TALF, PPIP and Fed Policy: Why the Fed's Balance Sheet Didn't Expand Until September
Western Asset
5 May, 2009
Executive Summary
Prior to September 2008, the Fed sterilized the effects of its special lending facilities by selling Treasuries whenever it extended loans through TAF, TSLF, PDCF, etc., keeping its total assets and banking system liquidity unchanged.
It did this in order to sustain strict control over the Federal funds rate.
With the economy’s sharp declines of September and after, it became clear that a more broad-based policy stance was required. Sterilization ceased and rapid growth in liquidity and money occurred, as well as incipient declines in private-sector interest rates.
It is most likely that the TALF and PPIP plans will be accompanied by similar growth in the Fed’s balance sheet and in the money stock.
This broader-based program of monetary stimulus has a better chance of reviving the economy.
Recently, the question has arisen as to how the Term Asset-Backed Securities Loan Facility (TALF) and Public-Private Investment Program (PPIP) facilities will affect the balance sheet of the Federal Reserve (Fed). Answering this question is useful not just for its own sake, but also for providing perspective on the Fed’s activities since September 2008. In this white paper, we first explain the Fed’s balance sheet and then relate this issue both to Fed policy setting in general and, more specifically, to the Fed’s actions so far this year.
Why the Fed’s Balance Sheet Didn’t Expand Until September 2008
The Fed’s balance sheet, like any balance sheet, consists of assets and liabilities. The assets are primarily marketable securities and loans to member banks and other institutions. The liabilities are primarily currency in circulation and the reserve balances that member banks hold on deposit at the Fed. (Reserve balances can be converted to cash at the discretion of the bank holding them.) The Fed’s liabilities comprise the liquidity of the private-sector financial system and are otherwise known as the monetary base.1
An increase in that base—in the Fed’s liabilities—is effected by an increase in its assets. The Fed buys securities or increases loans to banking institutions and pays for these asset acquisitions by creating money: either explicitly printing currency or by crediting the accounts of the participating banks. It is common to describe such activities as an expansion of the Fed’s balance sheet. While both the assets and liabilities of the Fed increase in this action, it is the liabilities that we care most about, as these are the raw material from which growth in the money stock proceeds. Similarly, by selling or calling assets, the Fed shrinks its balance sheet and so works to shrink the money stock.
The TALF and the PPIP are the latest in a string of lending facilities introduced to address the current financial crisis. TAF, TSLF, PDCF, CPFF and TARP were all instituted between December 2007 and October 2008, with function and intent similar to TALF and PPIP. Yet these programs had expanded to a total of some $370 billion by August 2008 without any material expansion of the Fed’s balance sheet and without any increase in the monetary base. Then, following the collapse of Lehman, FNMA, FHLMC, etc. in September 2008, the Fed’s balance sheet began to expand by unprecedented proportions (Exhibit 1).
The Fed’s actions with the pre-September-2008 facilities (TAF, TSLF and PDCF) differed from later lending in that the Fed sterilized this early lending. That is, when it lent funds through these facilities, it drained an equal, offsetting amount of funds out of the banking system by selling Treasuries. By swapping holdings of Treasuries for holdings of IOUs from banks etc., the Fed altered the composition and the riskiness of its balance sheet, but it kept the size of the balance sheet unchanged. In effect, the private sector financed these early lending programs by buying the Treasuries the Fed sold, with the Fed intermediating via its asset swap.
The reason the Fed so acted prior to September 2008 was that it was in a Fed funds rate targeting regime. When it pegged the funds rate at a particular level, it committed itself to supply whatever stock of liquidity was demanded at that funds rate target. Once it had provided that amount of liquidity, any further net provisions would push the funds rate below the Fed’s target.
Consider Exhibit 2.2 When the Fed pegs the funds rate at a particular target, it states, in effect, that the supply curve of money and credit will be horizontal at that funds rate. The actual stocks of money and credit will be whatever the private sector demands at the target rate. Any further provision of liquidity beyond that demanded amount would move the system down along that private-sector demand curve and inevitably push the funds rate lower. In a funds-rate targeting regime, the Fed could not expand its balance sheet unless it was willing to further lower its funds rate targets. Prior to September 2008, the Fed sterilized its lending activities in order to retain control of the funds rate.
Why did the Fed care so much about this control? It was in a rate-targeting regime because its primary concern was the level of interest rates, not the quantities of liquidity, money or credit. It believed that pushing the funds rate below target would be a more expansionary policy stance than it wished to pursue at the time.
When the credit crisis moved into a more disruptive and destructive phase in September 2008 and after, everything changed for the Fed. Suddenly, it realized either that its preceding policy had not been as expansive as it had thought or that the distress in the financial system warranted a much more expansive policy than it had previously been willing to follow. Either way, sterilization was out and quantitative easing was in. Rather than run policy solely in terms of the funds rate, the Fed force-fed liquidity into the system, both pushing the funds rate essentially to zero and ensuring money stock expansion that had not previously occurred.
The Fed is still firmly in a quantitative easing mode, so it is likely that TALF and PPIP will result in further expansion of its balance sheet. It has already injected another $250 billion into the banking system in the five weeks since it announced on March 18 its intentions to increase asset purchases.
Distinguishing Between Declining Yields and Easy Money
While interest-rate targeting had been the universal mode of conducting monetary policy among central banks for at least the last two decades, it has serious shortcomings. When a central bank focuses exclusively on interest rates, it is often unable to determine whether rates are falling (or rising) because of its policy actions or because of movements in the economy. Therefore, it can’t really tell whether its policy will be effective or not.
Interest rates can move because of shifts either in the demand for or supply of money and credit. When interest rates move primarily because of shifts in the demand for money and credit, there is no presumption that those rate changes will have their expected impact on the economy. For example, it is commonly accepted that the demand for money and credit moves pro-cyclically: a slowing in the economy slows demand for money and credit, putting downward pressure on interest rates regardless of what the central bank is doing. So if rates fall alongside a weakening economy, it is not clear from the rate movement alone whether policy has effectively eased or not. It is not clear whether policy is actually working to reverse the downward impetus to growth. A strong, affirming signal on the effects of policy can be provided by the stocks of money and credit, as we will explain shortly, but the Fed had turned a deaf ear to those signals prior to September 2008.
To see how the quantitative measures can clarify matters—and how focusing on rates alone can give ambiguous signals—consider three possible Fed policy regimes: interest rate targeting, money-stock targeting, or a reaction function. We’ve already seen that the supply curve of money and credit is horizontal in a rate targeting regime. In a money stock targeting regime, the Fed’s supply curve is vertical. The Fed might also supply different amounts of money and credit at different levels of the funds rates, so that the supply curve is upward-sloping, known as a reaction function regime. These three possible regimes are illustrated in Exhibit 3.
Suppose we observe a decline in interest rates, but also a decline in money and credit. Whatever the Fed policy regime, this could have occurred only if the demand for money and credit had declined, presumably due to a weakening in the economy. (If demand hadn’t shifted, then all movements would be along a particular demand curve, in which case rates and money would have to move in opposite directions.) Exhibit 3 illustrates that even allowing for a decline in the demand for money and credit (the demand curve shifting in and down), in order for interest rates and money and credit all to decline:
under a rate-targeting regime, the Fed would have to ease (supply curve shifting downward);
under a money-targeting regime, the Fed would have to tighten (supply curve shifting left); and
under a reaction function regime, the Fed supply curve might be unchanged, easing slightly (shifting out and down), or tightening slightly (shifting in and up).
So, when we observe a decline in both the funds rate and money and credit, whether Fed policy has eased or not depends on the semantics of what policy regime it is operating under. This is a matter of semantics because the same set of Fed open-market operations would achieve these results regardless of the policy regime in place, so the response of the economy would be the same as well. It doesn’t matter what policy regime the Fed is acting under or how its actions are described. If all we know is that rates and money/credit have declined together, there can be no presumption that the Fed has acted in a way that will stimulate the economy. It may just be the weakness in the economy itself that is driving rates down.
In contrast, if rates had declined alongside a pick-up in money and credit, there would be no ambiguity. It would be clear that policy had eased. (You can verify this yourself under the three policy regimes.) Thus, it would be clear that policy was working actively to reverse the economic weakness. It is not that money matters more than rates, but rather that the signals from both are important in verifying the direction and magnitude of a Fed policy response when there are already cyclical developments in play in the economy.
Between September 2007 and August 2008, the Fed lowered the funds rate from 5.25% to 2.00%, but money and credit did not pick up at all. This was only slightly different from the case detailed in Exhibit 3. In order for money and credit to hold steady opposite falling rates, money/credit demand would have to decline, with the Fed’s supply curve easing under rate-targeting or reaction-function regimes but holding steady under a money-targeting regime. Two out of three doesn’t count here; this is still an ambiguous situation. There was no way to know for sure whether Fed policy was actually working to stimulate the economy even though most of the FOMC believed policy was stimulative. Unfortunately, the economy’s plunge in September 2008 and after firmly contradicted those claims.
As seen in Exhibit 4, when the Fed was cutting the funds rate from September 2007 to August 2008, interest rates elsewhere in the financial markets were flat or rising, especially corporate bond yields and mortgage rates. Alongside the flat growth in money and credit, the rise in private-sector borrowing rates cast further doubt on whether Fed policy then was expansive. The higher corporate and mortgage rates can also be said to have exerted downward pressure on the economy even while the Fed judged its policy to be expansive based on the falling funds rate.
None of this is new or unconventional analysis. It was standard prior to the 1990s. In developing their pre September 2008 fixation on the funds rate, Fed policy-makers had been lulled into complacency by the tranquil economic environment in place from the late 1980s through 2006 (when cyclical swings in demand for money and credit were largely inconsequential). The 1960s and 1970s confronted Fed officials with problems similar to those seen in the last year, though in the opposite direction. All through the inflationary run-up over 1965-78, Fed officials claimed that their policy couldn’t be responsible for inflation because interest rates were rising. They ignored the rapid money growth accompanying the rising interest rates increases, and focused on interest rates as the end-all and be-all of monetary policy. They were just as sure and just as wrong then as they were last year. It was the same mistake in the opposite direction.
Recent Fed Policy Action (Inaction?)
In September 2008 and after, the financial crisis became super-critical and the economic decline became broad-based and severe. Fed officials likely concluded that their preceding funds rate cuts were for naught and that private-sector yields—and perhaps the monetary aggregates—needed to be addressed more directly. The most impressive feature of the Fed’s actions from early September into January was that not only did the monetary base and money stock data grow rapidly, but private-sector and term Treasury yields fell sharply as well. In stark contrast to the ambiguous signals of August 2007 through August 2008, all signals pointed to stimulative policy between September and January.
However, things stagnated between January and March of this year, with corporate bond yields backing up and M1 money and the monetary base slowing, though M2 continued to grow and mortgage rates mostly declined. Only the Fed knows why it stood pat then, but it signaled another round of stimulus on March 18. In the five weeks since that announcement, the Fed’s balance sheet had already expanded by another $250 billion. Based on its announced plans for purchases of $1.25 trillion in agency MBS securities and $200 billion of term Treasuries, further injections will occur.
So, why haven’t corporate and T-bond yields dropped alongside resumption of Fed stimulus? It took six to seven weeks from the time the Fed began balance sheet expansion to the time Treasury and corporate yields began to rally in November and after. A similar lag might be in place presently, and, in fact, there are indications that corporate bond yields have started to decline in the last few weeks.
It takes a broad-based monetary response to effectively counter deflationary forces such as are currently at work in the economy. We didn’t have that broad-based response prior to September, and while it appears to have waned after January, there are indications that it has resumed since March.
Economic Implications
Critics have massed on both sides in reaction to the Fed’s moves. Some claim a drop in velocity has prevented the rapid money growth from having any impact on the economy. At the other end of the spectrum, the claim is that the Fed’s moves will drive a resurgence of rapid inflation.
The claims of velocity decline ignore the fact that the economy responds to monetary moves only with a lag. Assuming a lag of six months or more from faster/slower money to faster/slower GDP, there is no reason to assert that velocity will decline to fully offset the money growth. The economy will respond—or not—in 2Q09 and after to the rapid money growth occurring in 4Q08 and after. At present, at the outset of 2Q09, the decline in velocity correctly viewed so far (that is, calculated against the slow, steady money growth of early 2008) is on the order of -10% per year. Velocity would have to fall at a much sharper rate in 2Q09 and after to prevent the faster money growth seen since September 2008 from allowing positive GDP growth.
Concerning inflation, the drop in velocity already seen does work to remove much or most of the inflationary potential from the recent burst in money growth. As discussed in a December 2008 white paper3, it is still not clear whether the Fed’s response to date has in fact been sharper than is necessary to counteract the deflationary forces currently at work in the economy. If it eventually becomes evident that the Fed has injected more stimulus than necessary, there will be some window of time over which the Fed can withdraw that stimulus without having triggered a virulent inflation. Real-world economies don’t lunge from deflation to rapid inflation in one fell swoop.
In conclusion, the Fed’s balance sheet expansion is indicative of a substantive shift in policy. Prior to September 2008, the Fed’s focus was on gradually lowering the funds rate, and its pace of funds rate declines was consistent with no acceleration in the money stock nor any increase in the size of its balance sheet. Its widespread lending activities under TAF, etc. were sterilized by asset sales. Since September 2008, it has been willing to abandon strict funds rate targeting and allow a much more broad-based program of monetary stimulus. TALF and PPIP will be conducted within that more broad-based program, and they will likely serve to further expand the Fed’s balance sheet.
We will find out in the next six months whether that program had significant impact on the domestic economy. If economic growth proceeds much faster than expected in coming quarters, that would be an indication that the Fed has stimulated more than necessary, in which case it would need to withdraw that stimulus to prevent inflation further down the road. Such a quandary would seem to be a welcome change from the dire economic outcomes policy-makers are presently dealing with.
Footnotes
There is now a discrepancy between the monetary base and total Fed liabilities, due to the presence of widespread international swap facilities initiated by the Fed to counteract the current financial crisis. The monetary base includes only Fed liabilities (liquidity provisions) directly at work in the domestic banking system, so it excludes these swap facilities. However, the swap lines are indeed a liability of the Fed. It has credited the accounts of foreign central banks at the Fed in the amount of some $600 billion, offset by a holding of an equal-value amount of foreign currency.
Because these swap facilities are now in existence in unprecedented quantities, the total of Fed liabilities differs substantially from the monetary base, but this is not a substantive difference in terms of policy implications. It is still the case that in conducting domestic monetary policy operations, increases in the monetary base can occur only via increases in Fed assets.
The specification of this diagram is a bit vague, because the same Fed policy regime can be described in terms of the markets for liquidity, money or even credit (lending). In either of those markets, a funds rate targeting regime results in a horizontal supply curve. Similarly, a money-stock targeting regime can be represented as a vertical supply curve for either liquidity, money, or credit.
In fact, if this analysis were to be embedded in a standard ISLM framework, so as to directly analyze the interaction between interest rates and GDP, a funds-rate targeting regime would also result in a horizontal LM curve in interest rate-GDP space. A reaction-function regime would result in a standard, upward-sloping LM curve. However, a money-supply targeting regime would not result in a vertical LM curve, but rather an upward-sloping one. William Poole provided an early treatment of monetary control issues in an ISLM framework in “Optimal Choice OF Monetary Policy Instruments In A Simple Stochastic Macro Model,” Quarterly Journal of Economics, May 1970.
See “What is The Fed Doing?” December 2008, available on our website.
Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).
Western Asset
5 May, 2009
Recently, the question has arisen as to how the Term Asset-Backed Securities Loan Facility (TALF) and Public-Private Investment Program (PPIP) facilities will affect the balance sheet of the Federal Reserve (Fed). Answering this question is useful not just for its own sake, but also for providing perspective on the Fed’s activities since September 2008. In this white paper, we first explain the Fed’s balance sheet and then relate this issue both to Fed policy setting in general and, more specifically, to the Fed’s actions so far this year.
The Fed’s balance sheet, like any balance sheet, consists of assets and liabilities. The assets are primarily marketable securities and loans to member banks and other institutions. The liabilities are primarily currency in circulation and the reserve balances that member banks hold on deposit at the Fed. (Reserve balances can be converted to cash at the discretion of the bank holding them.) The Fed’s liabilities comprise the liquidity of the private-sector financial system and are otherwise known as the monetary base.1
While interest-rate targeting had been the universal mode of conducting monetary policy among central banks for at least the last two decades, it has serious shortcomings. When a central bank focuses exclusively on interest rates, it is often unable to determine whether rates are falling (or rising) because of its policy actions or because of movements in the economy. Therefore, it can’t really tell whether its policy will be effective or not.
Suppose we observe a decline in interest rates, but also a decline in money and credit. Whatever the Fed policy regime, this could have occurred only if the demand for money and credit had declined, presumably due to a weakening in the economy. (If demand hadn’t shifted, then all movements would be along a particular demand curve, in which case rates and money would have to move in opposite directions.) Exhibit 3 illustrates that even allowing for a decline in the demand for money and credit (the demand curve shifting in and down), in order for interest rates and money and credit all to decline:
In September 2008 and after, the financial crisis became super-critical and the economic decline became broad-based and severe. Fed officials likely concluded that their preceding funds rate cuts were for naught and that private-sector yields—and perhaps the monetary aggregates—needed to be addressed more directly. The most impressive feature of the Fed’s actions from early September into January was that not only did the monetary base and money stock data grow rapidly, but private-sector and term Treasury yields fell sharply as well. In stark contrast to the ambiguous signals of August 2007 through August 2008, all signals pointed to stimulative policy between September and January.
Critics have massed on both sides in reaction to the Fed’s moves. Some claim a drop in velocity has prevented the rapid money growth from having any impact on the economy. At the other end of the spectrum, the claim is that the Fed’s moves will drive a resurgence of rapid inflation.
Because these swap facilities are now in existence in unprecedented quantities, the total of Fed liabilities differs substantially from the monetary base, but this is not a substantive difference in terms of policy implications. It is still the case that in conducting domestic monetary policy operations, increases in the monetary base can occur only via increases in Fed assets.
In fact, if this analysis were to be embedded in a standard ISLM framework, so as to directly analyze the interaction between interest rates and GDP, a funds-rate targeting regime would also result in a horizontal LM curve in interest rate-GDP space. A reaction-function regime would result in a standard, upward-sloping LM curve. However, a money-supply targeting regime would not result in a vertical LM curve, but rather an upward-sloping one. William Poole provided an early treatment of monetary control issues in an ISLM framework in “Optimal Choice OF Monetary Policy Instruments In A Simple Stochastic Macro Model,” Quarterly Journal of Economics, May 1970.
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Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).