In thinking about the can of worms I opened about this topic, I started jotting notes on directions I might take next. There are so many possilbities. As a matter of inquiry, I found and perused an old copy of Keynes’ General Theory, looked at old international finance lecture notes from Professor Stanley Zin, and reviewed some of the data on the St Louis Federal Reserve FRED website. In doing so, I came across this release from April 9, 2020, which includes updated statements of net assets by the consolidated Federal Reserve system.
I also came across, quite by accident, this Federal Reserve authored paper from 2013, addressing the state, and projected changes to, the Federal Reserve balance sheet.
Then, I came across this article in @WSJ dealing with Federal Reserve intervention in the bond market over the past week:
In addition to lower-rated corporate bonds, the Fed said it will now allow purchases of new classes of debt that were excluded in the central bank’s response to the 2008 financial crisis. These include purchases of triple-A-rated tranches of existing commercial mortgage-backed securities and newly issued collaterized loan obligations.
Wall Street Journal, April 9, 2020: Fed Moves Spark Corporate Bond Rally by Sebastian Pellejero and Sam Goldfarb
This is precisely the phenomenon @elerianm writes about in The Only Game In Town. He wonders, “Would the artificial pricing of financial assets, repeatedly boosted by central bank liquidity and a generalized perception that these institutions that these institutions were markets’ BFF (best friends forever), lead to excessive risk taking and larger resource misallocations that would come back to bite growth and stability? Would a big surge in inflation materialize down the road? Would central banks be forced to unload their ballooning balance sheets, destroying value and destabilizing financial markets? Would repressed volatility give way to damaging “volatile volatility?”
To @elerianm’s point, the following was also reported in the Wall Street Journal article: “Just the promise of the Fed’s intervention has reignited the corporate-bond market in recent weeks. Companies issued more than $105.3 billion in investment-grade bonds in the past month, said Bank of America Global Research, with $37.7 billion of that occurring in the week ended Wednesday.”
At this point, I think a simple question to attempt to answer is, “what does it mean to say that the Federal Reserve’s balance sheet has grown?” The balance sheet at the time of the 2013 paper’s distribution can be found below, per this release:
This stands in pretty stark contrast with this release from this week (April 10, 2020), which reflects a substantial increase in the size of the balance sheet:
So, since the Fed has initiated nontraditional monetary policy, including the use of its balance sheet to intervene in markets, the total assets of the Fed has grown in both absolute terms as well as relative to GDP. The following chart demonstrates this on an absolute basis:
Observations I would highlight from above include: a) dramatic expansion of the balance sheet during March/April 2020 to approximately $6 trillion from roughly $4 trillion, b) change in the composition of assets to include 24% of assets held in Mortgage Backed Securities (MBS), and c) a current Fed ‘assets-to-capital’ of 157x, contrasted with a previous ratio of 133x.
For the sake of comparison, here is the Q3 2019 balance sheet from JP Morgan’s 10Q, which shows ‘assets-to-capital’ of 10x. (To be clear, my point in making this comparison is not to suggest that we should expect comparable explicit leverage ratios at our central bank, but rather to point out that, in the belief that “there is no free lunch,” the implications of increased leverage must be externalized someplace).
As a final matter of curiosity tonight, I pulled the Fed balance sheet for January, 2005, as a measure of “pre-crisis” structure. Here is what I found at this release. Here the ‘assets-to-capital’ ratio calculates to roughly 36x. Notably, there is no category for MBS.
In summary, the Fed has a dual mandate to support employment and price stability. (The Richmond Fed has a nice article about the history of this mandate here.) Tools historically available to accomplish this include changes to reserve ratios (rarely used), the discount rate, open market operations, and interest on reserves (IOER). In dealing with the GFC, the Fed expanded its use of these tools by growing its balance sheet in scale and composition (e.g. MBS) while effectively expanding its leverage and pursuing more explicit strategies to “direct” the market through “forward guidance”. Furthermore, it began more aggressively utilizing IOER mechanism to nudge commercial bank behavior, as well.
With these dramatic swings in the makeup of the Fed’s balance sheet, and now intervention in corporate debt markets, I continue to be curious about how these moves manifest in the real economy. I will dig deeper another day.
What could go wrong? | Prices for debt from companies including Ford jump on the Fed’s plans to buy new and existing bonds from so-called fallen angels. https://t.co/0DCeFVpGNC via @WSJ
— Jens Thorsen (@jensholger78) April 11, 2020