Thursday, August 27, 2009

Fed’s Exit Strategy

After the reappointment of Ben Bernanke, discussions about the exit strategy from the massive increase in liquidity intensified again. On Squawk Box of the CNBC Asia channel one guest expressed his doubt that the Fed will be able to withdraw the liquidity because they are holding a lot of illiquid assets.

The Fed has more levers to control money supply than just open market operations and I will discuss them below, but let’s focus first on the balance sheet.

The inflationary danger arises from the fact that banks (depository institutions) hold over 819bln in deposits at the Fed (the second line in the liabilities side). If these institutions withdraw their deposits at the Fed and start lending out, there will be inflation. In order to reduce inflationary pressures, the Fed should be able to withdraw money from circulation. In normal times, the operation is very simple – the Fed officials sell some of Fed’s assets on the open market. By doing this, the Fed gets back cash and thus money supply in the economy goes down. To be able to perform this operation, however, the Fed must have liquid assets.

If we look at the asset side, we will see that the Fed has over 600bln in mortgage backed securities. Clearly, these are not good candidates for an open market operation. But in addition, there are at least three items that can be quickly sold or cancelled – US Treasury securities ($736bln), Term Auction Credit (credit with short maturity of about $220bln), and Commercial Paper facility of about $50bln. The last two items are part of credit facilities that the Fed can cancel easily once commercial banks start lending. The total amount is above 1trillion. In short, the Fed has enough balance sheet instruments to counteract the potential conversion of bank deposits into money.

Consolidated Balance Sheet of All Federal Reserve Banks (August 20, 2009) (Billions of USD)


Liabilities and capital


US Treasury Securities

Mortgage-backed Securities

Term Auction Credit

Commercial paper

Other portfolio holdings

Liquidity swaps

Other assets










Deposits of deposit. institutions

US Treasury












But these balance sheet tools do not exhaust the ammunition of the Fed to counteract any raise in inflation. Let me enumerate here some of the possible actions:

1. Open market operations (as described above).

2. Closing down of lending facilities (as described above)

3. Change in reserve requirements. What matters for inflation is the increase in broad measures of money. The Fed can raise required reserves ratios and by doing this they can reduce dramatically the speed at which money enters the economy. Required reserve ratios are used rarely because they are a very powerful tool (too powerful, one might say) in the control of money supply.

4. Change in the interest rate paid on the deposits of commercial banks. The Fed currently pays interest to banks that deposit their money in the Fed. If they increase this rate, the process of conversion of deposits into currency will slow down.

5. Issuance of central bank bonds. Currently the Fed does not have the authority to issue bonds (why would they borrow money, if they can print money?). But for the purposes of controlling money supply, they may ask the Congress to authorize them to issue bonds if they run out of Treasury bonds (i.e. they use all of them in open market operations) and they still need to reduce money supply further. This is a less conventional tool, but it has been used in China since 2003. Indeed this is how the People’s Bank of China sterilizes the effect of capital inflows and trade surpluses on money supply.

Armed with all these instruments, it is clear that, technically at least, the Fed possesses the levers to control the supply of money, so that rate of inflation does not increase above their (implicit) target persistently.

If you want to monitor the balance sheet of the Fed, it is published weekly on the following site: (scroll down to where you see “Consolidated Statement of Condition of All Federal Reserve Banks”.)

Below is my interview for CNBC Asia from August 26, 2009, about the reappointment of Ben Bernanke as the chairman of the Fed (I know that I am biased). I also discuss Fed’s exit strategy briefly.

Ilian Mihov