Given the bull nature of the market, why on Earth would the Fed scheme up new ways to prop up banks now? Judging by the broad strokes of this plan, it looks like a scheme to get out of Treasuries for the Fed — a balance sheet reduction plot, transferring the bonds from them to banks.
Federal Reserve officials are considering a new program that would allow banks to exchange Treasurys for reserves, a move aimed at ensuring liquidity during difficult times that also would help the central bank decrease the size of its nearly $4 trillion balance sheet.
The so-called standing repo facility is in its early discussion phases. Respected St. Louis Fed economists David Andolfatto and Jane Ihrig have authored two papers on the plan, which they say would ease the regulatory burden for banks who feel pressured into holding ultra-safe assets.
In some quarters, the idea is viewed as a natural extension of current Fed policy. Others, though, think it in essence could be a repackaged form of quantitative easing and thus yet another iteration of the Fed’s decade-long tinkering in financial markets.
The idea comes as central bank policymakers look for ways to cut the bond holdings on its balance sheet without being disruptive to markets.
“With this facility in place, banks should feel comfortable holding Treasuries to help accommodate stress scenarios instead of reserves,” Andolfatto and Ihrig wrote in March. “The demand for reserves would decline substantially as a result. Ample reserves — and therefore the size of the Fed’s balance sheet — could in fact be much closer to their historical levels.”
In a follow-up a few weeks ago, the duo wrote that the first paper “generated a considerable amount of discussion among industry experts. Many people seemed broadly sympathetic to the proposal, while others expressed skepticism.”
A question of balance
Determining an appropriate size for the bond portfolio has been an ongoing headache at the Fed.
Fed Chairman Jerome Powell’s comments in December that a program to cut the balance sheet was on “autopilot” contributed to a market meltdown that lasted through the fourth quarter. Since October 2017, the Fed has been allowing a set level of proceeds from Treasurys and mortgage-backed securities holdings to roll off each month, resulting in a reduction of just shy of $500 billion.
A subsequent Fed policy pivot that included an intention to end the balance sheet roll-off in September assuaged the market. However, the question of where the level of bonds, and reserves, ends up over the long run remains.
Instituting a standing repo facility would encourage banks to hold more Treasurys and thus reduce the demand for reserves, which escalated following the financial crisis when big Wall Street institutions faced a crippling liquidity shortage. Congress responded to the crisis with reforms that mandated higher holdings of safe assets. While Treasurys are considered safe, they aren’t as liquid during times of stress.
The Fed ideally would like to see a lower reserve level, with the New York Fed putting the desired number from banks around $784 billion. The level of bank reserves at the Fed peaked at nearly $2.8 trillion in mid-2014 and is currently $1.55 trillion, or some $1.41 trillion above the required amount. Reserves and the bond assets are on opposite sides of the balance sheet and thus tend to move in sync.
Backers see the repo facility as a relatively risk-free way of giving banks a release valve in times of financial tightness while providing at least a stealthy form of QE.
“It makes it a much easier transition. The banks would not feel obligated to hold these reserves if the could get the reserves quickly by selling Treasurys to the Fed,” said David Beckworth, a research fellow at the Mercatus Center and former economist at the Treasury Department. “This would be a much more market-driven QE. The banks could quickly get reserves. You could see a big balance sheet again, but that would be driven by the banks.”
Under three previous QE stages — another called “Operation Twist” was balance-sheet neutral — the Fed credited itself with funds that it then used to acquire Treasurys and mortgage-backed securities. The total of the operations was about $3.8 trillion and is widely felt to have stemmed liquidity issues, held interest rates low and juiced up the prices of risky assets like stocks and corporate bonds.
Over the past year and a half or so, the Fed has sought to shed some of those assets and restore some normalcy to monetary policy.
Former Fed Chair Janet Yellen had characterized the balance sheet roll-off as akin to “watching paint dry” as it would run “in the background.” Reality, though, hasn’t been so smooth, and the Fed has sought ways to allay market fears that the new policy regime would be disruptive.
In summary, under this plan, banks would not need to hold cash reserves, but they could instead hold Treasuries. By doing this, the Fed could dump their bonds on them and the banks get to hold something of patriotic value. It seems to me like a good plan to get liquid on banks, while at the same time providing banks with a higher return in the form of government bonds. This of course could lead to disaster, should America’s sovereign debt ever come into question. The banks would be tethering themselves to the Federal Government and I guess, at the end of the day, what difference does it make now?
Long TMV.
