FED WATCH: Fed's Expanding Balance Sheet Raises Concerns
Last update: 11/18/2008 11:51:14 AM


By Michael S. Derby
A DOW JONES NEWSWIRES COLUMN


NEW YORK (Dow Jones)--Within the Federal Reserve's explosively expanding balance sheet lies peril, along with the seed of a possible shift in how the central bank will influence economic activity in the coming years.
The Fed's balance sheet has more than doubled to over $2 trillion since the start of the financial crisis in August 2007 as the central bank expanded its lending activities far beyond the previous confines of deposit-taking banks.
Its actions raise a number of challenges. Chiefly, if it's not managed right, the liquidity created by the securities now on the Fed's books could become a significant inflationary driver over time. There's the matter of risk, given the changed composition of securities the Fed is now willing to hold. Also, the way the balance sheet is now being used is upending much of the conventional conduct of interest rate policy.
The Fed's balance sheet is primarily an accounting of all the securities it holds, and its expansion has been astonishing. In data reported last Thursday the Fed said its assets now stand at $2.2 trillion. In comparison, the Fed held $858 billion on its books in the week ended on Aug. 1, 2007, just before the financial crisis erupted.
Historically, the balance sheet has comprised mostly risk-free Treasury securities the Fed both owns and has borrowed as part of purely technical operations to achieve the central bank's monetary policy objectives.
But then the financial crisis took hold, and everything changed for the central bank. The launch or expansion of an armada of programs aimed at righting credit markets and restoring liquidity and confidence between banks has driven the growth.
To that end, the Fed now counts on its books over $500 billion in funds it lends to deposit-taking banks via its Term Auction Facility and its traditional discount window tool.
There's the $65 billion tied to the primary dealer credit facility, which provides liquidity to the banks the Fed deals with directly and who underwrite Treasury auctions. Add to that, several rapidly expanding and large programs to buy short-term corporate debt called commercial paper; Barclays Capital notes the Fed now owns 16% of that sector. There's $615 billion in what are called "other Federal Reserve assets," which mainly covers currency swap arrangements put in place with other central banks.
Balance sheet growth is not likely to be over, either. Earlier in the month Federal Reserve Bank of Dallas President Richard Fisher said the holdings could hit $3 trillion by year's end. In a recent speech Fed Governor Kevin Warsh said while the Fed doesn't want to "crowd out" private capital and investment decisions, he also expects to see more growth in the Fed's holdings.


Price Problems?


Ultimately, what the Fed's done with the balance sheet could prove the tonic the economy needs, especially in light of the breadth of the current downturn. But some are feeling anxious.
Federal Reserve Bank of Philadelphia President Charles Plosser has appeared particularly concerned about what's happened to the Fed's balance sheet. In a speech last week in Pittsburgh, he repeated his view the Fed needs to be careful about extending its responsibilities beyond the control of inflation. He also fretted that the central bank's rapidly growing responsibilities, which have tied it ever more closely to the Treasury, could ultimately compromise its much cherished independence.
Plosser warned that what's happened with the balance sheet could become problematic once the economy's prospects begin to improve. "We have put a lot of liquidity out there" that will eventually need to be withdrawn, and "we will have to shrink the balance sheet" as part of that effort.
"The timeliness with which we adjust our (balance sheet) decisions will be critical here" because if the action is mistimed, inflation problems could very easily follow, Plosser said.
JPMorgan's Michael Feroli can see where Plosser is coming from, at least based on economic theory. A growing balance sheet pumps up bank reserves, and those reserves increase the money supply, thus increasing the possibility of inflation at some point.
But Feroli isn't particularly worried, in large part due to the extent of the economy's current troubles. "If your instinct is that the worst recession since 1981 is not inflationary, trust your instinct" and not traditional theories of money, he told clients in a note.
Plosser's worries aren't widely shared within the Fed. Chairman Ben Bernanke downplayed the inflationary potential of the balance sheet in late October and Atlanta Fed chief Dennis Lockhart said much the same thing on Nov. 7.
Still, a change announced Monday restarted inflation concerns. The Treasury announced that it would "decrease in the coming weeks" a program of selling Treasury bills that the Fed relied on to support some of its balance sheet expanding efforts.
That news raised potential red flags for Tony Crescenzi, a veteran Fed watcher at Miller Tabak. Without Treasury support for its efforts, Crescenzi said, the Fed could end up in effect firing up the printing press.
It may be that the Fed needs that stimulus to counteract year end funding pressures, Crescenzi said, although there are other explanations for what's happening.


Parallel Perils


It's well understood that the Fed's balance sheet now contains more risk than it is used to given the corporate and other types of debt it now accepts as backing for the money it lends out. Fed officials stress that the central bank sets the collateral level according to the securities' risk. Still, the bank is exposed to far more uncertainty in its holdings than officials are used to.
In congressional testimony Tuesday, Rep. Jeb Hensarling pressed Fed Chairman Ben Bernanke about the dangers of the balance sheet's current composition. The Fed chief responded "we need to do what we need to do" to ensure an economic recovery. That said, "the overwhelming amount of our lending is at very low credit risk" and thus is something that merits little worry.
There are other issues at play, as well - ones that go to the core of how the Fed operates.
Federal Reserve Bank of San Francisco economist Glenn Rudebusch said the Fed has grown its balance sheet so expansively that it has amounted to what's called "quantitative easing." That means the Fed is supplying more liquidity than is needed to keep its chief tool, the overnight target rate, at the officially stated level.
Writing in the bank's FedViews note, Rudebusch said monetary policy as a whole has acquired a more "speculative" orientation. He argued the Fed may ultimately have to change what it officially targets as a means to influence the economy, and that the central bank will need to reevaluate how it communicates its policy goals.
(Michael S. Derby, a special writer with Dow Jones Newswires, has covered the Federal Reserve since 2001. He also writes about bond markets and the economy. He can be reached at 201 938 4192 or by email: michael.derby@dowjones.com.)