How will the Federal Reserve System’s balance sheet change when it is shrunk?
This is an old article, first published in 2017 on the official blog of the Federal Reserve Bank of New York (FRBNY).
Recently, every speech by Fed Chairman Jerome Powell draws great attention from the market. When monetary policy will change from easing to tightening is a concern for investors. The amount of dollar liquidity determines whether asset prices will push up or not.
In this context, this article popularizes the expected changes in the Fed’s balance sheet and helps to better understand the Fed’s policy expectations.
Due to the large-scale asset purchasing program (LSAP, QE), the Federal Reserve System’s (Fed) balance sheet has increased significantly in scale in recent years. Since then, through the repayment of principal and capital with interest with the contingent securities owned by the Fed and continuous reinvestment, the scale of the balance sheet has become very large.
When the Federal Open Market Committee (FOMC) decides to reduce the Fed’s balance sheet scale, the speed of reinvestment is expected to gradually decrease in accordance with “FOMC’s policy normalization and plans in June 2017.
How does the purchase of assets increase the Fed’s balance sheet scale? How can reducing reinvestments reduce the balance sheet scale?
In this article, we will answer the questions by describing the Fed’s balance sheet mechanism. Then, in our next article, we will introduce the balance sheet mechanism of Mortgage-backed security (MBS).
Firstly, we will describe the simplified balance sheets of the Fed, the Treasury, Banking Sector, and non-public banking sectors. The picture below omitted some of the items in the balance sheet, allowing us to focus and understand the necessary mechanisms related to the Fed’s actions.
How does the Federal Reserve System change the size of its balance sheet?
1. On the Fed’s balance sheet, we focus on the treasury bonds on the asset side, and deposits of various account holders with liabilities from the Fed on the liabilities side. (These deposits include the remaining balance of the Treasury and reserve deposits of banks).
2. On the contrary, the Treasury will treat its remaining cash as assets in TGA’s “checking account”, and issue Treasury bonds as a liability.
3. The Banking Sector will use treasury bonds and reserves as assets to distribute (issue/absorb) bank deposits to the public.
4. The public could hold treasury bonds and bank deposits as assets. However, by comparing the banking sector and Treasury, the public could not hold the remaining deposit in the Federal Reserve account (such as the Fed’s liabilities).
The qualification of opening and maintaining a Fed account is limited to deposit institutions (known as DIs), financial sectors, and certain other financial institutions such as the Treasury and Government-Sponsored Enterprises (GSEs), designated financial market institutions, and foreign official institutions. Wealth corresponds to the difference between public assets and liabilities.
Through the setup, as shown in the picture above, we can see how the Fed’sasset purchases will increase the size of its balance sheet. The figure below describes the impact of purchasing treasury bonds from the banking sector. The Fed issued more reserves (by electronically crediting the reserves to the Fed account of the bank that sells the bonds) to purchase treasury bonds.
So, for every Dollar of securities purchased, the Fed’s assets and liabilities will increase by 1 Dollar. When the bank sells treasury bonds, the bank’s treasury bond assets will decrease, and the reserves assets will increase.
When the Fed purchases assets from the public, as shown in the picture below, since the public cannot hold the reserves issued by the Fed, the mechanism is different. Therefore, the banks hold reserves and the public holds more bank deposits instead. Three transactions will occur simultaneously:
1. The Fed purchases contingent securities and issues reserve liabilities, just like the situation mentioned above.
2. Since the public cannot directly hold the treasury bonds, the bank holds the reserves on behalf of the public, and the sum obtained from the sale will be deposited into the contingent security seller’s deposit account.
3. When the public sector sells treasury bonds, the treasury bonds will decrease, and the deposits in banks will equally increase.
How does the Fed change the size of its balance sheet?
From the Federal Reserve’s perspective, it does not matter who (which department) sells the contingent securities; in both cases, the size of the balance sheet is equal to an increase in scale. On the contrary, the scale of the bank’s balance sheet is determined by whoever sells the assets.
If the bank sells assets, the size of the balance sheet of the banking industry remains unchanged, but the structure changes. However, if the non-public banking sector sells the assets, the banking sector’s balance sheet will at least initially increase the scale of purchased assets. (The banks can offset this initial growth by participating in transferring the asset liabilities to the non-banking financial institutions. If they want to limit the growth of their balance sheets, this is not shown in the picture that we presented but, for example, banks can sell their assets to the public.
Carpenter, Demiralp, Ihrig and Klee’s research showed that most of the assets purchased during the large-scale asset purchasing period were mainly from the non-banking sector.
The Reinvestment Policy of the Fed
To build some understanding of the Fed’s reinvestment policy, we first consider the maturity of treasury bonds held by The Federal Reserve, and The Federal Reserve will not reinvest in the earnings of matured securities, the Treasury also does not issue new securities.
In this case, as depicted in the next picture, the Treasury will transfer cash from TGA to the Fed when the securities mature. When the Fed’s assets decrease, the liabilities decrease, and the size of the balance sheet decreases.
In the remaining parts of this article, we will assume that the Treasury issues new securities to replace maturing bonds and maintains its outstanding debt at a constant level. For simplicity, we assume that the new security is issued simultaneously as the old security matures. However, this may not always be the case in practice.
If the Fed reinvests the proceeds of its maturing Treasury securities into new issues, the size of its balance sheet remains unchanged. For each Dollar of maturing securities, the Fed will buy a dollar of new securities to maintain its Treasury holdings (More details are available on the New York Fed website).
This is an operational rollback policy pursued by the Fed over the past few years. (When the Fed replaces maturing holdings with securities auctioned by the Treasury, the Fed’s purchases are seen as an additional process to the size of the auction; announced by the Treasury.)
Now we can look at the situation where the Fed does not reinvest and see how this will reduce the balance sheet size. For the sake of simplicity, let’s assume that the Fed stops reinvesting completely. Still, if they reinvest only a part of the maturing securities, the mechanism is similar, and the balance sheet shrinks proportionately.
If the Treasury issues new securities and the old securities mature, then the other departments will have to take over if the Fed does not buy new securities. The figure below shows how banks buy new securities. When two transactions occur simultaneously:
1. As mentioned before, the Treasury has paid off maturing securities to the Fed, which reduces the balance of TGA of the Treasury and the size of treasury bonds held by the Fed.
2. Banks buy new securities issued by the Treasury. This step leads to the transfer of cash balances from the banking sector to the financial department, which is offset by transferring the securities to the banking sector.
3. At the end of this process, the Fed’s balance sheet size reduces, whereas the Treasury’s balance sheet remains unchanged, and the balance sheet of the banking industry has the same size but different composition.
How does the non-public banking sector purchase newly issued treasury bonds? This situation will be illustrated in the last figure. When three transactions occur at the same time:
1. As mentioned before, the Treasury pays off the maturing securities to the Fed.
2. The banking sector purchases securities from the public, so the Treasury’s TGA balance at the Fed increases.
3. Since the non-public banking sector cannot hold reserves, the public uses the bank deposits to buy securities, resulting in the decrease of the bank deposits.
This is basically the opposite of the third picture above. As mentioned earlier, banks and the public could take follow-up actions to change their assets and liabilities. The final impact of the balance sheet can be presented in many ways according to their preferences.
In this article, we described the Fed’s purchasing mechanism and the impact of the FOMC’s reinvestment policy, focusing on the simplified balance sheets of the Fed, the treasury, banking sector and non-public banking sector.
This method helps to explain how asset purchases increase the Fed’s balance sheet size, and how stopping reinvestments reduces the balance sheet.
We also discussed what will happen to the balance sheet of the banking industry. Of course, this depends on whether the public or the banking sector buys or sells their treasury bonds. In our next article, we will explore some similar issues in the MBS case.
Similar to what we did in the previous article, we started with a simplified set of balance sheets, as shown in the following figure. The three departments in the balance sheet are exactly similar to those mentioned in yesterday’s article: They are the Fed, the banking sector and the public.
We will not examine the Treasury’s balance sheet, instead, we introduced the MBS issuer’s balance sheet. MBS issuer may be one of the government-funded companies- Fannie Mae and Freddie Mac, or the government enterprise, Ginnie Mae. These three institutions are MBS institutions that guarantee the consolidation of personal mortgage loans (into asset pools).
For simplicity, we shall name these institutions as “MBS issuers”.
We also focus on different items on the balance sheet. We now focus on the institutional MBS on the asset side of the Fed’s balance sheet, whereas on the liability side, we hold the cash assets held by the MBS issuer, not the cash assets held by the Treasury.
MBS issuers have mortgage loans and deposits in the Fed on the asset side, and the MBS issued on the liability side. So when it comes to the banking sector, the only change is that MBS has replaced treasury bonds on the asset side.
On the asset side of the public, we added houses and added mortgage loans on the liabilities side.
The main difference between Treasury bond and Institutional MBS
The Fed’s purchasing mechanism is the same as we described in our previous article. Therefore, we can simply replace the treasury bonds with MBS on the balance sheet. However, the characteristics of treasury bonds and institutional MBS are different in certain important aspects:
1. Treasury bonds have predictable interest and principal repayment statements. For example, most interest-bearing securities pay a predetermined fixed interest on a specific date and pay the full principal when they fall due. Institutional MBS is more complicated, partly because mortgage loans back these securities. The repayment of MBS principal and interest depends on the family’s repayment of the relevant mortgage loans; These payments go through the mortgage institutions and eventually reach MBS investors (Repayment will also go through the mortgage service provider — not shown in our chart).
2. In contrast to Treasury bonds, most mortgage loans are amortized on a regular basis. This means that the MBS principal will be gradually reduced according to the family’s regular monthly payments.
3. Families also have the right to repay their mortgage loans beforehand at any time, such as selling their homes or refinancing at lower interest rates. This option means that the repayment mode associated with MBS is more unpredictable than the repayment method of treasury bonds.
MBS trading and the Fed’s reinvestment policy
To understand the impact of the Fed’s reinvestment policy in this context, we need to describe the impact of household mortgage loans (principal and interest) on the balance sheets of all relevant sectors.
Assuming that the Fed holds MBS related to the mortgage loan, we first consider the case where the principal repayment of the mortgage is $1. The figure below shows the end result of this trading sequence.
1. First, to make the payment, the family can transfer money to the MBS issuer by issuing checks or asking the bank. This will either result in a $1 reduction in public deposits in the bank. The loan principal we bear also increases the family’s housing equity: the difference between the value of the house and the balance of the mortgage loan.
2. After this, the bank will send $1 from its reserve account at the Fed to the MBS issuer’s Fed deposit account.
3. The Fed’s MBS issuer deposit account will be reduced by one U.S. dollar and paid to MBS investors (i.e. the Fed). This will make the MBS issuer’s deposit balance in the Fed Account remain unchanged.(Let’s assume that there is a simultaneous sequence of events, but in fact, the balance of deposits transferred from the bank to the MBS issuer may accumulate in the MBS issuer’s account before making the repayment to the MBS investor.)
4. Since Fed holds MBS, the Fed’s MBS holding is reduced by $1 USD.
If the Fed reinvests the proceeds from MBS, their MBS holdings will rise again and banks’ reserves will also rise.
Overall, just like what we have shown in the previous article, the Fed’s balance sheet remains unchanged in terms of the reinvestment of treasury bonds.
In other words, due to MBS’s trading and settling methods, there might be a delay between the time the Fed pays from MBS and the time when they purchase alternatives. As a result, the size of the Fed’s balance sheet might rise and fall momentarily.
In the figure below, the public pays $10 USD, representing a combination of principal repayment ($1 USD) and interest expense ($9 USD).
1. The public will ask the bank to send the repayment amount to the MBS issuer, and the deposit in the bank will be deducted by 10 Yuan. However, as the principal is only part of the repayment, the balance of mortgage loans held by the public has only decreased by 1 Yuan. Therefore, the remaining payments reduce the wealth of the public.
2. As shown in the figure above, banks pay by transferring reserve deposits from the Fed account to the federal reserve deposit account of the MBS issuer.
3. MBS issuers pay MBS holders by reducing their federal reserve account deposits.
However, in this case, the payment of principal is only part of the payment, so the asset side of the Fed’s balance sheet is lowered by only $1 USD. For the remaining payment, the interest represents the interest income of the Federal Reserve funds that were ultimately remitted to the Treasury, that is, all of the Fed’s income minus costs. The reduction in reserves held by banks may be temporary.
As the Federal Reserve’s income is remitted to the Treasury and the Treasury pays the balance of deposits to cover expenses, so the interest portion of the Treasury will eventually return to the banking system.
In our previous article, we assumed that whenever the Treasury redeems securities, it will issue new securities to the debt level unchanged through this rollback issue. We can make similar assumptions in the case of MBS issuers.
When some families completed their mortgage payments, other families have made new mortgage loans. We will see what happens in this situation in the figure below.
Assuming that a family moves into a new city, and sells their old house, and buys a new one. Let us assume that the original $100 USD mortgage loan is part of the MBS held by the Fed, and the new mortgage loan is also $100 USD, which is included in the new MBS.
If the Fed stops reinvesting, the new MBS will be bought by someone else, which is a bank in this case. For the sake of simplicity, we will assume that the value of the new MBS equals the value of the old MBS.
From the public’s perspective, nothing has changed, except the fact that one loan is replaced by another loan with a similar value. Similarly, for the MBS issuers, the loan on the asset side are replaced by another loan, whereas the MBS is replaced by another MBS on the liabilities side. The assets on the balance sheet of the banking sector is replaced with a new MBS.
Lastly, from the Fed’s perspective, when the Fed’s balance sheet size decreases, the reserves will also decrease.
In this article, we described the mechanisms related to the purchase and payment of the balance sheet. However, by comparing the treasury bonds discussed in the previous article, the key difference is that it is hard to predict the repayment time of MBS, and this depends on the house owner’s actions.
Despite these differences, the final impact of the Fed’s balance sheet is very similar to MBS and treasury bonds. When these securities mature or are paid off, the size of the Fed’s balance sheet and the supply of reserves decreases.