What is one to make of a balance sheet that has exploded from roughly $870 billion in 2007 to almost $4 trillion today. That is the balance sheet of the US Federal Reserve Board as the financial crisis of 2008 saw one of the largest bailouts in financial history followed by three rounds of quantitative easing (QE) plus Operation Twist whereby the Fed exchanged short dated Treasury maturities for longer dated Treasury maturities. It was with QE3 that the Fed began to purchase $40 billion a month of agency mortgage backed securities (MBS) every month greatly adding to its holdings of MBS.
Below is a timeline of QE since 2008 imposed on a chart of the Dow Jones Industrials (DJI). It makes for an interesting read.
The Fed has stated that as recently as its June FOMC "that the range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." At its September FOMC, the Fed voted 9-1 to continue with QE3 of $85 billion a month citing tighter financial conditions. This is despite the Fed saying at various times that they may scale back their bond purchases this year, depending on the economic outlook.
Talk of the "taper" appears to be largely a media event but the odds of the Fed "tapering are low to none given that the new Fed Chairman Janet Yellen comes on in January 2014 and the likelihood of any "taper" is unlikely until at least after the budget and debt debates of January 2014. Yellen is a noted Fed dove and many analysts believe that under Yellen the Fed could even increase QE. This is despite economic numbers that appear to suggest that the US economy is improving. But digging under those numbers reveals an economy that is lethargic at best and could under the right conditions even slide back into recession. Most measures of economic activity remain far below levels seen prior to the 2008 financial crash.
The chart below shows that the holdings both US Treasury securities exploded from just over $400 billion in 2008 to $2.1 trillion today. The holdings of MBS have gone from nothing in 2008 to $1.4 trillion today. This is incredible growth. The Fed is in a trap of its own making. If they "taper" the stock market falls and interest rates rise. Continuing with QE means that the holdings of MBS and US Treasuries would most likely continue to grow. This creates a huge problem later because a portfolio of this size cannot be moved quickly. As well, both the valuation and the liquidity of the MBS portfolio becomes over time questionable. Many believe that the Fed would have little choice but to allow securities to mature even as they continue to add to the portfolio. However, with the MBS portfolio what if they cannot collect?
While the exploding balance sheet of US Treasuries and MBS appears to be a growing problem the real problem maybe on the other side of the balance sheet. Banks are obligated to hold what is known as "required reserves" with the Fed. It amounts to roughly 10% of deposits. Currently "required reserves" total about $77 billion. The Fed pays 0.25% on those balances.
When the Fed purchases Treasury bonds and MBS from the banks, they give the banks what is known as a reserve credit on the Fed's balance sheet. These are what are known as "excess reserves". They have now grown from virtually nothing in 2008 to $2.3 trillion today. The Fed also pays 0.25% for these "excess reserves". This is costing the Fed currently an estimated $575 million annually. In turn, the banks are earning more than they would earn just placing them in US Treasuries. Treasury securities under two years currently yield less than 0.25%. Placing funds with the Fed assures the banks that their funds are perfectly safe, liquid and earn a superior yield to what is generally available in the market. The banks can lend the funds out to qualified borrowers; however, the risks are considerably higher. This leaves the banks free to leverage themselves and trade using the funds on deposit with the Fed as collateral. It is strategy that pays better than lending the funds out to potential borrowers although with different risk parameters.
These huge amount of "excess reserves" placed with the Fed may explain why the broader economy remains lethargic and as well why the money multiplier and money velocity indicators have fallen to record lows. The funds meant to stimulate the economy through QE3 are instead effectively "parked" with the Fed. As Martin Armstrong of Armstrong Economics has pointed out it explains why inflation remains low as the strategy is deflationary and it explains why the economy remains lethargic as the money is "hoarded" instead of being lent into the economy. Money supply (M2) growth has been tepid and is growing at lower rates far below what it has grown during previous recoveries. As a result of the massive growth in "excess reserves" the monetary base has exploded. "Excess reserves" are a part of the monetary base but are not a component in other measures of money supply (M1 and M2). The monetary base has grown from just over $800 billion in 2008 to over $3.6 trillion today.
Martin Armstrong noted the October FOMC minutes contained a potential hidden gem. Buried in the minutes was the suggestion that the Fed should reduce the current rate of interest paid to the banks on "excess reserves". That in turn might encourage the banks to lend the funds into the economy rather than hoard as appears to be currently the case. But what if they can't find sufficient qualified borrowers? The banks continue to hold billions of dollars of mortgages and others including student loans and home equity lines that are behind in their payments. Accounting regulations allow the banks to carry this debt as if it were whole. But is it? For these reasons QE is more likely to continue or even grow rather than be "tapered". The Fed's balance sheet should continue to explode and that is a potential big problem at a later date. Nothing goes up forever.