reserves if necessary. At this time, more than 500 depository institutions have registered for
the term deposit facility. Those firms, in aggregate, hold nearly $600 billion of the reserve
balances that are currently in the financial system. We also have added 58 money market
funds as counterparties for reverse repurchase agreements, in addition to the 20 primary
dealers that are our regular counterparties. Those money funds currently hold more than
$1.5 trillion of assets, with a good portion of those assets in the type of short-term
repurchase agreements that we would be offering. In short, we have already established
considerable capacity to drain reserves with these two tools, and we will continue to advance
them in productive directions.
Lastly, the FOMC could also remove policy accommodation by halting the reinvestment of
maturing assets or by selling securities that are held in the SOMA portfolio, as noted by
Chairman Bernanke at last week's press conference.
Conclusions
My purpose today was to provide information on the manner in which the Desk has
conducted the asset purchases that the FOMC has decided to pursue and the associated
implications for financial markets and the Federal Reserve's balance sheet.
On the whole, I believe that the recent asset purchases by the Federal Reserve have had
helpful effects on financial conditions and have been implemented in a manner that has been
flexible enough to avoid any significant negative consequences for the functioning of financial
markets. Moreover, while the programs have resulted in significant changes to the
characteristics of the SOMA portfolio, those changes will not impede the ability of the Federal
Reserve to adjust the degree of policy accommodation when judged appropriate by the
FOMC.