Balance Sheet Implications of New Fed Policies
Since the target federal funds rate bottomed out near its zero lower bound during the financial crisis, the Federal Reserve’s balance sheet has been an important policy tool for the Federal Open Market Committee (FOMC). As a result, the Fed’s balance sheet has expanded from just under $900 billion in early 2008 to just over $2.8 trillion currently. The expansion follows two rounds of large-scale asset purchases, which included traditional assets, such as U.S. Treasury securities, as well as nontraditional assets like mortgage-backed securities and agency debt. Changes in the composition of the balance sheet have been occurring also, as short-term Treasury securities are being sold to purchase longer-term Treasury securities, in order to further increase the average maturity of security holdings and put more downward pressure on long-term interest rates.
On September 13, the FOMC decided to take additional policy actions in order to boost the pace of economic recovery and further ease financial conditions. One change came in the form of communication, as the Committee stated that it expected to keep the target federal funds rate low into mid-2015 and that rates would remain low “for a considerable time after the economic recovery strengthens.” This statement should help to lower longer-term interest rates by setting expectations about future policy, thereby encouraging investment and spending.
Additionally, the Committee decided to engage in another round of asset purchases, which will further expand the balance sheet. This time, the Federal Reserve will purchase $40 billion in additional mortgage-backed securities (MBS) each month until conditions in the labor market show significant improvement, marking the first asset purchase plan with no defined limits. The Committee also indicated that it will continue its MBS purchases next year if the outlook for the labor market does not improve substantially in coming months. It may undertake additional asset purchases as well.
Given current Fed policy, which reinvests the repayments of current mortgage-backed securities and agency debt in new MBSs, there should be no reduction in current MBS holdings over time, just mild variation due to the timing of repayment and reinvestment. Assuming a constant level of current holdings through the end of the year, the decision to purchase an additional $40 billion each month will expand the Fed’s portfolio of MBSs by about $145 billion during that time. This would bring the total value of MBS holdings up to nearly $987 billion, a 17 percent increase from the value in early September.
Assuming that the level of the other assets on the Fed’s balance sheet remain somewhat constant throughout the remainder of the year—a reasonable assumption—the $145 billion in additional mortgage-backed securities should lead to a comparable increase in the size of the balance sheet overall. The resulting size of approximately $2.9 trillion would be about a 5 percent increase from the balance sheet’s current level.
Also, as part of the September FOMC statement, the Committee reiterated that the Maturity Extension Program (MEP) would continue for the remainder of the year. Through this program, long-term Treasury securities are purchased with the proceeds obtained from the sale and maturation of short-term Treasury securities, effectively extending the average maturity of the Fed’s Treasury holdings. Prior to the financial crisis, Treasury securities maturing in less than 1 year made up approximately half of the Fed’s Treasury holdings. Currently, securities with this maturity make up less than 1 percent of the Fed’s Treasury portfolio. The current proportion of Treasury securities held with a maturity greater than ten years is about 22 percent. The percentage of Treasury securities set to mature between 5 and 10 years is 48 percent, and the proportion maturing between 1 and 5 years is 30 percent.
The typical amount of short-term Treasury securities sold each month by the Fed in order to purchase longer-term securities has been between $40 billion and $45 billion. Since the amount of Treasury securities in the portfolio with a maturity less than 1 year is at very low level, sales for the most recent months have consisted mainly of Treasury securities with maturities in the 1- to 5-year range. If a similar trend were to continue until the end of the year, the percentage of Treasury securities in the Fed’s portfolio with a maturity between 1 and 5 years could drop an additional 10 percent, meaning securities maturing in 5 years or more would make up nearly 80 percent of all Treasury securities held. This change in the maturity distribution of the Treasury securities held, along with the reinvestment in and additional purchases of mortgage-backed securities, which are long-term securities as well, will extend the average maturity of the Fed’s security portfolio even further and should put additional downward pressure on long-term interest rates.
Looking ahead to next year, if the Committee continues to purchase MBS to support the economic recovery, the size of the Federal Reserve’s balance sheet will likely continue to expand. These purchases will also continue to shift the composition of the balance sheet away from shorter-term assets to longer-term assets. The statement released by the FOMC in mid-September indicates that the size and composition of the balance sheet changes will depend on economic conditions.