EC The Neatest Idea Ever For Reducing The Fed’s Balance Sheet

I mentioned a week and a half ago that I’d had a “really cool” idea that I had mentioned to a member of the Fed’s Open Market Desk, and I promised to write about it soon. “It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce”. First, some background.

It is currently not possible to directly access any inflation index other than headline inflation (in any country that has inflation-linked bonds, aka ILBs). Yet, many of the concerns that people have do not involve general inflation, of the sort that describes increases in the cost of living and erodes real investment returns (hint – people should care, more than they do, about inflation), but about more precise exposures. For examples, many parents care greatly about the inflation in the price of college tuition, which is why we developed a college tuition inflation proxy hedge which S&P launched last year as the “S&P Target Tuition Inflation Index”. But so far, that’s really the only subcomponent you can easily access (or will, once someone launches an investment product tied to the index), and it is only an approximate hedge.

This lack has been apparent since literally the beginning. CPI inflation derivatives started trading in 2003 (I traded the first USCPI swap in the interbank broker market), and in February 2004 I gave a speech at a Barclays inflation conference promising that inflation components would be tradeable in five years.

I just didn’t say five years from when.

We’ve made little progress since then, although not for lack of trying. Wall Street can’t handle the “basis risks,” management of which are a bad use of capital for banks. Another possible approach involves mimicking the way that TIGRs (and CATS and LIONs), the precursors to the Treasury’s STRIPS program, allowed investors to access Treasury bonds in a zero coupon form even though the Treasury didn’t issue zero coupon bonds. With the TIGR program, Merrill Lynch would put normal Treasury bonds into a trust and then issue receipts that entitled the buyer to particular cash flows of that bond. The sum of all of the receipts equaled the bond, and the trust simply allowed Merrill to disperse the ownership of particular cash flows. In 1986, the Treasury wised up and realized that they could issue separate CUSIPs for each cash flow and make them naturally strippable, and TIGRs were no longer necessary.

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Beating Buffett 5 months ago Member's comment

This is a rather intriguing idea.

Kelsey Williams 5 months ago Contributor's comment

And, yet, we still operate financially within the context of a fractional-reserve banking system. Hence, any reserve requirement less than 100 percent is implicit of excess reserves. And derivatives are a huge subset of the system which continues to re-leverage the same money over and over again, even after any initial reserve requirements are met. The threat of a credit implosion grows exponentially regardless of the Fed's tinkering and eventually there will be a forced de-leveraging. 'When' is anybody's guess.

Gary Anderson 5 months ago Contributor's comment

Other nations report reserves and yet the Fed does not control the money supply by upping reserve requirements. So in our system, what are excess reserves anyway. They are the opposite of required reserves, right? And also, aren't they a base money? Different from deposited. And they are offset by bonds whereas Brains would not be. Just trying to understand the current Fed issues. One more question. Banks issue deposits through lending. So said the BOE. So reserves are not needed, right. What is the mechanism by which they hamper lending if banks create broad money by lending?

Michael Ashton 5 months ago Author's comment

No, banks must hold reserves against their activities such as lending. The way the Fed controls (or anyway, the way they did for almost most of a century before the financial crisis) the money supply is to make greater or lesser amounts of reserves available in the system. By restricting the amount of reserves, the Fed restricts the amount of lending (and incidentally, causes rates to rise since scarce reserves are bid up. But that's an effect, not a cause). Right now, the Fed can restrict reserves but it won't affect the banks' ability to lend as these are all "excess." Until the Fed sufficiently reduces the balance sheet they have almost no control over the money creation process. (They could also raise reserve requirements and make all excess reserves required, but that would forcibly de-lever banks permanently and there's really no chance of that happening).

Central banks tell us this doesn't really matter, that they can control the health of the patient by changing the markings on the thermometer rather than by regulating the patient's temperature...but to be kind that's "speculative" at best.

Cyrus Smith 5 months ago Member's comment

Michael, thank you for this very insightful read into inflation and your clever strategy with TIPS.