Guest post: Why shrinking the Fed balance sheet may have an easing effect

This guest post is from Manmohan Singh, author of Collateral and Financial Plumbing and a senior economist at the IMF. The views expressed are his own and not those of the IMF.

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Federal Reserve policy makers have recently started discussing when to start gradually reducing their $4.5tn balance sheet. Minutes of their March meeting suggest “that a change to the Committee’s reinvestment policy would likely be appropriate later this year.” This is a subject that the Fed has approached cautiously, out of concern that any decision to shrink the balance sheet would be seen as a tightening of monetary policy. I argue that in fact, unwinding may not be tantamount to tightening.

Why? First of all, because letting the balance sheet shrink would release “good” collateral such as US Treasury securities, while reducing the excess reserves that commercial banks keep on deposit at the Fed. These deposits came about when the Fed bought up trillions of dollars in securities in a bid to keep long-term interest rates low, a strategy known as quantitative easing. Many of the securities were bought from non-bank financial firms, (i.e., pension funds, insurers, asset managers) which stashed the proceeds at depository institutions. Those banks in turn deposited money at the Fed, where it earned interest (only banks can earn interest on excess reserves.) Non-banks are likely to reuse good collateral, rather than sizeable deposits at banks that have remained idle.

As we have argued in earlier posts, there may not be a one-to-one relation between policy rate hikes and the unwinding of central bank balance sheets. New regulations instituted to make the financial system safer require banks to hold more “high quality liquid assets”. Both US Treasuries and excess reserves count as high quality liquid assets. But that’s where the similarity ends.

Good collateral, when pledged, is constantly reused in a process that is similar to money creation that takes place when banks accept deposits and make loans. That is why good collateral and excess reserves are very different in their implications for market functioning. The relation between the two may not even be positive—i.e., presently, US Treasuries in the hands of the market, with reuse, is likely to lubricate markets, while excess reserves (or money) has remained idle in recent years.

Increasing the availability of good collateral also creates incentives for the reuse of other, less desirable collateral. Most collateral in the markets is exchanged (for money) as a portfolio of securities, rather than as individual securities. Research suggests that at present, the collateral reuse rate is below two, on average, down from about three times before the Lehman crisis. The reuse rate is unlikely to bounce back since collateral does not flow in a vacuum but needs bank balance sheets to move. However, private sector balance sheets remain clogged by deposits, a byproduct of QE. Assuming no changes in regulations (e.g., leverage ratio), a lower level of deposits will allow collateral reuse to increase, as balance sheet space at banks becomes more available.

Excess reserves and the money transmission problem

Deposits have taken too much balance-sheet space of the banking sector with excess reserves of the banks at the Fed are presently over $2tn. This inhibits financial intermediation and in turn, monetary policy transmission. As an analogy, oil is only needed for lubricating a car’s engine; similarly, excess reserves, are needed only to smoothen out the need for reserves in the financial system. They were close to zero before the Lehman crisis. Now instead of an “oil change” we are carrying the oil in the car trunk, in our homes, everywhere.

Markets currently can digest duration of good collateral. As seen in the past year, policy rate hikes may not percolate to the long end of the yield curve and vice versa, because the investor base is very different for the short and long end.

For example, from the time of the Fed’s 25 basis-point rate hike on Dec 16, 2105 until the eve of U.S. elections on November 8, 2016, the yield on the 10-year US Treasury note actually declined, to 1. 8 per cent from 2.3 per cent, as markets digested duration despite sizeable sales of Treasuries by many emerging markets throughout 2016.

So the unwinding of a central bank’s balance sheet may not result in tightening. Collateral that will be released (from the asset side of the Fed balance sheet) to the market, with reuse, is a far better lubricant for the financial system than the reduction in banking system deposits, (i.e., reserves balances on the liability side of the Fed balance sheet). Although the Dodd Frank Act and Basel III make it more expensive for collateral to be reused, the increase in the balance sheet space of the banking system (due to the central bank unwind) may more than neutralize the regulatory cost. Thus, a leaner central bank balance sheet, if it doesn’t result in a tightening effect, could justify a much higher policy rate in this cycle than currently being anticipated.

There are sound theoretical reasons why, in normal times, lean balance sheets allow central banks to focus on the core of its mandate. (Bindseil’s Jackson Hole paper, 2016). As central banks contemplate the timing of their balance sheet unwind (e.g., not rolling over maturing securities and outright sales thereafter), it may be useful to keep the collateral reuse perspective.