Yogi Berra, The Fed’s Balance Sheet, And Liquidity

The story is that the Fed’s quantitative easing program injected large amounts of liquidity into financial markets, causing bond rates to fall and stock prices to accelerate. Consequently, the argument goes that, the shrinking of the Fed’s balance sheet through maturity runoff will cause bond rates to increase and, presumably, stock prices to retreat. But what are the essential mechanics of Federal Reserve asset purchases, and how might they affect liquidity in the market?

When the Federal Reserve began its quantitative easing program, it purchased Treasury obligations in the marketplace through the primary dealer facility and paid for those securities by writing up the reserve accounts of the sellers’ banks, simultaneously increasing the sellers’ bank deposits. Effectively, the Fed created money in the purchase transactions, but as far as the public’s asset position is concerned, the purchases substituted demand liabilities for Treasury obligations. The sellers received deposits; their banks’ reserves increased by the same amount; and the sellers’ Treasury holdings were reduced.

From the perspective of the consolidated government balance, Treasuries were removed from the public; and on-demand Fed liabilities were substituted in their place, bearing a lower interest cost than the Treasuries they replaced. One form of very liquid asset (Treasury securities) was replaced by another (reserve deposits at the Fed, with corresponding deposits held by the public in its bank). The Fed’s purchasing Treasuries bid up bond prices and put downward pressure on interest rates.

One of the main effects of QE was to redistribute the ownership both of Treasuries and of bank reserves and their associated deposits. We can’t quantify or identify the sellers of securities, but we do know that a large portion of the excess reserves associated with those purchases ended up with US affiliates and subsidiaries of foreign banks. Presumably sellers were institutional investors, hedge funds, and money market mutual funds but could also include individuals.

Foreign banks’ share of reserves peaked at about 50% in the fall of 2014 and is presently about 35%. Those excess reserves in US and foreign subsidiaries were potentially available to generate a large increase in bank loans and the money supply. A dollar of excess reserves would support an estimated $20 increase in credit and the money supply if it were converted to required reserves as part of the bank credit creation process. But this obviously didn’t happen. Indeed, the ratio of bank loans and leases to bank reserves in Oct 2008 was 26.0, whereas that same ratio as of October 31, 2018, was only 5.6; so bank credit did not expand nearly to the same degree that bank reserves expanded. Interestingly, despite the series of QE experiments, in September 2014 a dollar of reserves was associated with only 2.9 dollars of bank loans and leases right before the Fed stopped adding to its portfolio in October 2014.

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Disclaimer: The preceding was provided by Cumberland Advisors, Home Office: One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL 34236; New Jersey Office: 614 Landis Ave, Vineland, NJ ...

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