In the quarterly reports of the Federal Reserve balance sheet, it is possible to appreciate the composition of the assets, obligations, capital and financial information of the Federal Reserve. With these reports that are issued quarterly, it is possible to analyse how the portfolio of the Federal Reserve is composed as well as to give some clues as to what the monetary policy will be like. It is important to remember that for the Federal Reserve, the main monetary policy tool is the interest rate of the federal funds and a secondary tool is a modification in their assets that are reported in the balance sheet.
In the March report of the balance sheet of the Federal Reserve, it was stated that since 2009 the Federal Reserve had the power to carry out Open Market Operations (OMOs) in the domestic market. These operations included limited purchase and sale of:
- Treasury securities.
- Government-sponsored enterprise (GSE) debt securities, and federal agency.
The OMOs have historically been used by the Federal Reserve to adjust the supply of reserve balances, as well as to maintain the federal funds rate close to the objective established by the Federal Open Market Committee (FOMC).
In addition, in recent years the Federal Reserve has implemented other tools to provide liquidity in the short term to domestic banks and other depository institutions through the discount window.
Between October 2016 and February 2017, the System Open Market Account’s (SOMA) holdings of Treasury securities changed little due to the FOMC policy of rolling over maturing Treasury securities at auction.
In this period of time, the SOMA’s holdings of agency debt decreased due to the maturity of the bonds. On the other hand, MBS increased due to the reinvestment of the main payments. The agency mortgage-backed securities were assets acquired by the bank to provide support to the real estate and housing market after the 2008 crisis and thereby also provide security in the US financial market.
The MBS are financial instruments traded in the capital markets, whose value and flow of payments are guaranteed by a portfolio of mortgage loans, generally residential property. The fact that the Federal Reserve resorted to this type of unconventional monetary policy was to avoid the deflationary risk and give a boost to the economy that had been sunk since 2008.
From 2009 to 2014 the expansion of SOMA securities holdings was driven by a series of large-scale asset purchase programs(LSAPs) that were conducted to give an impulse to the housing market and give a boost to the economy from the financial system.
In the graphs of the article, it is observed that there was not a significant change between the previous reports and the one of the first quarter of 2017 where there have not been large acquisitions, but there has not been any reduction of the assets since it is complemented with the monetary policy reports. normalisation of the balance sheet was to begin until the end of 2017 and various statements have given hints that this normalisation will be very slow to not affect the credit market and therefore the economy.
In the May report, SOMA’s holdings did not show large changes in line with market expectations, which still did not expect any reduction in holdings. Agency debt holdings decreased between February and April due to the maturity of the bonds and the holding of MBS also decreased due to a difference between the payment times of the principal and when this amount was reinvested.
Since mid-2014 the Federal Reserve was one of the first central banks to issue press releases informing the market of its intentions to begin the normalisation of the balance sheet since the objective of this unconventional policy had been achieved for the bank. After knowing these intentions, the markets were a little volatile given that this would mean less liquidity for the market and for the financial system, and possibly higher interest rates for banks which would lead investors to review their portfolios.
In the August report, there were few changes in the bank’s assets due to the policy of reinvesting the treasury securities in auctions. The agency debt decreased as in the previous reports due to the maturity of the bonds while the MBS did not change its amount in the balance. If this report is complemented with the monetary policy report of the Federal Reserve, the market concluded that the normalisation program would begin in October. In addition, the last rise in the interest rate of the federal funds occurred at the June meeting so the market had a great expectation regarding the normalisation of monetary policy in general and that included the balance sheet.
In the report of the fourth quarter of 2017 the FED explained that since the 20th of September 2017, the FOMC had announced that in October it was going to start the normalization program of the balance sheet where its assets were going to be reduced gradually due to the reduction in the reinvestment of the main payments received from the securities held by the SOMA. Principal payments will be reinvested only to the extent that the established limits would be exceeded.
Initially, the decline in SOMA securities holdings would be capped at $6 billion per month for Treasury securities and $4 billion per month for MBS. The limits could reach maximums of $30 billion per month for Treasury securities and $ 20 billion per month for MBS. From 2009 to 2014, the FOMC made a large expansion of SOMA securities holdings through a series of LSAPs that were conducted to support the housing market, support the financial market and give a boost to the economy.
Once the limits reach their respective maximums, it is expected that these values will be maintained so that the asset holdings continue to decline in a predictable and gradual manner, until the FOMC decides otherwise.
The gradual reduction of the holdings of the assets of the Federal Reserve will result in a decrease in the supply of reserve balances. The FOMC expected to reduce the number of balances to a low level compared to the one the bank had in recent years, but higher than they had prior to the financial crisis.
The level should reflect the banking system’s demand for reserve balances and the FOMC’s decisions on the correct monetary policy. This way of reducing the balance slowly would avoid large imbalances in the economy and possible effects on monetary policy. Although in the report the committee was clear on what the objective of standardisation was, no rank was given on the appropriate level of assets, which has been a criticism of these unconventional monetary policies since they had not been used actively before. What there is uncertainty for many analysts about what can happen after normalisation.
Graph 71. Domestic SOMA securities holdings. Data from https://www.federalreserve.gov/monetarypolicy/quarterly-balance-sheet-developments-report.htm
Graph 72. The US Treasury notes and bonds nominal. Data from https://www.federalreserve.gov/monetarypolicy/quarterly-balance-sheet-developments-report.htm
Graph 73. MBS. Data from
The above graphs show the total amount of assets held by the FED and two of the most representative assets on the balance sheet. As you can see, the MBS is a little less than half of the balance sheet, which reflects the large number of assets that the FED should divest, since some analysts believe that the equilibrium situation is where the banks only have public debt and not bonds, neither private nor corporate debt. These mortgage-backed assets are not as safe as public debt, so a significant reduction in these should be generated in the balance sheet.
With the data that is available so far, it is expected that normalisation will continue without problems because the pace of the US economy and the labour market have been positive. As for inflation, despite not yet being at the desired level, if it is close and is expected to increase over the next few years due to the good performance of the global economy, there is no situation that could affect this program. In the first report of the bank’s acquisition of assets in 2018, a difference should be seen with the reports exposed so far and with the graphs in this article.
The normalisation of assets has been expected since 2014 because according to some studies, this is the second highest amount of assets in the balance in all history. At the FOMC meeting in November, it was decided to raise the federal funds rate up to 1.5%, so a rise in interest rates on loans is expected. Given this measure in addition to normalisation, this large balance sheet also maintained the low rates in the medium and long-term.