The Federal Reserve Board recently announced the preliminary and unaudited results of its 2012 operations. For those of us cautioning against the Fed’s increasingly dramatic operations, the results come as no big surprise. For those who think the Fed is fighting to save the economy, the results deserve a closer look.
|Jan. 1, 2013||Jan. 1, 2012||Yearly Change|
|Special Drawing Rights||5,200||5,200||0|
|US Treasury Securities||1,666,118||1,672,092||-5,974|
|Federal Agency Debt||76,783||103,994||-27,211|
|Repurchase Agreements and Loans||587||9,082||-8,495|
|Federal Reserve Notes||1,126,861||1,034,520||92,341|
Figure 1 shows the Fed’s financial position at the beginning of 2012 and compares it to the beginning of 2013. Some of the results look quite appealing:
1. The Fed didn't sell any of its gold holdings. In fact, the gold holdings are greater than they appear because the Fed accounts for its assets and liabilities with historical values. The $11bn. of gold represents 260 million ounces (a little under 9,000 tons) and valued at the historical price of $42.44/oz. If we were to update the value of these gold holdings to reflect their current price (around $1,670), the Fed would hold over $434bn. of the shiny metal.
2. The Fed has reduced the total size of its balance sheet. Much discussion has taken place about the dramatic increase in the size of the Fed’s balance sheet over the past four years. Luckily, at the start of 2013, the Fed held almost $10bn. fewer assets than it held a year before. (I should note that this is still only a reduction of a tenth of a percent, but it’s a start.)
3. Included in this reduction in assets was a $6bn reduction in the Fed’s U.S. Treasury holdings. The Fed might still be financing the U.S. government by purchasing its bonds, but it’s doing a little less of it.
4. While the Fed might have reduced its holdings of U.S. Treasury debt, it drastically increased its holdings of mortgage-backed securities (MBS) (by almost $90bn.). This is a troublesome development for several reasons. First, MBS in many cases represents low quality loans once held by the banking system. By purchasing these bonds the Fed has shifted the risk of their potential default from the banking system onto its own books. (More on this risk later.) Second, MBS are recorded at their face value. The true market value of these securities is anyone’s guess, and won't be known until the Fed prepares to sell them.
5. The amount of outstanding Federal Reserve notes (those ratty one dollar bills that keep service staff paid) increased by $92bn., which is about 9 percent. This increase in the amount of outstanding notes was offset by a large decrease in the amount of money held on deposit with the Fed. Although the U.S. Treasury holds a good number of these deposits, depository institutions (banks) hold the lion's share. This decrease in funds on deposit at the Fed might be signaling that banks are becoming optimistic about the state of the economy and starting to lend out their reserves. This lending has been weak throughout the recession and has led to a large buildup of excess reserves.
The decrease in deposits, and with it a shrinking of the total size of the Fed’s balance sheet, would generally be a sign for optimism. The two trillion dollar expansion of the Fed’s balance sheet in the aftermath of the 2008 credit crunch was alarming—even among those who fundamentally agreed it was necessary! The size of the increase, and the scope of the assets being bought up, marked a solid departure from any experiment the Fed had previously attempted.
While many economists, including most Fed officials, tried to assuage the public’s fears that this large scale increase in the money supply would cause hyper-inflation, some economists dissented.
I have previously written (here and here) that the Fed’s actions would not necessarily place too much upward pressure on prices provided the value of the assets it purchased remained stable. The theory in a nutshell—which is commonly accepted by most economists—goes something like this:
The Federal Reserve increased the money supply by purchasing assets of questionable quality from the banking system. It paid for these assets with cash (an increase in Federal Reserve notes) and received the assets now entered on its balance sheet (mostly mortgage-backed securities and Federal Agency debt). If banks took the fresh money and lent it out to borrowers to spend in the economy, inflationary pressures would build on prices. To avoid this outcome, the Fed commenced paying interest on reserve balances (both required and excess). Banks would hold on to the new reserves, earn a small profit, and improve their capital positions. Even though the interest rate offered on reserves was meager (only 0.25 percent as of today), banks by-and-large chose this path rather than risk parting with their money, and perhaps losing it, through loans to private companies and individuals. It was a win-win solution. Banks received a capital infusion and remained solvent. The Fed “saved” the banking sector while not provoking an inflationary run-up in prices.
The Fed can stave off inflation only as long as the banking system does not make use of its fresh reserves. Luckily, they can just reverse the original transaction to avoid this fate. When the banking system gets back on its feet, the Fed can buy back the reserves that it issued over the past four years by selling off the assets that it owns. This is the standard story from Fed officials and seems to be a rational explanation for how the future will unfold. However, there are two significant problems.
The first problem is how much will the sale of the Fed's MBS and Federal Agency debt-holdings bring. The combined figure of over $1.7 trillion shown on its balance sheet today represents the face value of these securities. I don’t believe many analysts think that MBS have increased in value much since the Fed started purchasing them several years ago. The Fed can only reduce its liabilities by selling off its assets. If the Fed wants to rein in reserves, it needs to offer the banking sector something in exchange—whether MBS or other assets. If these assets fall in value the Fed will have insufficient assets to exchange for the reserves it has created, and the money supply will have permanently increased as a result.
The second problem is what happens if the Fed holds an auction for its assets and no one comes? The banking system was able to trade its poor quality assets to the Fed for high quality reserves. What makes the Fed think, that at some point in the future, they will want the poor quality assets back? A housing rebound might come along, and with it an improved risk-return profile on MBS. Yet, this seems unlikely at this time. Some might say that this problem is really a non-issue—the Fed will find a buyer for its assets, it’s only a question of price. That “solution” brings us back to the previous problem of what low price will the Fed have to accept to sell off its questionable assets.
If the economy improves, the banking sector will increasingly loan out its reserves and bring inflationary pressure to prices. If the economy does not improve, the Fed will not be able to unload the low-quality assets on its balance sheet, and thus the inflationary pressures will remain. The so-called win-win solution to the crisis has become a lose-lose scenario.
This year in review for the Fed signals that the banking system might be moving to make use of its reserves. The shift out of deposits held at the Fed, and into currency, signals that banks are regaining a willingness to restart lending operations. These loans increase the money supply in the hands of the public, and will eventually cause price inflation.