Long Term Perspective

With interest rates near zero and leaving no room to maneuver, the Fed switched to quantitative easing as its primary monetary policy tool in December 2008. Quantitative easing sounds technical but it can be boiled down to several key ideas. The traditional approach to monetary policy is raising and lowering the fed funds rate – that is the Bank trades reserves for short-term Treasury securities. But with the onset of the subprime crisis in 2007, monetary policy moved beyond just interest rates.

 

Credit markets froze in 2007 and into 2008 because financial market players were unsure about the quality of many of the bundled securities such as mortgage-backed assets. Banks and other financial institutions did not know what financial assets to trust and were unwilling to lend with bundled securities as collateral. To improve financial markets, the Fed cut the fed funds target in December 2008 to a range of zero to one quarter percent – essentially zero. But the Fed believed more liquidity was needed than would be provided by a near zero fed funds rate. It added two objectives: to keep adding to liquidity overall (money available for lending) and to swap low quality assets (such as mortgage-backed securities with subprime loans) for high quality, highly liquid assets (Fed reserves). Later in March 2009, the Fed announced that it would buy long-term Treasury securities to add liquidity to financial markets and to bring down longer-term interest rates – more quantitative easing outside the realm of moving short-term interest rates.

 

Here are summary points about quantitative easing:

 

• Traditional monetary policy raises or lowers short-term interest rates by swapping reserves for short-term Treasury securities.

 

• Quantitative easing uses the Fed's balance sheet to add liquidity without changing interest rates. The Fed swaps reserves for illiquid assets already in the financial markets and for high-quality assets that have longer maturities than the Fed normally buys.

 

• When the Fed conducts quantitative easing, it uses its ability to pay interest on bank reserves to keep the fed funds rate from falling below the desired level.

 

• More recently, the Fed has used its balance sheet to shift interest rates, pushing down long-term rates, with Operation Twist, QE3, and QE4, the latter ending in October 2014.

 

 

The Fed's quantitative easing is reflected in the massive surge in total assets starting in the autumn of 2008. Total assets include such diverse items as U.S. Treasury securities, federal agency debt securities (such as Fannie Mae and Freddie Mac), mortgage-backed securities, repurchase agreements, term auction credit, primary credit (discount window), secondary credit, seasonal credit, primary dealer credit, asset-backed commercial paper money market, credit extended to AIG, Term Asset-Backed Securities Loan Facility, net portfolio holdings of Commercial Paper Funding Facility LLC, net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility, net portfolio holdings of Maiden Lane LLC, Maiden Lane II LLC & Maiden Lane III LLC, float, central bank liquidity swaps, and "other" Federal Reserve assets.

 

Short Term Perspective

Early in 2010, the Fed started preparing markets for the start of the unwinding of its massive balance sheet. The April 2010 FOMC statement confirmed that its special lending programs had largely been concluded with one remaining special lending facility being wound down. The Fed, however, did reopen central bank liquidity swaps to help ease liquidity problems in Europe related to concerns over sovereign debt difficulties for Greece, Spain, and some other European countries.

 

But by mid-2010, with the recovery faltering and inflation extremely low, the Fed's focus shifted from unwinding its balance sheet to another expansion. By November that year, QE2 was announced. The second round resulted in the Fed buying an additional $600 billion in long-term Treasuries through the end of the second quarter of 2011. The additional purchases of Treasuries were on top of the Fed's reinvestment of pay down on agency debt and mortgage-backed securities into longer-term Treasuries. Then, QE3 was announced at the September 2012 meeting. The Fed purchased additional agency mortgage-backed securities at a pace of $40 billion per month. This policy was affirmed through the September 2013 FOMC meeting.

 

At its December 2012 meeting, the Fed announced a new purchases program of Treasuries of initially $45 billion per month. This so-called QE4 (although some call it an extension of QE3) replaced Operation Twist and began in January 2013 and had no specific timetable. As of the December 2013 FOMC meeting, the Fed began to slow the pace of bond purchases – still adding to the balance sheet but less rapidly. This deceleration in asset purchases was extended through the September 2014 FOMC meeting. Additions to the Fed's balance sheet ended in October 2014. The Fed's balance sheet at mid-September 2015 was $4.488 trillion — up from under $1 trillion prior to the start of quantitative easing. As of December 2015, there was no guidance on when unwinding will begin.

 

 

The big item still on the Fed's balance sheet from expansion is secutities held outright. This includes the huge runup in mortgage-backed securities held by the Fed. A developing debate within the Fed is what to do with the MBSs. The Fed can let them mature (a slow process), gradually sell them, or a combination of these two actions. Currently, the Fed has decided to reinvest the paydown on mortgage-backed securities and agency debt with purchases of Treasuries. Securities held outright continue to grow with purchases of mortgage-backed securities (QE3) and Treasuries (QE4). It should be noted that the Fed has not given its programs official numerical designations for various rounds of QE. Some economists lump the last round of purchases of long-term Treasuries into their designation of QE3 (combined MBS and Treasuries even though the start dates differed).