How the Fed took the money out of monetary policy
Submitted by EconWeeklyite
The Federal Reserve used to have only a few tools to do its job —that is, until it got the genie out of the bottle. Sometimes quietly, other times conspicuously, the Fed is surely changing the way it creates liquidity.
(Jim Hamilton has been narrating these changes since the summer. Part of this post is my one-stop account. Jim’s posts, which are much better, are here: September 23, December 14, December 16, March 15.)
The central bank has a balance sheet, just like any other bank. As assets, it holds government securities, loans to depository institutions (banks), and other assets. As liabilities, it has currency (the cash in your pockets) and reserve balances. Reserves are deposits that banks keep at the central bank. When a bank needs currency it withdraws from its deposit, effectively turning it into bills and coins that you and I can use.
Until now, macroeconomics textbooks have been telling us that central banks use three tools to control the amount of currency in circulation. Looking at them from an accounting perspective will help us understand what the Federal Reserve has been up to recently:
1) Open market operation. This is an outright purchase of government securities from banks. When conducting this operation, the central bank increases its assets and credits banks’ reserve balances. Eventually, banks withdraw from their reserves at the central bank and turn them into cash. So an open market operation amounts to withdrawing government securities from the economy and replacing them with cash. The central bank can also reduce the amount of cash in circulation, by doing just the opposite: selling government securities and absorbing cash. By far, an open market operation is the best-know of the central bank’s tools.
This is a simplified version of the U.S. Federal Reserve’s balance sheet on August 15, 2007:
| Federal Reserve’s balance sheet, $ millions (Aug. 15, 2007) | |||
| Assets | US government securities | 789,601 | |
| Repurchase agreements | 24,000 | ||
| Reverse repurchase agreements | -31,941 | ||
| Direct loans | 264 | ||
| Other assets | 37,058 | ||
| Liabilities | Currency in circulation | 813,085 | |
| Reserve balances | 5,897 | ||
| Changes in the Fed’s balance sheet after a $1,000M open market operation | |||
| Assets | US government securities | +1,000 | |
| Repurchase agreements | 0 | ||
| Reverse repurchase agreements | 0 | ||
| Direct loans | 0 | ||
| Other assets | 0 | ||
| Liabilities | Currency in circulation | +1,000 | |
| Reserve balances | 0 | ||
| Changes in the Fed’s balance sheet after a $1,000M repurchase agreement, offset by an open market operation | |||
| Assets | US government securities | -1,000 | |
| Repurchase agreements | +1,000 | ||
| Reverse repurchase agreements | 0 | ||
| Direct loans | 0 | ||
| Other assets | 0 | ||
| Liabilities | Currency in circulation | 0 (-1,000 + 1,000) | |
| Reserve balances | 0 | ||
| Federal Reserve’s balance sheet, $ millions | |||
| Assets | Aug. 15, 2007 | Dec. 26, 2007 | |
| US government securities | 789,601 | 754,612 | |
| Repurchase agreements | 24,000 | 42,500 | |
| Reverse repurchase agreements | -31,941 | -40,542 | |
| Term Auction Facility loans | 0 | 20,000 | |
| Direct loans | 264 | 4,535 | |
| Other assets | 37,058 | 52,869 | |
| Liabilities | Currency in circulation | 813,085 | 829,193 |
| Reserve balances | 5,897 | 4,781 | |
| Federal Reserve’s balance sheet, $ millions | |||
| Assets | Dec. 26, 2007 | Mar. 19, 2008 | |
| US government securities | 754,612 | 660,484 | |
| Repurchase agreements | 42,500 | 62,000 | |
| Reverse repurchase agreements | -40,542 | -46,143 | |
| Term Auction Facility loans | 20,000 | 80,000 | |
| Primary Dealers Credit Facility | 0 | 28,800 | |
| Direct loans | 4,535 | 125 | |
| Other assets | 52,869 | 36,603 | |
| Liabilities | Currency in circulation | 829,193 | 818,362 |
| Reserve balances | 4,781 | 3,507 | |
Source: Federal Reserve, H.4.1 release.
With its new tools, the Fed has provided liquidity without printing much money. It has temporarily absorbed risky and illiquid securities, and supplied government securities, which are risk-free. So instead of monetary policy, in the sense we traditionally have thought about it, the Fed has become a risk-absorber (temporarily, we hope). Or, to put it less kindly, a pawnbroker.
Will these new tools make it to the textbooks? It’s hard to tell whether the particular facilities (TAF, TSLF, etc.) will survive. I think that some unified, generalized form of credit to non-depository institutions will stay. But I’ll have to write about that another time.
(Clicking that button gives $0.10 to Francisco. Join tipjoy! How does tipping work?)
Visit 1800blogger to see all of our industry leading blogs.
Are you an investor? Have something you want to say about the economy? Register on Econoimist Blog now and get published within minutes. Before posting, it is recommended that you review our posting guidelines.
