The Supplemental Financing Program
Prior to the financial crisis, the Federal Reserve balance sheet had followed a steady growth path of about 5.5 percent per year, and its total value had topped $900 billion. During the financial crisis, the assets side of the Fed’s books saw an enormous expansion when it began to extend its lending and liquidity programs, growing at an average rate large enough to double its value each year and exceeding the $2 trillion mark. The most notable expansion occurred immediately following the collapse of Lehman Brothers in mid-September 2008.
Growth in the liabilities side followed suit, keeping the balance sheet, well, balanced. A large part of this liability growth occurred in the balance of excess reserves held at the Federal Reserve.
When Lehman Brothers collapsed, there was an instant need for an influx of extra liquidity into the market. The Federal Reserve expanded its existing credit-easing policies and extended new programs to provide this liquidity and to lend to struggling financial institutions. These institutions would in turn keep the liquidity as reserves with the Federal Reserve, providing a backstop for them in the adverse economy.
At the time, a concern about the mounting excess reserves, and thus the monetary base, began to surface. In normal times, the Federal Reserve could have drained the excess reserves by selling Treasury securities to the public. (Payments for these securities would clear by having the Fed reduce the reserve account of the purchaser’s bank.) With no public market for Treasury securities, though, an alternative was created. The Treasury announced its Supplemental Financing Program (SFP) two days after the collapse of Lehman Brothers.
Established to help the Federal Reserve manage the expansion of the reserve accounts being created by the infusion of new liquidity, the program is actually an extension of the typical Treasury deposits held at the Federal Reserve. Treasury bills were sold at special auctions designed specifically for the program to dealers and depository institutions already associated with the Federal Reserve. Proceeds from the auctions were deposited at the Fed by the Treasury into the SFP account, reducing the total excess reserves.
The Treasury has continued to fund credit-easing policies in this way, and it now finds itself approaching its legal debt limit of $12.1 trillion. A temporary solution to this limit is to start to trim down the supplemental account held with the Federal Reserve. Almost exactly a year after the program’s inception, the Treasury announced its intent to reduce the balance of the account to $15 billion, a reduction of nearly $185 billion. Such an action will create a chain effect throughout the market that will ultimately produce a change on the Federal Reserve’s balance sheet.
When the Treasury deposits are withdrawn from the Federal Reserve’s balance sheet, the Treasury will use the cash recovered from the operation to pay off part of its debt. As mentioned, the debt was in the form of Treasury bills issued to the public. In the midst of a slow recovery, the cash that will be returned to the public will find its way to the depository institutions that work closely with the Fed. Following this would be the return of those funds to the Federal Reserve’s balance sheet as reserve liabilities.
What results is a growth in the monetary base, but the transition will have very little if any effect on the Fed’s credit-easing policies. It might be harder to see, but it is true that the consequences of this action are far from a simple printing of money. The growth in the monetary base that results is a shifting of funds between Federal Reserve accounts. Based upon the current state of the economy, the growth will likely go unrealized.
Two major factors will help to keep the growth in check. First and foremost, the depository institutions that receive these new deposits are still facing very large capital constraints. These constraints will discourage institutions from lending their reserve balances as they continue to work to stabilize their operations. Secondly, the ability of the Fed to pay interest on reserves should allow the Fed to control the expansion of the monetary base, even though the applicability of this practice is still largely untested. So, at the present time, it appears as if the transformation of the Federal Reserve’s liabilities will be only a simple transition in account balances and will have little effect on credit-easing policy.