The Fed’s Huge Record in Seven Charts

How did the Federal Reserve’s balance sheet become so important? What does this mean for the markets? Will it lead to crippling inflation down the road?

With Federal Reserve publishes annual report on its open market operations, this is the right time to look at the results under the microscope.

The balance sheet was broadened under the leadership of former Fed Chairman Ben Bernanke. Many believe that the main task of his successor, Janet Yellen, will be to reduce the size of the Fed’s assets without disrupting financial markets.

– Greg Robb

Also read:A Quick Guide to Fed Communication to Consider and What to Ignore

With short-term interest rates stuck at zero, in the spring of 2009 the Fed began purchasing $ 1.1 trillion worth of treasury bills and mortgage-backed securities under a program known as name of quantitative easing. The idea was to lower long-term interest rates and stimulate growth. Investors were also expected to be kicked out of safe assets and take on more risk.

This graph shows three waves of buying, the first round in the spring of 2009, a second round of buying when the economy stumbled in November 2010, and a third round in September 2012 after another period of downturn.

In 2013 alone, the Fed’s balance sheet actions resulted in a cumulative additional purchases of $ 1.02 trillion of long-term securities to a year-end level of $ 3.8 billion.

During the year Treasury holdings increased by $ 543 billion and MBS holdings by $ 509 billion. The Fed predicts its balance sheet will peak at $ 4.2 trillion by the end of this year. that the Fed has started to cut its bond purchases.

Read also: Yellen says a healthy economy is within reach

This graph shows how bond purchases have turned central bank investment policy upside down, said Lou Crandall, chief economist at Wrightson ICAP. Central banks used to hold short-term assets so that they could raise liquidity in an emergency.

Short-term assets previously made up 60% of the Fed’s portfolio but now represent less than 10%.

Brian Bethune, professor of economics at Tufts University, said this graph shows how much of the assets the Fed controls.

“It’s rather shocking,” he said.

But it also shows that the central bank has shifted the risk of higher interest rates to its balance sheet from the private market, Bethune said. Private sector wealth will not be hit as hard when bond prices fall and rates rise.

The duration of the Fed’s portfolio fell from 6.3 years to 6.8 years in 2013. The duration of the agency MBS portfolio almost doubled to 5.7 years.

Bethune said this graph is another way to show how the Fed has immunized the private sector against higher rates, but not entirely.

Crandall said it also shows that the Fed has been successful in offsetting the increase in duration designed by the Treasury Department.

The Fed’s bond purchase generated high net income, totaling $ 84 billion in 2013.

The Fed transfers all excess profits to the US Treasury Department, handing over $ 79.6 billion in 2013.

There are fears that these remittances will dry up when interest rates soar and the value of securities on the central bank’s balance sheet decline.

This graph shows the Fed’s latest projections for its net income over the next decade. The higher the rates, the less revenue the Fed would receive, but the central bank doesn’t see its net income drop to zero.

The projection is based on the assumption that the central bank will not sell its mortgage backed securities. In the absence of asset sales, unrealized losses have no effect on remittances to the Treasury.

Many economists believe the Fed will not sell any assets. Remember that selling the assets would tighten credit, the opposite effect of quantitative easing.

The chart shows that the Fed’s mortgage asset purchases accounted for half of gross 30- and 15-year fixed-rate agency MBS issuance during the year, but the share increased markedly as new issues declined towards the middle of the year, while buying held up. constant.

By the end of the year, the Fed was absorbing 60% of agency MBS issuance.

The Fed said there were few signs of significant market disruption.

This chart shows a record $ 2.5 trillion in excess reserves on the books of commercial banks.

A big fear among some economists is that when the banks decide to lend this money, it will lead to substantial inflation. Charles Evans, the chairman of the Chicago Fed Bank, recently tried to throw some cold water on these fears.

“What if the loans resume? Well that would be really great. Significantly higher bank loans would certainly be associated with higher demand for loans and a generally stronger economy. Strong growth and a decrease in the scarcity of resources would be part of this story, and a rising rate environment would be a natural force easing mounting inflationary pressures, ”Evans said. in a speech earlier this month.

The Fed would increase the interest rate it pays on excess reserves if it wanted to ease inflationary pressures. Reserve balances are expected to peak at $ 3 trillion by the end of this year.