The Federal Reserve would like to reduce the size of its balance sheet, but recent events are dictating otherwise.
The Fed's balance sheet grew by roughly $300 billion last week, driven by emergency lending facilities rolled out to address the ongoing crisis in the banking system. The new loans effectively offset the central bank's last three months of balance sheet reductions.
"These tools are now working at cross purposes," said Derek Tang, co-founder of the Washington-based research firm Monetary Policy Analytics. "It's really a microcosm of the wider tension at hand, which is that policy is too tight for the banking system, but not tight enough for inflation, for the macroeconomy."
Fed Chair Jerome Powell, following the Federal Open Market Committee meeting on Wednesday, said the current balance sheet expansion is meant to be a limited phenomenon, drawing a distinction between recent actions and the central bank's asset buying campaign that ran between March 2020 and March 2022.
"The intent and the effects of that [recent expansion] are very different from when we expand our balance sheet through purchases of longer-term securities," Powell said during a post-meeting press conference. "Large-scale purchases of long-term securities are really meant to alter the stance of policy by pushing up the price and [pushing] down longer term rates, which supports demand through channels we understand fairly well."
That so-called quantitative easing during the height of COVID-19 more than doubled the balance sheet from $4.2 trillion to $8.9 trillion as the Fed bought Treasury securities and mortgage-backed securities to drive down the cost of capital.
Last spring, the Fed began a quantitative tightening exercise to shed Treasuries and MBS from its balance sheet by allowing matured securities to expire without replacing them. The program has been running at its full, $95 billion per month clip since last September.
Powell said shrinking the balance sheet in this way is still a necessary part of the Fed's strategy for combating persistent price inflation. Based on the core Personal Consumption Expenditure Index, the Fed's preferred measure, prices rose at a 5.5% annual rate last month, well above the 2% targeted by the central bank.
Still, the failures of Silicon Valley Bank and Signature Bank earlier this month and the ensuing volatility in the banking sector have increased liquidity needs among banks that have seen an uptick in withdrawal requests. To prevent those deposit demands from turning into more ruinous bank runs, the Fed has gone to great lengths to provide liquidity.
"That balance sheet expansion is really temporary lending to banks to meet those special liquidity demands created by the recent tensions. It's not intended to directly alter the stance of monetary policy," Powell said. "We do believe that it's working. It's having its intended effect of bolstering confidence in the banking system and thereby forestalling what might otherwise have been an abrupt and outside tightening in financial conditions."
To ensure banks had enough liquidity to weather the storm, the Fed launched a special lending facility, known as the Bank Term Funding Program. Through it, banks can pledge government-backed securities at their full par value for loans up to one-year in duration at a fixed interest rate. This allows banks to access more liquidity than they otherwise could through the Fed's standard emergency lending facility, the discount window, which provides a haircut to the market value of pledged assets and caps loans at 90 days.
In the near term, this new super discount window has the potential to grow the Fed's balance sheet significantly. When the program was launched, Fed officials said it is "large enough in the aggregate to cover all the banking system's uninsured deposits," though they did not expect it to see anywhere near that usage.
Indeed, initial use of the super discount window was modest, despite the widespread uncertainty in the bank sector. During its first three days of operation, banks pledged $16 billion of assets to the facility and drew less than $12 billion of loans, leaving the $4 billion balance undrawn for the time being.
Meanwhile, discount window borrowing grew by $148 billion last week. In a blog post, Bill Nelson, chief economist at the Bank Policy Institute, said there are several possible explanations for the disparity between the two facilities. The standard discount window accepts a wider range of assets as collateral and many banks already had those assets prepositioned at the window, making it easier to draw on those lines of credit.
The type of credit offered at the super discount window also might not have lined up with the needs of the banks that borrowed last week, Nelson added. Most of the lending was primary credit rather than secondary, indicating the borrowing banks are in generally sound financial conditions.
Another contributing factor to the Fed's balance sheet growth is the $143 billion of loans to the bridge banks set up by the Federal Deposit Insurance Corp. to handle the assets of Santa Clara, Calif.-based Silicon Valley Bank and New York-based Signature Bank. Powell did not disclose the terms of those loans, but said they were fully guaranteed by the FDIC.
The countervailing trends in the Fed's balance sheet, while peculiar, do not pose any immediate risks to banks. Still, if depository institutions turn to the central bank for liquidity at a high enough level, the dynamic raises the questions about the calibration of monetary policy and its impacts on the banking system, Tang said, especially if the crisis is protracted.
"So far the Fed has tried to adhere to what they call the separation principles, separating financial easing from monetary tightening," he said. "That sort of separation principle is finite. It's not absolute. It really depends on the circumstances."
Ultimately, the element of the Fed's balance sheet management that is most important for banks is the supply of reserves, which serve as cash holdings for banks at the Fed.
The Fed pursues an "ample reserve" regime, in which the supply of reserves is slightly above the amount demanded by banks. Fed officials, including Gov. Christopher Waller and Federal Reserve Bank of Dallas President Lori Logan, have said the current level of reserves is well above that target range, pointing to the $2 trillion of liquidity that is placed in the Fed's overnight reverse repurchase agreement, or ONRP, facility.
ONRP lending sits on the liability side of the Fed's balance sheet, along with reserves held by banks and cash in circulation. Through this facility, money market funds buy securities from the Fed and agree to sell them back the next day at a slightly higher price.
Waller and others have said that $2 trillion represents excess liquidity in the system. They argue that if banks need that liquidity, they can compete with money market funds by offering higher interest rates to win over depositors.
"It sounds like you should be able to take $2 trillion out and nobody will miss it, because they're already trying to give it back and get rid of it," Waller said during an appearance at the Council on Foreign Relations in January. "Now, at some point, as reserves are draining out, it'll come out of the banks and then the banks, if they need reserves, it's sitting over there on this ONRP facility, being handed over by money market mutual funds. You're gonna have to go compete to get those funds back."
For some banks, including smaller banks that already pay more for deposits and regional banks that are seeing an outflow of deposits amid the current crisis, competing for new deposits could prove easier said than done. This raises concerns that, even if the overall level reserves is sufficient, that abundance might not be enjoyed equally by all banks.
"Aggregate reserve balances are ample, but they're not distributed between banks evenly or the correct way. Big banks are now experiencing deposit inflows, so even before last week, we saw smaller banks were much closer to the brink, or much closer to the pre-COVID norm than big banks were," Tang said. "If big banks and small banks aren't willing to trade reserves with each other because there's reserve hoarding, then that means reserve scarcity is closer as well."
During this week's press conference, Powell said the Fed is neither concerned about the overall supply of reserves or their distribution throughout the banking system.
"In terms of the distribution of reserves, we don't see ourselves as running into reserve shortages," Powell said. "We think that our program of allowing our balance sheet to run off predictably and passively is working. And, of course, we're always prepared to change [policy] if that changes but we do not see any evidence of that change."
Yet, some say the shift from too many reserves to too few often happens much quicker than projections suggest, especially when a central bank shifts from quantitative easing to quantitative tightening. Raghuram Rajan, the former governor of the Reserve Bank of India and a current finance professor at the University of Chicago, said that is because banks get accustomed to having ample liquidity to draw from.
Not only does this result in a higher minimum level of reserves for banks to feel comfortable, Rajan said, but it also leads to banks crafting their own balance sheets in ways that quickly become unsustainable when monetary policy changes.
"The system is not happy just accumulating reserves, it actually wants to use them, and the way banks use them is by writing claims on reserves. They do this either by shortening the maturity of their liabilities and going for cheaper funding, which comes with risk that it can be withdrawn on a moment's notice, or they shrink time deposits, because they feel they have plenty of liquidity," Rajan said. "The problem, of course, is reversing that is not easy."
