Thursday, July 2, 2009

Federal Reserve's balance sheet shrinks modestly

The Wall St. Journal is doing a great public service by publishing an interactive graph of the evolution of the Fed's balance sheet (above), which you can find here, updated every Thursday night. The graph shows the breakdown of all the things the Fed has effectively bought in order to expand the amount of money available to the banking system. The size of the Fed's balance sheet is roughly comparable to the monetary base (the sum of currency and bank reserves), which are the only two components of the money supply that the Fed has direct control of.

The chart shows that recently there has been a modest reduction in the Fed's balance sheet, and that same reduction shows up in a $200 billion shrinkage in the monetary base since mid-May. That's not really a tightening, however, since most of the money the Fed has created (in the form of bank reserves) is still sitting idle in banks' accounts at the Fed. Those same excess reserves have not been used to create new deposits. We know that because M2, which includes money created by banks using their reserves, has not increased by an exceptional amount in the past six months, even though reserves have almost doubled since last September.

The chart also shows how the Fed has been steadily purchasing Treasuries and mortgage-backed securities in recent months. The Fed still owns fewer Treasury bonds today than it did before the crisis, however. It unloaded lots of Treasury bonds in the early stages of the crisis in order to help satisfy the world's insatiable demand for Treasuries.

So, although the Fed has purchased an extraordinary amount of assets in recent months, that has not resulted in an expansion of the money supply of similar magnitude. Yet. That can change in coming months, of course, but we have no choice but to wait and see what exactly happens. Whatever the case, the modest contraction in the Fed's balance sheet over the past month or so is not by any means an indication that they have tightened monetary policy. Fed policy remains extremely accommodative, but the system's desire to utilize abundant bank reserves to expand the supply of money remains muted. This is an uncomfortable but very significant standoff that will not last much longer before being resolved one way or the other.


Unknown said...

Scott, not being that astute, can you expand on your statement, "This is an uncomfortable but very significant standoff that will not last much longer before being resolved one way or the other." Specfically, resolved one way or another.


Scott Grannis said...

Good question since it's hard to answer. The standoff: on the one hand the Fed has dumped tons of reserves into the system, which is potentially very inflationary; on the other hand the market seems not to want to use those reserves in an inflationary manner. The resolution of this depends on how fast the market's appetite for loans increases (since loans are now so cheap and money for lending so potentially abundant) and how fast the Fed is able to withdraw the reserves. Either the Fed ends up doing just the right thing or we have a big inflation problem.

alstry said...

Or we wake up one morning and learn the system is a massive fraud.....something Economists are not trained to consider and attorneys are experts in analyzing.

What if:

We learn that the media morphed simply into a pulpit for Wall Street:

And Wall Street was one Massive Madoff like Ponzi Scheme...

As an expert who has had the privelge of prosecuting a number of cases involving fraud, I am highly confident that the dicipline of economics will look back at this period and could we not have known?????

ronrasch said...

Scott, as we watch the drama of Fed actions unfold, we can be grateful for the great work that you develop and share here to help us watch these cataclysmic forces at work. Thank you for this terrific blog. Happy Fourth of July to you and yours/

Scott Grannis said...

ronrasch: Thanks!