In a recent speech, Dallas Fed president Lorie Logan discussed efficient and effective central bank balance sheets. Central banks naturally design their balance sheets and policy implementation frameworks to reflect institutional features of the jurisdictions in which they operate. The resulting frameworks vary on the surface, but there are commonalities in the underlying policy principles.
Central bank balance sheets should be efficient and effective. Those twin principles imply keeping money market rates close to the interest rate on reserves, supplying ample reserves and maintaining strong ceiling or lending tools.
Among the factors discussed, Logan focused some of her comments on asset choices.
The Federal Open Markets Committee (FOMC) has said it intends to hold primarily Treasury securities in the long run. This approach leaves open two questions: Are some Treasury securities more efficient or effective to hold than others? And, against the backdrop of a primarily Treasury portfolio, might efficiency or effectiveness call for holding modest amounts of other assets?
Considering only the Fed’s balance sheet, efficiency considerations counsel against holding Treasury securities that are in particularly scarce supply. For example, the Fed has usually limited its holdings of any one security and avoided buying in-demand securities such as those that are newly issued or cheapest to deliver into futures contracts. If long-term Treasury securities have a special liquidity premium, efficiency could also suggest steering away from holding them—but, as I will discuss in a moment, the consolidated government perspective undoes this conclusion.
Effectiveness, meanwhile, suggests the Fed should structure asset holdings so they normally remain in the background and do not distract from our primary monetary policy tool, the overnight rate target. While fluctuations in net income do not affect the Fed’s ability to conduct monetary policy, they can become a communications challenge. Roughly matching the duration of our assets and liabilities would reduce these fluctuations and could, thus, enhance the effectiveness of policy communications. The Fed’s liabilities consist primarily of currency, which pays zero interest and has very long duration, and reserves, which pay a floating rate and have zero duration. Asset-liability matching thus suggests holding a mix of short-term and long-term securities. A portfolio that’s neutral relative to the outstanding Treasury universe would be one way to approximate this.
Shorter tilt
Some observers argue that tilting the portfolio toward shorter-duration assets would provide flexibility that could enhance effectiveness. Short-dated assets can run off to rapidly reduce reserve supply. Or the central bank can trade them for longer-dated assets to absorb duration and influence term premiums without expanding reserve supply. These forms of flexibility were valuable in the pre-GFC scarce-reserves implementation regime, in which we needed to maintain precise control of reserve supply. And, indeed, we tilted the Fed’s portfolio toward Treasury bills in that regime. But the ample-reserves regime reduces the need for precise control of reserve supply. Our balance sheet has also grown, so even a neutral portfolio would now contain a substantial dollar quantity of Treasury bills. In the current regime, then, I don’t think tilting the steady-state portfolio toward short-dated assets would materially enhance effectiveness.
Importantly, Treasury securities the Fed holds as assets are liabilities for the Treasury Department. They cancel out on the consolidated government balance sheet. As a result, the consolidated perspective can shed a different light on what’s efficient and effective.
As an example, Suppose securities of a certain duration have a particular liquidity value in the market. You might think it’s inefficient for the Fed to hold such securities, since the market values them highly. However, the Treasury could conceivably issue more such securities to meet the market’s demand. So, from a consolidated perspective, the Fed’s actions aren’t the sole determinant of efficiency.
In the US, the Fed sets monetary policy while Congress and the Treasury determine the fiscal costs taxpayers support. One of those fiscal costs comes from the duration risk associated with potential interest rate fluctuations on government debt. The Treasury determines the maturity structure of the consolidated government debt and the associated duration risk. When certain securities have a particular liquidity value, for example, Treasury decides whether to supply more of them, taking account of how this action would affect taxpayers’ exposure to duration risk.
If Treasury can offset what the Fed holds, does the consolidated perspective imply anything at all for the Fed’s asset choices? I think it does. In practice, Treasury keeps its issuance regular and predictable to foster an attractive market for investors.
“Given this approach, I believe the most appropriate strategy for the Fed is to likewise be predictable by purchasing a neutral mix of durations relative to whatever mix Treasury chooses to issue. Then there is nothing for Treasury to offset. The Fed-only perspective also suggested a neutral portfolio. My bottom line, then, is that from both angles, in the US, a neutral portfolio would be efficient and effective,” she said.
At present, the Fed’s portfolio is significantly overweight longer-term securities and underweight Treasury bills. Our reinvestments of maturing securities represent a small fraction of the portfolio. And when we eventually reach an efficient level of reserves and need to begin expanding the portfolio in line with growth in demand for our liabilities, those purchases will also be small relative to existing holdings. In this context, it could take many years to reach a neutral mix of holdings by structuring our purchases to be proportional to issuance.
“Although I view a neutral mix of purchases relative to issuance as appropriate in the long run, it would make sense in the medium term to overweight purchases of shorter-dated securities so as to more promptly return the Fed’s holdings to a neutral allocation,” she said.
Repo long view
While securities represent nearly all the Fed’s assets, there are small quantities held of other assets, such as discount window loans and repos.
“In the long term, in my view, it could be interesting to consider whether allocating a modest share of the Fed’s long-run balance sheet to loans or repos could improve the efficiency and effectiveness of policy implementation,” said Logan.
For example, auctioning a fixed quantity of discount window loans each day could encourage banks’ operational readiness and demonstrate that borrowing is a normal activity for healthy firms. Such a facility might also smooth the redistribution of reserves around the banking system.