What’s on FED’s balance sheet
The FED’s balance sheet liabilities include these major items:
- All Federal Reserve Notes, aka. the US dollar papers, existed around the world
- Deposits, the digital dollars other banks park at the FED in order to earn interests
- Reverse repurchase agreements (reverse repos), this is the main subject of this article.
Before dive into the detail of reverse repurchase agreements, let’s see their compositions over time (data since 2003):
Since the 2008 financial crisis, the dollar amount of digital deposits sitting in the banks have ballooned from teens of billion to nowadays around 2500 billions. What’s backing this giant liabilities in FED’s balance sheet are mainly “securities held outright”, which include:
- US Treasury securities
- Mortgage-backed securities
- Federal agency debt securities
And most of the recent increase should thank to 3 rounds of quantitative easing programs from the FED itself, as illustrated by this chart:
What are repos
Repurchase agreements, or repos, and its counter part reverse repos are among the tools used by the Federal Reserve System to achieve its monetary policy objectives is the temporary addition or subtraction of reserve balances via repurchase and reverse repurchase agreements in the open market. These operations have a short-term, self-reversing effect on bank reserves1) https://www.newyorkfed.org/aboutthefed/fedpoint/fed04.html – Repurchase and Reverse Repurchase Transactions .
In its essence, when the actual Federal funds rate is higher than the target, the New York Reserve Bank will usually increase the money supply via a repo (effectively borrowing from the dealers’ perspective; lending for the Reserve Bank). When the actual Federal funds rate is less than the target, the Bank will usually decrease the money supply via a reverse repo (effectively lending from the dealers’ perspective; borrowing for the Reserve Bank) 2) https://en.wikipedia.org/wiki/Open_market_operation#United_States – Open market operation in United States .
What’s happening to reverse repos
But something odd has been happening for a while. In light of the historical low rates environment since 2008 financial crisis, designed to stimulate the economy, it seems that FED has been trying to increase its Federal funds rate to its target. The evidence is its reverse repos in its liabilities since 2003:
Firstly, it has been steadily rising since the FED started to taper its QE3 around Q4 2014.
Secondly, its volatility is visually greater since the tapering of QE3. Also I have a feeling that, the volatility of it seems also reverse correlated with the overall market volatility, which has been remarkably low.
What will happen next
Let’s zoom into the FED’s liabilities for the last five years:
So far we have established that the increasing of reverse repo on the FED’s balance sheet is unprecedented, but is it in itself a problem?
It is a difficult question, just as QE was an unprecedented monetary move too, its full impact on the economy in the long run is still yet to see. However the difference this time is that, reverse repos have a deflationary effect in the economy, since it effectively soak up deposits from the banks and convert them into repos that are signed by the FED. And the central banks are in general afraid of deflation, for reasons that Austrian Economists in general view as a myth 3) https://mises.org/library/deflating-deflation-myth – Deflating the Deflation Myth ;
So if it’s indeed a problem wait to be solved, either to reverse to historical norm or to reduce the deflation effects if any, there are 4 scenarios it would happen:
- Helicopter money in deposits: direct inject deposits into banks, and US government issue order that these deposits are fairly distributed among its citizens.
This way the red deposit component will enlarge, while the yellow reverse repos components will shrink.
- Helicopter money in paper cash printing: A less likely scenario similar to (1), although this time the blue cash component will enlarge instead. It’s hard to imagine how legally and popular-supporting way US government would come up with to distribute all these paper money. Besides that, we are also having a global war on cash going on.
- QE4, the FED stops its monetary tightening attempt, and go back to low interest rate environment. This time the red deposit component would jump another ladder up and dollar will tank and asset price will fly again to another level:
- Deflationary! All “hell” breaks loose and we will be in uncharted territory, again!
What do you think will happen?
References [ + ]
|1.||↑||https://www.newyorkfed.org/aboutthefed/fedpoint/fed04.html – Repurchase and Reverse Repurchase Transactions|
|2.||↑||https://en.wikipedia.org/wiki/Open_market_operation#United_States – Open market operation in United States|
|3.||↑||https://mises.org/library/deflating-deflation-myth – Deflating the Deflation Myth|