I Don’t Know Why She Swallowed a Fly

Over the past 13 years, the Federal Reserve has consistently solved problems – whether they were partly or entirely of its own creation — by becoming larger and more involved in the financial system. That greater size and involvement has led in turn to still more problems, which the Fed has again sought to fix by expanding its reach into markets. This process has transformed the Fed from an efficiently scaled institution conducting policy with a small imprint on financial markets to a behemoth that is the largest borrower in both the unsecured and secured short-term funding markets. The Fed predicts that by 2023, its balance sheet will equal 39 percent of gross domestic product, up from 6 percent in mid-2007. How did we get here? Consider the problems the Fed faced and the solutions it adopted.

Problem: The Treasury Department’s account at the Fed swelled from $5 billion before the global financial crisis to $1.8 trillion in 2020, with a corresponding rise in volatility. The Treasury traditionally kept almost all its cash at commercial banks. But once the Fed started paying an above-market rate on reserves, the Treasury moved all its cash to the Fed, reducing the need for the Fed to borrow from banks, and saving taxpayers money. However, variability in the Treasury account made it difficult for the Fed to conduct monetary policy with a small balance sheet. Solution: Conduct monetary policy using a giant balance sheet so vast that swings in the Treasury account no longer matter.

Problem: Foreign official institutions have an increasingly hard time keeping cash at U.S. banks and broker-dealers, in part because of the capital consequences associated with investing those deposits. Solution: Remove limits on the foreign repo pool, where foreign institutions can deposit savings at the Fed, and increase the interest rate, with the result that the pool has risen from less than $50 billion before the global financial crisis to about $250 billion in recent years.

Problem: QE3 produced a Fed securities portfolio so large that selling the securities as originally planned could disrupt financial markets and generate huge losses for the Fed (because the value of those securities declined as interest rates rose). Solution: Change exit plans to no longer include asset sales. Instead, stay larger for longer.

Problem: The giant balance sheet caused by QE3 created so much liquidity that the Fed was unsure in 2014 if it could increase the fed funds rate just by raising the interest rate it pays to banks on their deposits. Solution: Create a “temporary” Overnight Reverse Repurchase Facility, at which it can pay interest to money market mutual funds and government-sponsored enterprises (by borrowing money from them), expanding the Fed’s set of counterparties to include entities about which policymakers otherwise have deep concern.

Problem: Banks, bank examiners and bank investors got used to the liquidity from the Fed’s inflated balance sheet. As the Fed tried to shrink back down to a reasonable size, in September 2019, those elevated demands came up against the variability in liquidity from swings in the Treasury’s account. This caused money market rates to spike alarmingly. Solution: Reverse course and get bigger, beginning by lending primary dealers $200 billion.

Problem: The giant balance sheet produced so much liquidity that the fed funds market, where banks short of liquidity at the end of the day borrow from banks with excess liquidity, evaporated. The only remaining lenders are GSEs, which have Fed accounts but earn no interest. Solution: Keep oversupplying reserves so banks don’t need to borrow from each other. Make the temporary ON RRP facility semi-permanent so that the fed funds rate remains between the rate GSEs can get at the facility and the rate banks can get on reserve balances

Problem: Bank regulations hostile to capital market intermediation succeeded in reducing broker-dealers’ capacity to intermediate in Treasury and corporate bond markets. Solution: Purchase $1 trillion in Treasuries in three weeks, and backstop the corporate bond market when the COVID crisis hit. Keep buying $120 billion in Treasury and Agency securities each month. Open a permanent standing repo facility to lend to large broker-dealers to finance their holdings of Treasury securities.

Problem: The market got used to Fed QE4 purchases, even though market functioning returned to near normal by the second half of 2020. Solution: Keep buying.

Problem: Leverage ratio requirements (which treat all assets as equally risky) calibrated by the Fed when reserve balances were projected to be $25 billion became binding on banks with reserve balances at $4 trillion. The Fed would have to pay banks a high interest rate to get them to fund further growth in the balance sheet. Solution: Borrow instead from money market mutual funds, which are exempt from the leverage ratio requirement, at the ON RRP facility.

We saw this process in a nutshell recently when the G-30 released a report in the morning observing that Treasury market capacity has declined in part because of the leverage ratio requirement (imposed by the Fed and other banking agencies) and the Fed announced in the afternoon that it would be creating lending facilities for large broker-dealers and foreign official institutions to support Treasury market liquidity.

There is another way. To become smaller and less entangled in financial markets, the Fed needs to do three things: First, taper and stop asset purchases as soon as possible. Second, comprehensively review the regulations that have diminished the U.S. financial system’s capacity to handle flows of securities without government intervention. Third, contract its balance sheet (while controlling balance-sheet volatility) until the interest rate on reserve balances falls below market rates; contract further as demand for now-expensive Fed liquidity declines.


Bill Nelson is chief economist at the Bank Policy Institute and previously served as a deputy director in the Division of Monetary Affairs at the Federal Reserve Board.

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