Simon Potter: Reducing the size of the Federal Reserve's balance
sheet - the benefits of moving gradually and predictably
Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the Federal
Reserve Bank of New York, to the National Association of Securities Professionals, New York
City, 16 November 2017.
* * *
Good afternoon and thank you for the kind introduction. I would also like to add my warm
welcome to the New York Fed. We very much value the National Association of Securities
Professionals' (NASP) efforts to promote professional excellence and encourage economic
empowerment for people of color and women on Wall Street, and for our community, and are
pleased to host this year's kickoff to the NASP's 21st Annual Symposium.This year's symposium
is organized around the timely theme of "Keeping Pace when Market Dynamics Shift". In that
vein, I welcome the opportunity to discuss with you some important changes that are in train with
respect to the Federal Reserve's balance sheet, and how these may impact financial markets.
As always, the views I will express today are mine alone and do not necessarily reflect those of
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the New York Fed or the Federal Reserve System.
Before I discuss the Fed's balance sheet I would like to briefly review some pilot programs we
conducted over the last few years and their impact on our counterparty policy. As a number of
you are aware, between July 2013 and December 2015, the New York Fed conducted two
counterparty pilot programs with small firms, the first focused on treasury operations and the
second on mortgage operations. As we announced at the time, we initiated these programs to
explore ways to broaden access to open market operations and to determine the extent to which
firms beyond the existing primary dealer community could augment the New York Fed's
operational capacity and resiliency in its monetary policy operations. We very much appreciate
the NASP's efforts to encourage eligible firms to participate.
The experience gained through these programs informed changes in the New York Fed's
eligibility criteria for primary dealers, which were announced in November 2016. At that time, the
minimum net regulatory capital (NRC) threshold for broker dealers was reduced from $150
million to $50 million. And to better align the capital threshold for banks with the new NRC
thresholds, the minimum Tier 1 capital threshold for banks was raised from $150 million to $1
billion. At the same time, a 0.25 percent minimum Treasury market share threshold was
introduced to more directly quantify the business capabilities of firms expressing interest in
becoming a primary dealer.
Through these changes, the New York Fed is seeking to expand and diversify the pool of firms
eligible to apply for primary dealer status, while also recognizing that a certain scale of activity is
needed in order to be able to meet the many business obligations to which primary dealers must
commit, in supporting the operations of the Federal Reserve and the Treasury. These changes
offer the opportunity to increase capacity and further support competitive pricing for the Fed's
open market operations. Going forward, the New York Fed will periodically review its
counterparty policy.
Turning to monetary policy, at the conclusion of its September policy meeting, the Federal Open
Market Committee (FOMC) announced that it would begin to reduce the size of the Federal
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Reserve's securities portfolio. Over the past month, the Fed took the first steps in a multiyear
effort to bring the Federal Reserve's balance sheet to its longer-run size, by not reinvesting a
portion of the securities repayments it received. In the remainder of my prepared remarks today,
I will offer my views on this policy from a financial markets perspective, drawing on a fuller set of
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remarks I delivered last month, which can be found on the New York Fed's website.
The message I'd like to leave you with today is one of confidence. I am confident that the FOMC's
plan will reduce the size of the portfolio in a gradual and predictable, "no surprises" manner; that
the FOMC's plan will promote good market functioning in the Treasury and agency
mortgagebacked securities markets as the portfolio declines; and that it will not prove disruptive to the U.S.
mortgage market or the U.S. Treasury's debt management program. And I am also confident that
the plan's design, and the FOMC's clear communication prior to the plan's implementation, will
mitigate the risk of sharp or outsized asset price reactions to the decline in the portfolio's size
over time.
Of course, we cannot and should not prevent Treasury and agency MBS prices from reacting to
relevant economic and financial developments, or indeed from gradually moving over time in
response to the progressive decline in the size of the Federal Reserve's holdings and
consequent increase in the amount of securities held by the private sector.
In fact, we very much want asset prices to respond appropriately and fully to economic and
financial news. Over the coming years, such news could span a wide variety of topics, such as
central bank policy in this country and abroad, the ongoing debate over fiscal policy, and the
evolution of expectations for the longer-run neutral rate of interest.
That said, we do seek to mitigate the risk that our operational actions contribute to unnecessary
surprise, disruption, or volatility.
There is of course always a risk that events could unfold differently from expectations. In
particular, central banks have had little direct experience with the impact of such a reduction in
holdings of domestic securities and in reserves. One relevant experience, of course, was the
socalled "taper tantrum," in 2013 which showed that markets can have outsized reactions to
changes in balance sheet policy even before they happen.
More generally, experience with asset purchase programs, both here and abroad, clearly
demonstrates that market volatility can ensue from balance sheet policy changes that market
participants perceive as surprising, unclear, or rapid, or are not adequately distinguished from
short-term interest rate policy intentions. All of this indicates to me that, at policy turning points
like these, central banks should carefully and clearly communicate their intentions, provide as
much transparency as possible, focus on one tool at a time, and make transitions in policy
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implementation as slowly as overall macroeconomic policy objectives permit.
The rest of my remarks will go as follows. First, I'll provide an in-a-nutshell summary of the
structure of the Federal Reserve's balance sheet. Then, I will discuss why it is important that the
decline in the balance sheet be gradual and predictable, and explain how the FOMC's plan
provides this gradualism and predictability. I will then talk briefly about how the Federal Reserve
is ensuring it is prepared for unexpected developments. We will then open things up for
questions you may have.
The Fed's balance sheet, in a nutshell
Let's begin by reviewing, at a high level, where the Fed's balance sheet is today. Panel 1 shows
a summary of the Fed's assets and liabilities, as they are today. Substantially all of the $4.5
trillion of assets consist of Treasuries and agency MBS. On the other side of the balance sheet,
the Federal Reserve has three main categories of liabilities: $2.6 trillion of bank reserves and
other deposits, $1.5 trillion of paper currency, and about $400 billion of reverse repos.
Before the crisis, the balance sheet was much smaller, at around $900 billion. It reached its
present size as a result of the FOMC's large-scale asset purchase programs. Those programs
were undertaken to support the economic recovery by easing financial conditions to a greater
extent than could be achieved solely through reducing the federal funds rate, once that
instrument became limited by the zero lower bound on interest rates. These asset purchases
greatly increased the size of the asset portfolio, and equally increased the size of the Federal
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Reserve's liabilities, largely through growing the stock of bank reserves. The composition of the
balance sheet also changed. On the asset side, the most important compositional changes were
the addition of agency MBS and a substantial increase in the maturity of the Fed's Treasury
holdings.
For many years, the FOMC has made it clear that it did not intend for these changes to the
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balance sheet to remain forever. Instead, through its statements and its September 2014 Policy
Normalization Principles and Plans, the FOMC indicated its intention that, in the longer run, the
Federal Reserve will hold no more securities than necessary to implement monetary policy
efficiently and effectively, and that it will hold primarily Treasury securities.The FOMC also
communicated its intention to reduce the Federal Reserve's securities holdings in a gradual and
predictable manner, primarily by ceasing to reinvest repayments of principal on its securities
holdings.
Starting in its December 2015 statement, when the FOMC first started to raise its federal funds
target range away from zero, the FOMC also indicated that it anticipated continuing reinvestment
until normalization of the level of the federal funds rate was well under way. The FOMC's
strategy of waiting to begin reducing the balance sheet until normalization of the federal funds
rate was well under way has had several advantages. Most importantly, it reduced the likelihood
that an unexpected adverse shock to the economy would have necessitated a return to the zero
lower bound on the federal funds rate and potentially a reversal in balance sheet normalization.
Second, the FOMC's approach promotes the use of the federal funds rate as the active
monetary policy instrument, an instrument with which the FOMC has much greater
experience. In addition, delaying balance sheet normalization allowed the FOMC to meaningfully
assess the efficacy of its tools to control short-term interest rates with a large balance sheet, and
thereby judge how patient it could afford to be in reducing the balance sheet to its longer-run
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level.
Reducing the balance sheet's size
Over the past year, as the FOMC came to judge that normalization of the policy rate was well
under way, with another rate increase in December 2016, and further increases in March and
June 2017, FOMC deliberations turned to how balance sheet normalization might best be done.
As I noted earlier, for some time the FOMC has underscored that the balance sheet will be
reduced in a way that is gradual and predictable, so as to avoid risks of surprise, disruption, or
volatility, and would be achieved primarily by not reinvesting maturing principal. The FOMC's
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recently initiated plan does exactly this. Principal reinvestment will decline in a phased manner,
an approach which provides for an appropriate pace of reduction in the balance sheet, and is
quite straightforward to communicate.
Specifically, principal maturities will be reinvested only to the extent that they exceed gradually
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increasing caps. For Treasuries, the cap initially will be $6 billion per month, and will increase in
steps of $6 billion at three-month intervals over 12 months until the cap reaches $30 billion per
month. Agencies follow a similar pattern, with a cap starting at $4 billion and rising in three-month
steps to reach $20 billion. The FOMC also indicated that it anticipates that these caps will
remain in place once they reach their respective maximums. Over time, as the Fed holds fewer
securities, the private sector will gradually hold more. At the same time, Fed liabilities held by the
private sector, in particular reserve balances, will decline equivalently.
Panel 2, which draws on a July 2017 update to the System Open Market Account annual report,
illustrates how the caps will evolve in relation to anticipated maturities of Treasuries, on the left
hand side, and agency MBS on the right. As can be seen, once the caps are fully phased in, in
many months the caps are not expected to be binding, and so there would be no reinvestments
in those months. However, the caps will be exceeded in months with large Treasury maturities,
and we would reinvest the amount above the cap. For agency MBS, a change in conditions could
encourage faster MBS repayments than are shown here, producing monthly paydowns larger
than the 20 billion cap and thus some reinvestments-an issue I will return to later.
Policymakers have indicated that they want the portfolio's size to decline "in the background,"
and that the federal funds rate will be the primary instrument of monetary policy. Balance sheet
normalization is expected to continue until the FOMC judges that the Federal Reserve is holding
no more securities than necessary to implement monetary policy efficiently and effectively.
The FOMC has not specified how large the balance sheet should be at that point, other than an
expectation that the level of reserve balances will be appreciably below that seen in recent years,
but larger than before the financial crisis. My colleague Lorie Logan spoke in May on the many
technical drivers of this ultimate level, which include the mode of policy implementation that the
FOMC chooses in the longer run, possible increases in recent years in the financial system's
demand for reserves and Federal Reserve reverse repo liabilities owing to new financial
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regulations and other factors, and the long-term evolution of demand for paper currency.
Let me spend a few minutes discussing the importance of gradualism and predictability.
Gradualism
The case for gradualism in reducing the Fed's securities holdings rests on evidence, as well as
potential risks, that an overly fast flow of securities into private hands could be disruptive to
market functioning, as well as the FOMC's confidence that it can adjust its policy stance as
needed through changes in the federal funds rate. In particular, there is evidence that the agency
MBS market, due to the nature of its trading conventions, is prone to dislocation when market
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participants expect large transitions in central bank agency MBS flows. Such concerns can be
self-fulfilling: if market participants are concerned that an abrupt shift in flow might be disruptive,
they might, for example, withdraw from liquidity provision. An overly fast redemption flow of
Treasuries could also create challenges in the government's management of public debt
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auctions and result in communication challenges.
Rapid portfolio declines also could have unforeseen impacts on overnight money markets, for
example by creating significant shifts in dealers' demand for overnight repo financing. We have
seen such impacts in the past. This sort of volatility did not, and would not now, pose a major
problem to markets or policy implementation, but it is something worth avoiding if possible.
Rapid portfolio runoff could also make it more likely that bank reserves become scarce
unexpectedly or more quickly than policymakers had anticipated.
Finally, overly fast portfolio runoff could introduce undesired noise into financial conditions. This
could complicate policymakers' economic forecasting and make it more challenging to determine
and communicate the appropriate monetary policy stance.
Predictability
Predictability complements gradualism by promoting stability in market estimates for the future
size of the balance sheet, and confidence that the FOMC will not unintentionally create market
stress. It involves assuring the public that the flow of balance sheet reduction remains gradual
across a range of economic scenarios, including ones quite different from our central
forecast. Achieving predictability is complicated by uncertainty about agency MBS principal
repayments, an issue I'll summarize briefly.
To an extent, unexpected changes in the pace of existing home sales contribute to uncertainty
about MBS repayments. But by far the greatest source of aggregate uncertainty relates to
refinancing. When homeowners get a new mortgage with a better interest rate, and pay off their
old higher rate one in the process, existing agency MBS are paid off more quickly, and replaced
with greater issuance of newly-minted agency MBS containing the new, lower-rate loans.
The benefit of the FOMC's redemption cap is that it limits the pace at which securities will flow
back into private hands under scenarios in which interest rates fall much more than expected. To
illustrate this, projections for agency MBS repayments under a scenario of lower interest rates
are shown in Panel 3-as you can see, in this low rate scenario, the caps would still be
exceeded even when fully phased in.
By providing market participants some certainty that the pace of balance sheet decline will be
gradual across economic scenarios, this plan should help mitigate the risk of unexpectedly sharp
shifts in asset prices, liquidity, or market functioning should markets begin to put greater weight
on lower interest rate scenarios. Indeed, by promoting greater confidence in the stability and
liquidity of the Treasury and agency MBS markets across economic outcomes, the FOMC's plan
should result in lower risk and liquidity premia on these assets, relative to normalization plans
that do not promote such confidence.
Being prepared for the unexpected
While I am confident that the FOMC's plan will work well, there's always the risk that events
unfold differently than expected. In my view, we best prepare for the unexpected in two ways: we
need to be operationally ready to change course when needed, and we need to remain
analytically focused so we know when to recommend to policymakers that they do so.
For example, the FOMC has made it clear that it stands ready to resume reinvestment if a
material deterioration in the economic outlook were to warrant a sizable reduction in the federal
funds rate. The FOMC also indicated that it would be prepared to use its full range of tools,
including altering the size and composition of its balance sheet, if future economic conditions
were to warrant a more accommodative monetary policy than can be achieved solely by
reducing the federal funds rate.
Also, unexpected operational demands could emerge from technical developments within the
Treasury and agency MBS markets. Even though it is shrinking, the Federal Reserve's portfolio
is and will remain large, and market participants will look to the Federal Reserve to lend out on a
collateralized basis some of its holdings of Treasuries and MBS from time to time in order to
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facilitate settlement, as is done by most other large fixed-income investors.
Conclusion
Let me conclude now by reiterating the message of confidence with which I began my remarks. I
am confident that the FOMC's gradual and predictable plan to normalize the balance sheet will
reduce the balance sheet's size at an appropriate pace, that it will promote good market
functioning, that it will not disrupt the mortgage market or Treasury debt issuance, and,
importantly, that it will mitigate the risk of sharp or outsized asset price reactions. I am also
confident that the Federal Reserve is well prepared, both operationally and analytically, to identify,
understand, and address unforeseen circumstances over normalization as directed by the
FOMC. Finally, by accomplishing all these things, I am confident that the FOMC's policy
normalization plan should help promote the ongoing economic expansion.
Early signs on this front are encouraging, with no to very modest financial market volatility around
balance sheet announcements and the reduction in the balance sheet to date. It's too early to
declare success. However, should this stability continue, I believe the FOMC's approach may
offer useful lessons to other central banks which anticipate reaching a time of transition in their
policy stance. Thank you for your attention. I would welcome your comments and questions.
I would like to thank John Clark, James Egelhof, and Deborah Leonard, for their assistance in the preparation of
these remarks, Adam Biesenbach for his assistance with the data, and colleagues in the Federal Reserve
System for their insightful comments and suggestions.
2
The FOMC reaffirmed this policy in its November 1, 2017 statement and implementation note.
Potter, Gradual and Predictable: Reducing the Size of the Federal Reserve's Balance Sheet, October 11, 2017.
4
See Potter, Implementing Policy with the Balance Sheet, November 6, 2017, for further discussion of lessons
from experience with balance sheet policy.
5
The maturity structure of the balance sheet was only loosely incorporated into the purchase plan. Purchases of
Treasury securities were targeted at maturity sectors; within each sector, specific issues were selected for
purchase using a relative-value approach based on a spline fitted to market prices. Sack, Implementing the
Federal Reserve's Asset Purchase Program, February 9, 2011. Treasury securities acquired through
reinvestment are purchased in proportion to issuance. Agency MBS purchases are distributed across
instruments roughly in proportion to anticipated gross issuance of those securities at the time. Potter, The
Implementation of Current Asset Purchases, March 27, 2013.
6
Early FOMC discussions of balance sheet normalization, then referred to as an "exit strategy," were predicated
on an intention to return to, as put in the January 28, 2009, meeting transcript, "a more normal framework for
conducting monetary policy," which meant a return to an asset and liability structure closely resembling that
which prevailed before the financial crisis. Normalization-related matters were discussed in the minutes to most
of the FOMC's 2009 meetings. In a January 2009 speech, The Crisis and the Policy Response, Chairman
Bernanke provided extensive detail on the eventual normalization strategy, as envisaged at that time, including
his expectation that the balance sheet would be reduced "to the extent necessary at the appropriate time."
7
See Potter, Money Markets at a Crossroads: Policy Implementation at a Time of Structural Change, April 5, 2017,
for an assessment of the efficacy of these tools.
8
The Policy Normalization Principles and Plans indicates that the Committee did not anticipate selling agency
mortgage-backed securities as part of the normalization process, although limited sales might be warranted in
the longer run to reduce or eliminate residual holdings, and that the timing and pace of any sales would be
communicated to the public in advance. Portfolio projections released in July 2017 do not include sales of any
type over the forecast horizon.
9
Statement Regarding Reinvestment in Treasury Securities and Agency Mortgage-Backed Securities, September
20, 2017.
10
Logan, Implementing Monetary Policy: Perspective from the Open Market Trading Desk, May 18, 2017.
11
Kandrac, The Costs of Quantitative Easing: Liquidity and Market Functioning Effects of Federal Reserve MBS
Purchases (2014).
12
The Treasury Borrowing Advisory Council considered this topic in its third-quarter 2017 meeting, including the
potential impact of changes in central bank policy abroad. See the August 1, 2017, presentation by TBAC to the
U.S. Treasury.
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In addition to these topics, we at the Federal Reserve are following closely the potential for the decline in the
balance sheet to affect other aspects of the structure of financial markets or the banking industry. As one
example, we are paying attention to the possibility that a decline in the size of the balance sheet puts downward
pressure on bank deposits. As discussed earlier, in general, balance sheet normalization removes an asset
from the private sector that can be held only by banks (reserves) and replaces it with an asset that can be held
by anyone (securities). It is possible that, on net in equilibrium relative to a counterfactual in which the balance
sheet does not decline, (a) banks will hold fewer reserves; (b) banks will offset some of this decline by holding
securities instead, and some by taking in fewer deposits; and (c) non-banks will replace those deposits with
securities. The extent (if any) of any such decline in deposit activity on deposit and loan pricing will likely depend
on a variety of factors, including the extent to which the decline comes from wholesale institutional deposit
activity motivated by interest rate arbitrage. See Ihrig, Mize, and Weinbach, How does the Fed adjust its
Securities Holdings and Who is Affected?, September 22, 2017