Here's a quiz. Since January 2009, the size of the Federal Reserve's balance sheet has risen by: (a) 15 percent: (b) 30 percent; (c) 100 percent; (d) 200 percent.
To hear critics tell it, you'd think the answer would be (d). Last week, former Minnesota Governor Tim Pawlenty, a prospective presidential candidate, complained that the injection of "fiat money" was devaluing the dollar. The news has been filled with the Federal Reserve's loud efforts to inject cash into the economy by expanding its balance sheet — i.e., by creating fiat money. These include the purchase of $1.25 trillion in mortgage-backed securities in 2009 (QE1), and the current drive to buy $600 billion of government bonds (QE2).
As my colleague Aaron Task correctly answers in the accompanying video, however, the answer is actually (b) 30 percent. Last week the Fed had $2.627 trillion in assets (see item 8 in the report), compared with $2.041 trillion in January of 2009.
The Federal Reserve does a poor job of explaining itself, and labors mightily to operate behind an opaque shroud. But here's the point: The initiatives the Fed takes to increase the size of its balance sheet are generally well-covered, dramatic, swift and controversial: lending to AIG, back-stopping the commercial paper market, QE1, QE2, etc. But when the Fed reduces the size of its balance sheet, it often does so quietly and with little fanfare. When it acquires assets, the Fed creates money. When it receives payment of cash for assets, such as bonds or loans, it takes the cash out of circulation. And each week, about one quarter of the stimulus created by expanding the balance sheet is counteracted by balance sheet shrinkage. The end result: QE2 is going to be more like QE 1.5.
The relevant data is the Fed's weekly report on factors affecting reserves, available here. Historical data for the series can be seen here. In the past 30 months, perhaps the most tumultuous period in the central bank's history, the balance sheet has been dynamic. Some parts bulge, while others shrink. Massive new lending facilities appear overnight, and then wither away quickly.
The week before Lehman Brothers went down, on September 11, 2008, the Fed's assets were about $925 billion. Two months later, the balance sheet had swollen to more than $2 trillion. By the time President Obama entered office in January 2009, the balance sheet stood at $2.041 trillion. That included $350 billion in commercial paper that the Fed was guaranteeing, $416 billion in term auction credit extended to banks, nearly $40 billion in credit extended to AIG, $505 billion in Treasury securities, and a smidgen of mortgage-backed securities ($5.8 billion).
A year later, in January 2010, the Fed's balance sheet was about 10 percent larger, at $2.255 trillion. Yes, the Fed had largely executed its effort to buy $1.25 trillion in mortgage-backed securities. (The balance of MBS stood at $970 billion). But other components of the balance sheet had shrunk: Commercial paper on the Fed's books fell from $350 billion to $14 billion. The amount of term auction credit outstanding stood at $38.5 billion, down from $416 billion the year before. (As this data set shows, term auction peaked at $493 billion in March 2009 and disappeared entirely by April 7, 2010.)
In November 2010, the Fed announced its next effort to bolster the economy by expanding its balance sheet, pledging to buy up to $600 billion in Treasury Securities by the end of June 2011. At that time, the Fed's total assets stood at $2.3 trillion. In other words, between January 2010 and November 2010, even as mortgage-backed securities purchases continued, the total size of the Fed's balance sheet barely budged. The size of the three vehicles created to lend money to acquire toxic assets from Bear Stearns and AIG shrank as loans were paid down. The balance of the crisis-era Term Asset-Backed Securities Lending Facility fell every week. Oh, and holdings of mortgage-backed securities, which peaked on June 24, 2010, at $1.128 trillion, began to shrink.
Wait, didn't the Fed buy $1.25 trillion in mortgages in QE1? Yes, it did. But when people move, or sell homes, or refinance, they pay off mortgages, and the bonds backed by them disappear. Which is why the Fed's pile of mortgages is slowly melting. Last week's report shows that the Fed has $937 billion in MBS, down $113 billion from November, and down $191 billion from the peak in late June 2010.
The Fed has a lot more Treasury securities on its balance sheet today than it did in November (click here for details), $1.32 trillion, compared with $840 billion in November. In the most recent week, it added $28 billion in Treasury securities. But overall assets only rose by about $22 billion. Why? Holdings of MBS fell $6.7 billion.
The government bonds the Fed is acquiring now will sit on the balance sheet until they are paid down in several years, or until the Fed decides to sell them. But in the meantime, chunks of the Fed's balance sheet will wither away. The Fed last week announced it would auction off the $15.7 billion portfolio of securities in Maiden Lane II. The pile of MBS will continue to melt.
This is not to say that the Fed's balance sheet isn't massive compared with where it was before the crisis. It is. And it's not to minimize the potential dangers that can build up in an economy when interest rates are left at zero for a long period of time. But the Fed isn't quite as loose as many people think. As is so often the case, the headline number only tells part of the story.
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