Ben Bernanke Discusses Fed Balance Sheet Tomorrow

Wednesday, October 7, 2009

man at chartTomorrow evening, Federal Reserve Chairman Ben Bernanke will discuss the Fed’s balance sheet. It is a timely topic because, for over a year, the Fed has actively funded the financial services industry using many different programs. Here is a preview that can help put the Fed’s activities into perspective, along with questions that will hopefully be addressed.

First, a note about a good Fed data source. The Federal Reserve Bank of St. Louis produces a weekly booklet, U.S. Financial Data. This report has graphs of key weekly data for the previous 12+ months, offering a quick review of current trends. It is available free at http://research.stlouisfed.org/publications/usfd/.

New to the booklet last week is the following graph of the Federal Reserve’s asset breakdown – just the thing to prepare for Bernanke’s comments.

Fed assets graph

Source: Federal Reserve Bank of St. Louis, “U.S. Financial Data,” October 2, 2009

The top, light blue, segment shows all the short-term lending programs done to keep the financial services industry functioning. Following the Lehman closure, a panic market environment ensued in September/October 2008. So, the Federal Reserve stepped into its role as lender of last resort. The actions worked and, beginning in January, this part of the Federal Reserve’s balance sheet began a steady decline.

The white segment, rescue operations, covers AIG and some specialty portfolios, allowing them to unwind in stages. This is occurring now.

The growing middle blue segment is where the Fed is trying to foster credit growth by supplying funds to select areas: federal agencies (primarily Fannie Mae and Freddie Mac), the asset-backed securities market and, especially, mortgage securities, where their buying represents 80% of the market. This segment should grow through March 2010, when the Fed expects it to reach its maximums.

The bottom, dark blue, segment is called the Fed’s “traditional portfolio.” Actually, it now includes some non-traditional buying of long-term US Treasury bonds in an attempt to keep interest rates low. It is that buying that is causing the growth of this segment.

The takeaways from this graph is that the Fed, after last year’s sharp increase, has kept total assets under control, changing the allocation from emergency lending to supporting selected financial areas.

Given the Fed’s current balance sheet size, allocation and trends, questions that Bernanke should address in his remarks are:

  1. Why is the Fed buying 80% of all mortgage securities at low yields and not allowing the market to broaden, setting a true market yield?
  2. How does the Fed expect buying long-term bonds to affect yields when there is a large supply of new bonds each week and other buyers effectively set the market yield?
  3. Most importantly, shouldn’t the Fed be withdrawing from trying to influence credit market activity and yields, now that investors have returned and yield spreads for riskier securities have dropped to normal levels?

Perhaps we will get some answers tomorrow.

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