The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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February 06, 2009

Contraction, not tightening

Over at Financial Crisis and Recession, Susan Woodward and Robert Hall start a recent post, titled "The Fed contracts," with this:

"The Fed has indicated that it plans to pursue a policy of quantitative easing, that is, expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments…

"But... the Fed has engaged in quantitative tightening over the past month, reducing its borrowing and reducing its holding of higher-yielding investments…. So far, no explanation for the Fed's announcements of moving in an expansionary direction while actually contracting."

First, it is probably appropriate to point out that the use of the term "quantitative easing" is a bit out of synch with the policy approach embraced by "the Fed." This is from Chairman Bernanke's January 13 Stamp Lecture at the London School of Economics:

"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach—which could be described as 'credit easing'—resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental… In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."

At Economist's View, Tim Duy zeroed right in on the point:

"Woodward and Hall are confused because they do not recognize that the Fed has not initiated a policy of quantitative easing…because the Fed sees their actions as credit market related, they would have no problem with the balance sheet contracting if credit market conditions dictate."

What Woodward and Hall describe is credit easing in the Bernanke lexicon, as "expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments" is a description of changes in the composition of Federal Reserve assets. But the intent they assume is that of quantitative easing—which in the end is all about expanding the size of the balance sheet (on the liability size specifically).

In our opinion—and we rush here to add that is only our opinion—the key to unwinding the Woodward-Hall "puzzle" is in the last sentence of the Bernanke quotation above: "the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."

It is instructive to examine the source of the recent reduction in the Fed's balance sheet.


Though several categories of Fed assets have declined in recent weeks, the really large changes have been in currency swaps and the Commercial Paper Funding Facility or CPFF. In simple terms, currency swaps are the provision of dollars to foreign central banks to help satisfy dollar-based liquidity needs in foreign financial markets, the CPFF is a Federal Reserve funding facility to assist in the functioning of domestic commercial paper markets.

As the Chairman suggested in his Stamp Lecture:

"…when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities."

At least in U.S. dollar interbank lending markets, liquidity pressures have abated, as LIBOR rates have fallen substantially since last fall and have held relatively steady in recent weeks, and term financing premia have similarly eased.


Commercial paper yield spreads have also narrowed considerably for both asset-backed and financial paper since the introduction of the CPFF last fall:


Interestingly, a large amount of maturing CPFF paper was not reissued into the CPFF or the market in late January. This decline could be a result of some borrowers shifting to other, cheaper sources of credit. From CNNMoney:

"The Fed's commercial paper funding facility was a popular alternative for cash-strapped corporations at the height of the credit crunch, but demand for funding through the program has waned. Another government sponsored program, the FDIC's Temporary Liquidity Guarantee Program backs financial institution debt issued up to 10 years, a more attractive alternative for many companies."

There is one additional wrinkle. Agency mortgage-backed securities—which the FOMC has authorized the purchase of, up to $500 billion—show up on the balance sheet at the time the trades settle. As of February 4, the Fed's balance sheet has $7.4 billion in Agency MBS. However, if you sum the purchases that the NY Fed posts on their Web site, the total is closer to $92 billion so far. Thus, roughly $85 billion in MBS the Fed has purchased have yet to show up on the balance sheet because the trades haven't settled. (Hat tip to our colleague Mike Hammill for bringing this to our attention.)

The central bank's balance sheet is in fact contracting. Maybe. But is it policy tightening? Doubtful.

By David Altig, senior vice president and research director, and John Robertson, vice president and senior economist at the Atlanta Fed

February 6, 2009 in Capital Markets , Federal Reserve and Monetary Policy | Permalink


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An analogy to this from the simple version of macroeconomics. Suppose the FED wanted market rates to decline by 50 bps but it also had information that the demand for money schedule had recently declined enough to lower market rates by 80 bps. We could see a slight decline in the money supply and a lowering of interest rates. Of course, this one is a bit more involved than the simple model. Speaking about going beyond the simple model, check out Nick Rowe's two wedges post:


Posted by: pgl | February 07, 2009 at 06:43 AM

Ok, so is this good or bad? Good that there is less reliance on the Fed, or bad that less may be needed entirely? Good that the market is easing, or bad that it is contracting? More data needed.

Posted by: Lord | February 09, 2009 at 05:52 PM

Notice how "other" makes up the largest part of the book?

"Other", in this case, means lower quality assets. The Fed has been swapping cash for crap.

I sure would hate to think our cash is backed by crap. I bet others feel the same way.

Posted by: K Ackermann | February 11, 2009 at 09:43 PM

Well if institutions are turning to cheaper sources of credit, why has the AMLF been expanded to April 30, 2008? Doesn't this imply that there is still a big credit problem and that the Fed is going to have to loan out a lot more money to simultaneously support money market mutual funds and the commercial paper market?

Posted by: T Bill | February 12, 2009 at 05:13 PM

A careful study of the chart on "Federal Reserve Assets", which is a stacked-up accumulation-type chart, contradicts the claim in the article that "Though several categories of Fed assets have declined in recent weeks, the really large changes have been in currency swaps and the Commercial Paper Funding Facility or CPFF."

The graph shows clearly that Federal Reserve Assets in total have declined from a peak of nearly $2300 billion to a current value of around $1950 billion. The drop is $350 billion.

The graph shows that none of that $350B drop is in the Treasuries portfolio. But it also shows that some $150 billion of it -- nearly half -- is in the "Other" category, which presumably we are not "supposed" to focus on. By contrast, the drop in currency swaps is actually smaller, about $100 billion. And the drop in Commercial Paper Funding Facility (CPFF) is also about $100 billion.

Thus it would seem that "really large changes have been in" the category Other.

Posted by: Wisdom Speaker | February 20, 2009 at 03:38 PM

Following up to my previous comment, here are some balance sheet changes from the "other" category which (relative to their prior size) have been proportionately larger than those in the CPFF and Currency Swaps:

Repurchase Agreements were nearly phased out. Regular Discount Window credit is down by around half. Primary Dealer Credit Facility is down by over half from its peak. Credit direclyt Extended to AIG is down by about half. The ABCPMMMFLF is nearly phased out. Overnight securities lending to dealers is phased out.

By comparison, the reduction in the central bank liquidity swaps ("currency swaps") is only 20-25%. The CPFF LLC is actually just about unchanged according to other data I'm seeing.

On the other side: there are large elements of "Other" that have not contracted. Term Auction Credit is about the same. The Maiden Lanes are about the same.

What we are seeing, in my opinion, is a regime change from some of the "crisis" facilities to some longer-term market support facilities. I'm not qualified to judge whether this is sensible policy but it's certainly not the case that all the change is in the CPFF or the currency swaps.

Posted by: Wisdom Speaker | February 20, 2009 at 03:57 PM

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