Chart of the week
Having allowed its balance sheet to gradually shrink since the start of 2018, the Federal Reserve announced last March that it was ending this phase in September. Episodes of tightness in some money market segments have prompted the central bank to announce new refinancing operations and resume asset purchases in recent weeks. So, is this a fresh round of quantitative easing? The answer is no.
Although the Fed’s balance sheet ballooned from $900 billion to $4,500 billion between 2009 and 2015, it had been on an upward trend for quite some time. From the end of 1994 until the end of 2007, the balance sheet grew by just under 6.0% per annum, almost matching the average nominal growth rate for the economy over the same period. Central banks exert short-term control over interest rates by way of their monopoly over the banking system’s reserves. If reserves are scarce, interbank rates rise, and if they are too abundant, interbank rates fall. Central banks strive to maintain reserves at a level that places the benchmark Fed Funds rate in line with current policy. Although developments over the last decade have created some uncertainty as to the appropriate level of reserves, in hindsight, the situation is now becoming clearer.
Quantitative easing measures have markedly increased central bank reserve levels. When the Fed bought a bond from a bank, it paid that bank by way of credit transfer to that bank’s reserve account. The rising tide of reserves as a result of the Fed’s various rounds of QE has prompted the central bank to develop other instruments for setting short-term interest rates. In normalising its monetary policy, the Fed has logically looked to reduce the size of its balance sheet but has always acknowledged that the various regulatory shifts mean that banking systems must now operate with greater reserves than previously. The tightness seen at the start of September perhaps indicates that the level of reserves had dipped too low. Hence the Fed’s decision to rebuild its balance sheet. By buying short-dated securities, the central bank is confirming that it is not seeking to loosen monetary policy once again, but instead that asset purchases are the most appropriate transmission mechanism for its monetary policy.
The opinion expressed above is dated 24 October 2019, and liable to change.
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