from Follow the Money

Central bank intervention … unprecedented in scale and scope

March 13, 2008

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Steven Pearlstein of the Washington Post -- the source of the quote in the title -- writes:

"In the face of what is turning into the most serious financial market crisis since the Great Depression, the Fed has been more aggressive and more creative in using its limitless balance sheet - in effect its ability to print money - than at any time in history. ...

Last week it was a $200 billion cash for bond swap for the banks. This week it was a $200 billion bond for bond swap with the big investment houses."

Pearlstein’s phrase - "central bank intervention ... unprecedented in scale and scope" doesn’t just apply to the Fed’s intervention in the US market for mortgage backed securities.

It applies equally well to the actions of the emerging world’s central banks, who, in my judgment, are engaged in intervention of "unprecedented scale and scope" in the foreign exchange market.

China’s enormous $62b -- see Richard McGregor -- January 2008 reserve accumulation is just the most prominent example (even if it is more like $55b after adjusting for valuation gains, it is still huge). All in all, central banks added at least $150b to their reserves in January. February likely will be a bit lower, but it isn’t unreasonable to think that central bank intervention in the foreign exchange market in the first quarter will total close to $400b - a sum equal to the Fed’s intervention.

That implies central banks globally will have $400b to invest in the major markets as well as well - and, depending on how they allocate their assets, they will either be buying up some of the Treasuries that have been released from the Fed’s balance sheet into the market, or will add to the bid for Agencies and other mortgage backed securities from broker-dealers and banks now able to use those securities as collateral with the Fed. Or, if they bought euros, they could add to the pressure on the euro ...

Most students of central banks have focused on how they manage their liabilities - remember, cash is a liability of the central bank. Right now though the way central banks manage their assets may be having an equally large impact on global markets.

The Fed has $873b in total assets (using "reserve bank credit" as a measure of the Fed’s assets -- there are a few other small line items that bring total factors supplying reserve funds up to $925b, and I am not expert enough to know which is the better measure). Right now, $713b of that are Treasuries, and $670 are treasury bills and interest paying notes - the kind of assets the Fed is now willing to swap for agency collateral. That thought could change quickly.

Michael Feroli of JP Morgan notes that about half of 1/2 of the Fed’s balance sheet could soon be mortgages. Feroli, as reported by Grep Ip:

"in a short period of time the Fed could have up to $400 billion of mortgage assets on its balance sheet.".

So far, though, the Fed hasn’t expanded the overall size of its balance sheet much. Reserve bank credit was $850b in August; it is a bit under $875b now. Currency in circulation rose from $812b to $815b over that period.

The Fed though is in the process of a very large change in the composition of its balance sheet, as it will temporarily be holding Agencies as an asset against its liabilities rather than Treasuries. It hasn’t formally bought the Agencies though, only allowed banks and broker dealers with Agencies and certain private mortgage-backed securities on hand to use them as collateral to borrow (temporarily) the Fed’s existing Treasuries. See Guha and Scholtes of the FT for the details of the Fed’s latest facility.

As one asset on the Fed’s balance sheet rises, other assets will (likely) fall. Greg Ip explains:

Last December, it announced the creation of the term auction facility under which it auctions off loans to banks against a wide variety of collateral. To keep its balance sheet constant, it decided to let a roughly equivalent amount of its Treasurys mature. Since then, its Treasury portfolio has fallen from $779 billion to $713 billion.

I hope this makes sense; I am trying to work through the changes myself. Both jck of aleablog and the now famous Mr. Waldman have more.

If the Fed’s current actions do not work, what else could the Fed do?

Well, it could buy Agencies outright for cash. If it didn’t want to expand its balance sheet (and issue more cash), it would need to remove some of the cash it issued to buy the agencies with an offsetting operation.

The Fed though doesn’t want to buy Agency mortgage backed securities though, at least not now. Guha and Scholtes:

The Fed is not there yet. Outright purchases of mortgage securities would expose the Fed to much greater credit risk. The staffers emphasise that it wants to help the market; it does not want to become the market for allocating credit.

I like the phrase "not wanting to become the market." The Fed no doubt has observed what has happened to the PBoC after it became the market for foreign currency in China.

But what if the Fed changes its mind and decides that it needs to expand the amount of support it offers the market? Well, nothing precludes Fed from following the lead of emerging market central banks and issuing short-term "sterilization bills" to offset the growth of the assets on its balance sheet.

As around $900b, the fed’s balance sheet is something like 6-7% of US GDP.

With $1600b in foreign assets, the PBoC’s external balance sheet alone is more like 50% of China’s GDP.

In a world marked by unprecedented central bank intervention, the Fed’s balance sheet is still kind of small.

Expanding the Fed’s balance sheet dramatically to offset a massive deleveraging of the private financial system - a deleveraging that has been compared to a bank run in reverse, with the banks withdrawing credit from hedge funds and broker dealers in much the same way that households withdraw credit from the banking sector in a bank run - would be a truly radical step.

But with Martin Wolf now arguing that scenarios with more than a trillion in credit market losses cannot be ruled out - even more unprecedented central bank -- and government -- action cannot be entirely ruled out. The scale of the "great unwind" has been stunning. The pace of change in the policy debate only slightly less so.

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