The following is a paper published earlier this week by former Sempra Metals economist John Kemp looking in detail at the Fed’s emergency money market operations and its ultimate reliance on Chinese support. It’s a long read - 5,000 words - so we’ve split it into five parts. If you would like an accompanying selection of charts that are simply too large to publish here email alphaville@ft.com.
The scale of the Fed’s lending operations is revealed in the weekly Condition Statement, which is similar to the balance sheet of a private firm. In Jul 2007, before the onset of the crisis, the Federal Reserve Bank’s had assets of about $902 billion, mostly held in the form of a huge pile of US Treasury bills and bonds ($790 billion) with a few short-term repo loans to the banking system ($19 billion), some other longer-term loans ($41 billion), gold ($11 billion) and currency ($38 billion) making up the remainder. The Fed’s liabilities consisted of $812 worth of notes and coins in circulation, deposits from its member banks ($18 billion) and one or two other minor items. But the two largest items on the Fed’s balance sheet were the pile of US Treasury bills and notes it owned ($790 billion) and the currency in circulation which it had issued ($812 billion). Lending operations were marginal.
The main reason for owning a large stock of Treasuries was to back the currency issue and provide the Fed with resources to alleviate temporary liquidity shortages arising from lumpiness in tax payments and seasonal swings in credit demand by providing short-term funds through repo operations. More rarely the Fed would undertake reverse repo operations to drain excess funds from the system.
But as the crisis worsened in the autumn and spring, the Fed found itself as almost the only source of liquidity. Officials stepped up the provision of liquidity by vastly increasing the scale of repo operations, by which the Fed credited cash to the borrower’s accounts with the central bank, in return for receiving US Treasury bills to the same amount, and with a pledge that the borrower would buy the securities back within a specified time period, reversing the operation. The volume of funds provided through these temporary repo operations had ballooned from $39 billion in Sep 2007 to $99 billion by Apr 2008.
Temporary repo operations do not have any impact on the Fed’s own stock of Treasury paper. Although the Fed buys Treasuries from the market, the extra paper is not added to its own stock, because there is a legal agreement to sell them back within a specified period of time. The central bank merely holds them as a form of a collateral.
But officials worried the massive volume of funds being provided by these temporary repos would begin to expand the money supply and add to the upward pressure on already-high inflation. So the Fed tried to sterilise the impact of its temporary repos on the money supply by undertaking other offsetting measures to shrink the amount of money in circulation.
While it was borrowing Treasuries from the rest of the banking system through temporary repos designed to add liquidity to the cash markets, the Fed began to sell Treasuries from its own stock back to the banking system on a permanent basis to withdraw a similar amount of liquidity. The aim was to add short-term temporary liquidity but withdraw longer-term permanent liquidity in a similar amount and leave the overall money supply unchanged. The purpose was to insulate the Fed’s provision of liquidity to the banking system in its role as lender of last resort from the Fed’s need to maintain an unchanged federal funds rate at 2.00% and control money supply growth in its monetary policy role.
Between Mar and May 2008, the Fed sold $143 billion worth of Treasuries back to the banking system through permanent open market operations. The result of these and other operations was that the Fed’s own stock of Treasury notes fell -32% from $713 billion in Mar to $482 billion in May. As a result, there was little change in the size of the Fed’s overall balance sheet (with temporary repos and permanent reverse repos offsetting one another) but a marked change in its balance sheet, with a huge drawdown in the volume of Treasury notes owned outright and a big increase in temporary advances to the banks.
But as the crisis worsened and proved more prolonged than expected, temporary repo lending was inadequate. The Fed introduced a raft of new facilities designed to improve the functioning of the market. The Term Auction Facility, introduced in Dec 2007, and repeatedly expanded, provided as much as $150 billion in longer term repo credits with a maturity of 1-3 months. The Fed allowed commercial banks to borrow as much as $40 billion in loans from its Discount Window facility to ease funding shortages, and granted similar access to investment banks and other broker-dealers, lending as much as another $40 billion. It also provided about $29 billion worth of funding to JPMorganChase to support the acquisition of BearStearns.
But the overall impact of the facilities was marginal. Between Aug 2007 and Aug 2008, the size of the Fed’s balance sheet increased marginally from $903 billion to $936 billion. The main effect was to cut the pile of Treasuries which the central bank owned outright from $790 billion to $480 billion and replace them with a variety of other assets in the form of loans and advances.
Continued…
