Questions continue to surround the Fed’s eventual exit from years of quantitative easing. The ultimate fate of what is to become of the 3.5 - 4 trillion dollar portfolio of securities (the expected peak holdings of Fed’s balance sheet) will determine, among other things, long-term interest rates, mortgage rates, corporate and US government borrowing costs, profitability of the banking system, returns on pension and insurance portfolios, and even the value of the dollar. In short, the exit strategy will drive the fixed income markets for years to come.
discussed here), which is at historical lows.
In normal times this argument may hold, but these are by no means normal times. By purchasing unprecedented amounts of securities, the Fed “created” trillions of excess reserves. And the central bank may not want to wait until 2020 (see post) for the reserves to decline to more normal levels on their own. Here are some reasons:
|Loans and leases on US banks' balance sheets (source: NY Fed)|
These are some of the reasons the Fed may choose to drain at least some of the reserves. Selling assets may be one way to do it, but that may shake up the markets and significantly raise long-term interest rates. It will also generate realized losses for the Fed – another potentially unpopular outcome. But there is another solution. Back in 2009 the Fed set up tri-party repo arrangements with a number of dealers (see 2009 post). Eventually that will allow the central bank to lend out the securities instead of selling them. As dealers borrow the securities over a period of a week for example, they post cash as collateral to the Fed (dealers pay the coupon on the securities they borrow and receive the market repo rate on their cash “collateral”). That cash going into the repo account is taken out of “circulation”, thus draining the reserves.
If the Fed rolls these repo positions over time, the reserves will stay “drained” but the securities will still be owned by the Fed - until they pay down or mature. In effect the Fed would sterilize some or all of its securities purchases. Which means that draining the reserves does not have to entail the painful process of active portfolio unwind. And draining excess reserves is in fact a more likely exit strategy than some economists have been expecting.
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