The introduction of QE in order to re-instaure financial stability first and then bring back appetite for risky assets has led to an incredible expansion of the central banks’ balance sheet. For instance, the Fed’s total assets increased from roughly $900bn in the summer of 2008 to $4.5tr in 2015 after several rounds of monetary stimulus (see recap of QE history here). The purchase of those financial securities (Treasuries and MBS) through commercial banks led to a significant increase in reserves held at the Fed, which soared from a negligible amount prior the crisis to a high of $2.8tr in August 2014.
Then in October 2017, the Fed began Quantitative Tightening (QT), which consists in unwinding those massive portfolios and normalizing monetary policy. Since then, the Fed’s total assets balance has declined by roughly $500bn to $4tr, of which $2.2tr of Treasuries and $1.6tr of MBS. However, on the liability side, we noticed a strong reduction of reserves by approximately $1.2tr since their highs (current reserve balances of $1.6tr). Why have reserves fallen so dramatically since 2014?
The chart on the left shows the different components of the Fed’s balance sheet liabilities. While the excess reserves are down by $1.2tr, the currency in circulation and the Treasury balances have increased by $423bn and $291bn, respectively. The other smaller liabilities are foreign currency holdings and the reverse repurchase agreements (reverse repos, RRPs), which are roughly flat since 2014. Therefore, the increase in currency outstanding and Treasury balances accounted for $714bn, which confirms that the remainder is associated with the shrinkage of the Fed’s asset holdings (i.e. $500bn).
Reverse repos and Monetary Base
Even though the dollar amount of reverse repos is roughly at the same level where it was in 2014 (USD 250bn), an interesting observation arises when we look at the times series of the monetary base and reverse repos (figure 1, right frame). The monetary base, which is the sum of the currency in circulation and reserve balances, fell from $4.1tr in August 2014 to $3.4tr in January 2017 although the Fed had not started its QT process (assets were steady at $4.5tr). The fall in reserves was partly offset by an increase in reverse repos, which soared from $230bn to $520bn during the same period. This means that the Fed was already tightening its monetary policy back then by draining the banking system of the reserves it had created. The monetary base was reduced as the Fed was lending out its bonds in exchange for the reserves that the bond purchases created (transactions called reverse repos). Banks reserves are therefore temporarily reduced, replaced by ‘reverse repurchase agreements’.
Figure 1. Fed liabilities, monetary base and reverse repos (Source: FRED)