This post answers four frequently asked questions on the Fed’s balance sheet. The answers to the first two questions will affirm that the Fed is executing QT exactly as promised, even if it may not appear that way. The apparent discrepancy is due to TIPS appreciation and details in MBS settlement mechanics. The answers to the second two questions will show how the Fed balance sheet behaves when the Fed has and negative net interest income or capital losses. The Fed has special accounting rules where losses appear as “deferred assets” that will be repaid out of future earnings.
Is the Fed buying more Treasuries?
The Fed’s Treasury portfolio continued to grow even after QE due to principal adjustments from TIPS. Treasury Inflation Protected Securities (“TIPS”) are a type of Treasury security whose principal is adjusted for inflation each month to protect the investor from inflation. For example, $100 principal invested in TIPS would be adjusted to $110 principal after a year of 10% inflation. The Fed’s $370b holdings of TIPs has been gradually adjusted higher due to elevated inflation. That growth in turn shows up as small but steady increases in its overall Treasury holdings.
Since QT, Fed Treasury holdings have been dropping at a monthly rate roughly equal to the QT cap of $30b a month. Recall, maturing principal is allowed to roll off each month up to the QT cap limit and any amount exceeding the cap is reinvested. Maturing Treasury securities are scheduled to be redeemed on either mid-month or month-end, which are the same periods newly issued Treasury securities are settled. This is intended to allow investors to easily roll over their maturing holdings into newly issued Treasuries. This schedule is also why Fed Treasury holdings decline discretely twice a month.
Why isn’t Fed MBS Declining?
The Fed’s MBS holdings are declining, even if it is obscured by the sawtooth pattern of its holdings. The sawtooth pattern arises from the repayment and settlement schedule of MBS, where MBS generally receive maturing principal on the 25th of the month and newly purchased MBS settle around mid-month. The spikes in Fed MBS holding arise from the settlement of newly purchased MBS, and the declines are due to maturing principal. MBS securities are amortizing, so each monthly cashflow contains some principal which the Fed will either reinvest or allow to roll-off.
The Fed’s policy of settling MBS purchases within a 3 month window further obscures portfolio declines. The Fed will delay taking delivery of purchased MBS if it judges that postponement would improve market functioning. Although QE ended months ago, the Fed continued to reinvest maturing principal and those purchases have yet to fully settle. The amount of purchases yet to settle has declined since the onset of QT and will decline further when the QT cap is raised in September. At that time MBS reinvestment purchases will likely end because the QT cap will be higher than expected maturing principal.
For those seeking more details into MBS QT, John Comiskey has a good post demonstrating MBS QT using security level data.
Can the Fed afford higher rates?
The Fed will soon have negative net interest income from its portfolio, but it won’t make a difference to policy. The Fed earns interest income from its holdings of Treasuries and Agency MBS, but pays interest expense on its deposits (reserves) and repo borrowings (RRP). The net earnings from this “carry trade” are remitted to Treasury and total over $1.1t since 2009. Like any other bank, the Fed’s asset portfolio is comprised of longed dated assets but its liabilities are shorter dated and reset with changes in the Fed’s policy rate. If the Fed hikes to 3.5% by year-end as expected, then the Fed’s interest expense will exceed its interest income.
Negative carry is handled by the Fed through a special form of accounting that allows monetary policy to continue uninterrupted. The Fed will continue to pay its interest expenses, but will finance it by creating a “deferred asset” out of thin air. The deferred asset is essentially an IOU the Fed writes against its future income. The Fed expects to eventually have positive net interest income again when it cuts rates during the next economic downturn. Those earnings will first go towards repaying the deferred asset before being remitted to the U.S. Treasury.
What if the Fed loses money on MBS sales?
Capital losses on the SOMA portfolio happen when the Fed sells an asset for less than its amortized cost. The market value of the Fed’s QE portfolio fluctuates with interest rates, but the fluctuations only matter if the Fed sells securities. Over the past ten years the Fed’s securities holdings have varied from unrealized gains of $400b to its more recent unrealized losses of $300b. The Fed does not mark to market and has held its securities to maturity so these fluctuations have not had any impact on its income statement or equity. However, potential future MBS sales may result in realized losses as MBS market values have recently declined from higher rates.
The Fed handles capital losses with the creation of a deferred asset. Private businesses may write down equity when they realize capital losses, but the Fed does not write down its equity. Instead, the realized losses will be recorded as a “deferred asset” and repaid with future net interest income. Realizing a loss may be politically troublesome, but it does not have any operational implications for monetary policy. At most it reduces future remittances to Treasury and so slightly increases the future budget deficit.
34 comments On Fed Balance Sheet FAQs
Think you have really brought forth the realization that the balance sheet is a hugely unrecognized lever of policy. Was this always the case or more a matter of Fed aggressibely intervening this decade to effect monetary policy and outcomes?
There’s a difference between outside money and inside money.
This is the current path of DDs:
01/1/2022 ,,,,, 1.887
02/1/2022 ,,,,, 1.951
03/1/2022 ,,,,, 2.082
04/1/2022 ,,,,, 1.660
05/1/2022 ,,,,, 1.403
06/1/2022 ,,,,, 1.327
07/1/2022 ,,,,, 1.256
08/1/2022 ,,,,, 1.234
09/1/2022 ,,,,, 1.243
10/1/2022 ,,,,, 1.157
11/1/2022 ,,,,, 1.142
12/1/2022 ,,,,, 0.907
01/1/2023 ,,,,, 0.579
02/1/2023 ,,,,, 0.573
03/1/2023 ,,,,, 0.515
Based on the distributed lag effect of money flows, the volume and velocity of money, long-term money flows (means-of-payment money) are decelerating (proxy for inflation).
Last I checked , Reserves were $3.1 T and RRP $2.5 T, total $5.6 T . In 2021 the Fed has net income of $107 Bn. So it looks like net income likely turned negative at a 2% “rate”.
At closer to 4%, net interest income probably runs about Negative $100 Bn/yr.
This would add to Reserves as Joseph has pointed out.
So effectively the Fed is printing “Reserves” to pay the IORB.
Sort of like drinking a half bottle of booze to get sober ( tomorrow , not today!)
Is sobriety overrated?
Very Nice post!. Thanks for the acknowledgement and reference. It is very much appreciated. Cheers!
Its interesting that these accrued deficits at the Fed accumulate as a “Deferred Asset”. I would have thought it would be more appropriate to accumulate as a Negative Deferred Liability.
Lets not forget who is on the other side of this balance sheet entry …. The United States.
A Deferred Asset ( A Receivable) implies the United States owes the Fed.
A negative balance in a Deferred Liability ( A Payable) says, the Fed owes the United States but at the moment we are running a deficit so we cant pay you .
Think about the coffee shop scene with the young Vito Corleone and Don Fannucci. Who is shaking down who?
Isn’t this just more hyperbolic abuse of language, because there’s no violence?
“Its interesting that these accrued deficits at the Fed accumulate as a “Deferred Asset”.
“Interesting” is an understatement. Fraudulent or ultra vires may be more applicable.
Haven’t I seen this same tactic used on private sector balance sheets? Why do Ravi & co. demonstrate such a glaring double standard?
FF tactics the NJ n gtg t
Other countries cover similar deficits via giving the CB fresh government bonds. In the end they are all the same in essence. CBs are not profit seeking entities. Profit or loss doesn’t mean much, only move the budget balance some basis points. Accomplishing their prime targets (inflation) is way more important.
Thats a relief . So none of that syuff matters. Only thing to remember is credibilty dribbles out slowly at first , then all of a sudden !
As far as inflation , its not clear why paying banks more money as IORB will kill inflation.
In fact its not clear whay any of these things the Fed is doing has any effect.
So maybe its either :
1. The markets emotionally reacting to perceived loosening /tightening
2. Financial institutions like Citadel, Blackrock etc working with the Fed to create market moves when Powell tallks , so it looks like his words are having powerful effects on markets.
The payment of interest on IBDDs, interbank demand deposits, induces nonbank disintermediation, as the 2019 repo crisis showed (an inverted yield curve). The banks outbidding the nonbanks. pre-GFC the banks were “fully lent up”. Reserves, excess and required, were never a “tax”.
Banks aren’t intermediaries.
So Powell gets to spout a bunch of Econ PhD style word salads, and everyone listens intently to whether he uses a particular word etc etc . Hilarious .
Then , Citadel just buys/sells futures in various markets to make it look like Powells’s magic word salad is incredibly powerful.
After all Bernanke works at Citadel so he knows what kind of reaction Powell would want from the markets without even talking to him!
Why would these financial institutions cooerate/participate? Its obvious , they get backstopped on massive potential losses in adverse events .
As far as the banks . At a 4% Fed “rate”, thats on $3.1 T of reserves or about $120 Bn/yr. Thats incremental income. The aggregate income of banks in the US runs around $200 Bn/yr , so this incremental income is material.
Are you getting 2.5% on your checking/savings account? Of course not! So the banks are getting the full benefit of the IORB rate. The motivated bank customers would move to money market funds where they can get direct access to the RRP rate.
Over time as more money moves over to money market funds, RRP , its already basically a CBDC. RRP=CBDC.
Only thing left to do is to bring in the Social Credit Scores, Carbon Credit Score and Health Compliance Score into the equation.
Once that happens, the only thing that will matter is if you have connections with influential members of the Nomenklatura. Other than that you will be a peasant and follow orders or perish.
We all saw the JP Morgan head of gold trading get convicted for market manipulation.
Today we saw the Saudi oil minister all but accuse the US of manipulating oil futures and warning that they will cut supplies if it goes on.
So thats oil and gold.
So that only leaves Treasury futures. iam sure those markets are pristine and reflect the collective wisdom of a million mon and pop investors expressing their true preferences! I admit I dont have an Econ PhD – so I may have mis-stated how this preferences thing works.
As for stonks. well thats the final frontier. Apple must be leviatated at all costs. The best brains of the nation are on the job.
The US GDP is 75% services. What is that? lets see, you call an abulance , which will bill you $10,000. Thats GDP. You go to a hospital with a sprained ankle – bill $20,000 , thats GDP. How about financial services, insurance, trading, etc etc. – thats GDP.
Ofcourse that $50K/yr college cost is also GDP – even if you majored in Women’s Studies.
Then there is all the entertainment stuff – restaurants, strip clubs etc. thats GDP.
But we dont make laptops, semiconductors, most consumer items, antibiotics, vitamin C , lithium batteries …. hell just go to a wlmart and make a list.
So yeah we have an impressive $23T GDP , but only about $5 T is real stuff , tradeable stuff ( mostly aircraft and weapons). the rest is fluff and hilariously overinflated medical services and education services.
We have terrible healthcare outcomes , terrible education outcomes etc. So that hilarious cost does’nt translate into successful outcomes.
So sure, lets all mess around with the Fed’s machinations – Iam sure it will all work out somehow.
you are my new fav commenter.
let’s not forget that 68% of gdp is consumption as a proxy for actual gdp… which could be imported goods paid on credit… all this boils down to one thing. the financialization of our economy benefits wall street at the cost of main street. which leads us to stupid claims like wages are too high. when will the madness end.
No money stock acting alone is adequate as a “guidepost” for monetary policy. If you get a 200% increase in the primary money stock:
“Quantity leads and velocity follows” Cit. Dying of Money -By Jens O. Parson
Given that the Inflation Reduction Act will require the creation of new money, how can the spending be possible in the face of QT.
QT , allowing Treasuries to rolloff only makes the Fed’s deficit worse.
Balance sheet entries: Remove Treasuries , Remove a matching amount from TGA.
So less interest income, but unchanged IORB ( reserves did not change).
In 2010, the PBOC’s RRR went to 18.5% – “to sterilize over-liquidity and get the money supply under control in order to prevent inflation or over-heating”
The Fed “RRR” is currently ZERO.
Yes. The economy is being run in reverse. Powell eliminated reserve requirements against commercial bank deposit liabilities.
And the last vestige of legal reserve and reserve ratio requirements against the Federal Reserve Note, demand deposit, and inter-banks demand deposit liabilities of the Reserve banks was eliminated in 1968. Today the Federal Reserve Note has no legal reserve requirements, and the capacity of the Fed to create IBDDs has no legal limit.
These IBDDs are owned by commercial banks; they are bank free-gratis legal reserves and can be converted dollar-for-dollar into Federal Reserve Notes. The volume of IBDDs is almost exclusively related to the volume of Reserve Bank credit. When Federal Reserve Banks expand credit, for example by buying U.S. obligations, the balance sheets of the Banks reflect an increase in earning assets and an equal increase in IBDD liabilities, i.e., free-gratis legal reserves (not a tax).
Joseph – Are you still expecting US equity markets and risk assets to decline? I think you said in an interview somewhere not too long ago that US equities would go down around 30%… Do you still see this scenarios as having a high probability?
Excellent website and conversations. It is clear that the fed takes its marching orders from wall street as they have no clue as to what they should do, other than its political leanings.
“Money has a ‘second dimension’’, namely, velocity . . .. ” Arthur F. Burns in Congressional Testimony.
The cash/drain factor has fallen from 1.103 on 2/1/2020 to 0.440 on 7/1/2022. I.e., there is a huge volume of saved DDs, excess liquidity, in the economy.
Powell quoted Volcker on “expectations”. Expectations fell short last year.
The FED does everything backwards. QT should reduce the supply of money while increasing the supply of loan funds. That way you hit inflation harder than real output.
“On the liability side of the Fed’s balance sheet, the decrease may stem from either a reduction of reserves held by banks or a reduction in ON RRP take-up or a combination of both”
See: The Fed’s Balance Sheet Runoff and the ON RRP Facility – Liberty Street Economics (newyorkfed.org)
So here we are ,after 150 bp of “rate hike” , 3 months of QT and a couple of days into aggressive QT of $95 Bn/mo and the 10 yr Treasury yield is 20 bp LOWER than it was on June 15.
And yet the talking heads endlessly discuss 50 bp vs 75 bp a the next FOMC. I am starting to assume that either people are incapable of basic understanding of what these “rate hikes” really are, or just dont want to know.
The gap between gdi and gdp has been 3.5% larger than its gdp in 2022. N-gDp is still running too high. The FED needs to drain the money stock and simultaneously increase the velocity of circulation (the 1966 Interest Rate Adjustment Act).
Hi- similar to FOMC meetings on Federal Reserve balance sheet outlook, is there somewhere I can look to understand the Treasury’s point of view on Treasury General Account balance sheet going forward? It seems to affect the bond market significantly. Thank you