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These Charts Show How The Fed's Portfolio Might Have Looked Without QE

by devteam August 29th, 2013 | Share

A recent entry in the Liberty Street Economics blogrnof the Federal Reserve Bank of New York (FYBNY), compared the recent decline inrnTreasury yields to those of earlier sell-offs, focusing specifically on thernhistorical composition of the Fed’s System Open Market Account (SOMA) which, inrnrecent years, has been used to implement monetary policy.  Fed actions with regard to SOMA have beenrnintended to promote the Federal Open Market Committee’s (FOMC) dual mandate tornfoster employment and price stability.  </p

Specifically the FOMC exponentially increased thernsize of the SOMA portfolio (from around $500 billion in 2008 to about 2.7rntrillion in 2012) and shifted its composition from Treasury bills and Treasuryrncoupons to large holdings of Treasury coupons and mortgage-backed securitiesrnand lesser levels of agency debt.  ThernFed purchased these longer-term assets to reduce private sector holdings ofrnsuch assets and thus reduce term premia</iand long-term interest rates.</p

Thisrnpolicy also generated high levels of portfolio income and increased revenue tornthe U.S. Treasury.  Deborah Leonard, Assistant Vice President, Julie Remache,rnVice President, and Grant Long, Association, all in the FYBNY’s Markets Grouprnand MichaelrnFleming, Vice President, Research andrnStatistics Group, authors of “What If?  ArnCounterfactual SOMA Portfolio” on the blog forecast a net decline in thatrnincome as monetary policy is normalized. rnNet income may even dip below pre-crisis averages for a time, they say,rnand remittances to the Treasury could be suspended.</p

The four ask what the path of thernportfolio and the income it generated might have been had the FOMC not taken thernunconventional balance sheet actions. rnThey conducted a “counterfactual” exercise to explore such a scenario andrnanswer their own question.</p

The exercise is based on the assumption that the Fed’s response to thernfinancial crisis was solely to reduce the federal funds target rate.  Thus the counterfactual SOMA portfolio postrn2007 remained all-Treasury growing roughly in line with the currency in circulation.  They then compared their constructed reality tornactual balance sheet developments based on the FRBNY report Domestic Open Market Operations during 2012,rna projected portfolio path based on primary dealer expectations from the Desk’srnSurvey of Primary Dealers, and to the exit strategy principles from June 2011rnFOMC minutes.  These reality-basedrnassumptions are called the “baseline” scenario.</p

To simplify the exercise and because of the difficulty of projecting what wouldrnactually have happened the authors assumed that interest rates followed thernsame path for both scenarios.  In fact longrnterm interest rates might have been higher or lower in the absence of the Fed’srnunconventional monetary policy.</p

At the end of 2012, SOMA domestic securities holdings would have consisted ofrnroughly $1.3 trillion in Treasury securities in the counterfactual scenariorncompared to the $2.7 trillion in Treasuries, agency debt, and agency MBS SOMArnactually held.  The first portfolio wouldrnhave had a weighted average maturity (WAM) of 5.4 years at the end of 2012,rnsimilar to the WAM of the outstanding supply of Treasury securities.  The baseline portfolio of Treasury holdingrnhad a WAM of 10.4 years. </p

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The counterfactual portfolio would have continued to growrnsteadily as currency grew through the end of the exercise horizon in 2025.  The baseline portfolio is projected to varyrnfrom a peak of nearly $3.9 trillion in early 2014 as the presumed assetrnpurchases end, then remain elevated through early 2015.  A combination of redemptions and assets salesrn(as envisioned from the FOMC’s 2011 exit strategy principles*) would shrink thernportfolio steadily during the policy normalization period.  The sizes of the two portfolios would roughlyrnconverge in 2019.   <br /<br /Although the baseline portfolio returns to a nearly all-Treasury composition inrn2021, the composition of its securities holdings still has a slightly higherrnWAM than the counterfactual portfolio because of the longer-term Treasuryrnsecurities that were purchased in recent years</p

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The authors estimate that the net income generated by itsrncounterfactual portfolio would remain relatively steady at an average of aboutrn$27 billion from 2008 to 2012, reflecting both the short maturities and thernsmall size of the portfolio.  Thernbaseline portfolio rises steadily during the period, peaking at almost $90rnbillion in 2012. </p

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But, under the assumptions for the baseline scenario, netrnincome will begin to fall in 2016 and remain low for several years.  This reflects several factors includingrnhigher interest payments on excess reserve balances as rates rise, decliningrninterest income as the portfolio shrinks, and realized capital losses as agencyrnMBS are sold.</p

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In contrast, net income from the counterfactual portfolio isrnprojected to grow as policy is normalized. rnThe portfolio, heavily invested in short-term Treasury securities, willrnroll those holdings over in an environment of rising rates.  Moreover, because the portfolio is fundedrnprimarily with currency it has only minimal interest expense associated withrnreserves.  The income from the twornportfolios is forecast to converge late in the projection period by which timernthe baseline would be in a steady state, holding predominately Treasuryrnsecurities and its size once again roughly matching currency.  </p

The income the Fed generates, minus operating costs,rndividends, and capital maintenance, is remitted to Treasury and these remittancesrnhave been elevated since the crisis to a cumulative $325 billion from the endrnof 2007.  This is roughly $240 billionrnabove the estimated $85 billion from the counterfactual scenario.  This difference exists despite higherrninterest costs from funding the larger portfolio with excess reserves.</p

Should the Fed not generate sufficient income to cover thosernabove referenced expenses in future years, it would book a deferred asset andrntemporarily halt Treasury remittances. rnThe deferred asset would have to be paid down before remittances couldrnresume.  The projected declines in incomernin the baseline portfolio suggest such a scenario for several years while therncounterfactual scenario, with a steadier projected path, would avoid thatrnoutcome. Nonetheless the baseline is projected to remit a cumulative $820 billionrnto Treasury through 2025, $315 billion more than the counterfactualrnscenario.  This arises from its higher overallrnincome even if the timing of remittances is less smooth than that of therncounterfactual example.</p

The authors admit their estimates of counterfactual incomernand remittances are necessarily rough and depend on various assumptions, especiallyrnthe unrealistic one that interest rates would have been the same under eachrnscenario.  Moreover, when considering thernnet effects of monetary policy on the government’s fiscal position, one shouldrnalso account for the lower borrowing costs and support for the economicrnrecovery the Fed’s actions have produced. Nonetheless, they say their findingsrnbroadly highlight the effect of unconventional monetary policy of cumulativernTreasury remittances. </p

*In an addendum to the article the authors look at the Junern2013 FOMC minutes which appear to portend that the Fed might not sell agencyrnMBS as part of the normalization process although it might reduce or eliminaternresidual holdings.  A sell off wasrnanticipated in the above analysis based on the FMOC’s June 2011 exitrnstrategies. The Domestic Open MarketrnOperations report used in part to generate the baseline considered anrnalternativern”buy-and-hold” scenario that illustrates how the baseline balance sheet andrnincome projections change in the case of no asset sales.</p

Under the later assumption the general contours of thernportfolio’s size and income are projected to follow similar overall paths asrnthe baseline. However, the buy-and-hold portfolio is expected to take slightlyrnlonger to converge in size with the counterfactual portfolio, at which time itsrnsize once again roughly matches currency levels. Importantly, its compositionrnincludes significant holdings of both agency MBS and Treasury securities. Arnbuy-and-hold scenario avoids capital losses on agency MBS sales but has higherrninterest expense from additional reserve balances associated with a largerrnportfolio, on net resulting in higher portfolio net income over the medium termrncompared to the baseline and leading to roughly $55 billion cumulatively inrnadditional remittances to the Treasury. These are, of course, merely projectionsrnand actual income and remittances will be influenced by the ultimate size ofrnthe purchase program, as well as other balance sheet, interest rate, andrneconomic developments.</p

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About the Author

devteam

Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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