Steve Liesman and the Fed’s Balance Sheet
David R. Kotok
Chairman and Chief Investment Officer
Oil Slickonomics – Part 7
July 10, 2010
When Steve Liesman gave his Friday tutorial on CNBC, he summarized the various views within the Fed by quoting some of the members of the Federal Open Market Committee (FOMC). Essentially, there are three views.
Some FOMC members may be ready to add new programs in order to stimulate the economy and avoid a “double-dip” recession. Others (the majority) would do nothing now and wait to see if the economy needs more stimulation. A few, known as the “hawks,” want to shrink the Fed’s balance sheet now, or allow it to shrink naturally as $200 billion in mortgage holdings mature this year.
Steve may want to consider a second chapter in his tutorial. He may want to look at the liability side of the Fed’s balance sheet.
Readers please note: Steve is a dear fishing friend and a skilled Fed observer. He will be covering our annual invitational gathering in Maine this year. What Becky Quick named “Camp Kotok” will convene on the first weekend in August, and CNBC will cover it live on Friday, August 6, starting at 6 AM. We are sorry that our friends in Asia and Europe who asked if they might see some of the festivities on Worldwide Exchange earlier that morning may be disappointed. The decision is not mine. I have invited CNBC to cover the event starting at 5 AM so WEX viewers can see some of it. If you have a view on that, please email it directly to CNBC, since they may want to reconsider that decision. This determination of a 6 AM start was theirs, not mine.
Now back to the question for Steve. Has he looked for any specific Fed studies that may describe what the optimal size of the Fed’s balance sheet should be? I suspect he will not find them if he looks.
Prior to the Lehman-AIG debacle, the asset side of the Fed’s balance sheet was mostly deployed in holdings of US treasuries. It was about $900 billion. The key point is to look at the liability side at the same time. What you find is that the most of the liability side was composed of the US currency in circulation throughout the world. The second component was bank reserves. Moreover, those required bank reserves are mostly made up of cash that the banks keep in their ATM machines. Banks are rational businesses and realize that to have cash sitting in a vault is costly when the same cash can sit in an ATM and the bank can earn fees from the users of the machines.
Therefore, the size of the Fed’s balance sheet was mostly set by the worldwide demand for US currency. In other words, the global desire for pictures of George or Abe or Ben was the primary determinant of the size of the balance sheet. The liability side drove the size of the asset side.
Now consider that about two-thirds of the outstanding currency denominated in US dollars is in circulation elsewhere around the world. The US hundred-dollar bill is very popular with many users of it, including drug cartels and underground businesses. Conclusion: for decades, and prior to the Lehman-AIG fiasco that triggered a Bernanke-led policy change, the size of the Fed’s balance sheet was determined, in part, by the demand for hundred-dollar bills used by global persons from tourists to drug dealers. Now I admit immediately that I have made an extreme and simplistic statement and that the non-drug-dealer community around the world is large and there are many uses of US currency whether hundred-dollar bills or otherwise. But I make the statement in order to let this idea sink in: GLOBAL currency demand effectively determined the size of the Fed’s balance sheet. Moreover, the largest source of that demand was outside the United States.
Now fast-forward to today and the post-Lehman-AIG era. The balance sheet asset side is about $2.3 trillion dollars. That was a purposeful shift in response to the Lehman-AIG liquidity crisis. On the liability side, the Fed is now sitting on a trillion in excess reserves that US banks have deposited at the Fed in order to earn 25 basis points of interest rather than something less. Again, banks are being rational and seeking the highest return they can obtain on their excess overnight reserves.
So, should the Fed (1) enlarge the balance sheet by buying more assets and creating even more reserves that are excess? Maybe the answer is “yes” and maybe they should be doing it quickly and proactively. Maybe the answer is “no” and they should sit and wait to see what more the economy will need, if anything, to recover. In addition, maybe they should replace what is maturing and maybe they should allow the balance sheet to shrink in a natural way through the maturities of existing holdings.
They DO NOT KNOW. Neither do we. They do not say. Moreover, we are guessing.
Steve Liesman noted that the spread between Fannie and Freddie mortgage paper and US treasury interest rates started to widen after the Fed stopped buying the Fannie paper. In addition, we all know that housing has hit the skids again after the Federal government’s special credit to home purchasers expired. Moreover, we do know that the foreclosure rate is very high and that consumer confidence is lacking in America, and we know that the source of most home mortgages these days is federal programs that are mostly driven by Fannie and Freddie.
So, FOMC members and Fed observers, back to the questions that we may want to debate and discuss. What is the proper size of the Fed’s balance sheet? Is there one? How much does it vary?
Moreover, what makes it too large or too small right now? And why? Does housing need more support and should the Fed take the balance of Fannie paper to $2 trillion or higher? The banks are certainly not using their excess reserves to buy those securities. In addition, do we need more monetary stimulus when we see that the rate of change in fiscal stimulus is now turning from positive to negative?
When FOMC members discuss this in their speeches and conferences, it may be fair game to ask them directly to explain why they say the Fed’s balance sheet is too large or too small. Steve Liesman can ask them, too.
Steve, we look forward to your visit to Leen’s Lodge for the annual Camp Kotok retreat in August. Until then, we wish you tight lines and safe journey.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com