With the FOMC meeting currently under way, it's worth reflecting on the Fed's implementation of the monetary policy this year. Surprisingly, according to the latest Credit Suisse research, there hasn't been much quantitative easing in 2009. But how could that be possible, given the way the Fed has been growing its balance sheet? The chart below shows securities held outright by the Fed. How can this NOT be a form of quantitative easing?
Credit Suisse argues is that the monetary base has not really grown much in 2009, as the following chart shows.
So where is all the cash going from the Fed's purchases? It has to end up in the banking system and show up in the monetary base. The argument Credit Suisse makes is that all the short-term lending the Fed had put in place last year as an emergency measure has been shrinking in size, effectively offsetting the securities purchases.
Banks are de-leveraging, trying to reduce their borrowing from the Fed. Effectively securities purchases put Fed’s money with the banks, while the banks in turn pay back the Fed on their loans, thus neutralizing the impact. As we discussed before, this has slowed down the pace of the Fed's balance sheet growth significantly.
In addition some of the cash for the Fed's recent lending had come from the SFP program in which the US Treasury has issued treasury bills with the proceeds to be used by the Fed for its emergency lending. That type of program does not add any new cash to the system, because while the Fed injects cash (by lending to banks, etc.), the Treasury takes the liquidity out by selling bills. That in fact was the original purpose for SFP.
But SFP is expected to be wound down shortly. The impact of the reduction in short-term funding facilities will end as the programs come to a close. Therefore there will be nothing more to offset securities purchases going forward. That means that if the Fed continues purchasing paper at it's recent pace, quantitative easing finally will kick in with force.
This will end up ballooning bank reserves and truly “flooding” the system with dollars. The chart below from Credit Suisse shows their projection for reserves (translating into a rapidly rising monetary base):
The Fed is keenly aware of this problem going forward, particularly with the dollar weakness. Once SFP as well as the short-term facilities wind down, every dollar of purchased securities will be a new dollar “printed”. That is why the Fed is now supposedly putting together a new securities reverse repo program with the dealers. The idea is that going forward the Fed will be buying new securities by borrowing money from the dealers rather than “printing” new dollars. The Fed will place its securities with the dealers as collateral when it borrows. In fact the central bank may choose to borrow against the existing securities as well. New security purchases will be putting liquidity into the system, but by borrowing from the dealers, the Fed will be temporarily taking liquidity out.
Eventually the Fed will have to outright sell the trillion plus of securities it holds, taking liquidity out permanently (the reversal of quantitative easing) – a dangerous thing to do in this economy. And the more purchases it makes going forward, the harder on the economy it will be to reverse it. For now however, the reverse repo effort will have to do, by (at least in part) compensating for the wind down of SFP and the short-term emergency lending programs.