A recent entry in the Liberty Street Economics blog
of the Federal Reserve Bank of New York (FYBNY), compared the recent decline in
Treasury yields to those of earlier sell-offs, focusing specifically on the
historical composition of the Fed’s System Open Market Account (SOMA) which, in
recent years, has been used to implement monetary policy. Fed actions with regard to SOMA have been
intended to promote the Federal Open Market Committee’s (FOMC) dual mandate to
foster employment and price stability.
Specifically the FOMC exponentially increased the
size of the SOMA portfolio (from around $500 billion in 2008 to about 2.7
trillion in 2012) and shifted its composition from Treasury bills and Treasury
coupons to large holdings of Treasury coupons and mortgage-backed securities
and lesser levels of agency debt. The
Fed purchased these longer-term assets to reduce private sector holdings of
such assets and thus reduce term premia
and long-term interest rates.
policy also generated high levels of portfolio income and increased revenue to
the U.S. Treasury. Deborah Leonard, Assistant Vice President, Julie Remache,
Vice President, and Grant Long, Association, all in the FYBNY’s Markets Group
Fleming, Vice President, Research and
Statistics Group, authors of “What If? A
Counterfactual SOMA Portfolio” on the blog forecast a net decline in that
income as monetary policy is normalized.
Net income may even dip below pre-crisis averages for a time, they say,
and remittances to the Treasury could be suspended.
The four ask what the path of the
portfolio and the income it generated might have been had the FOMC not taken the
unconventional balance sheet actions.
They conducted a “counterfactual” exercise to explore such a scenario and
answer their own question.
The exercise is based on the assumption that the Fed’s response to the
financial crisis was solely to reduce the federal funds target rate. Thus the counterfactual SOMA portfolio post
2007 remained all-Treasury growing roughly in line with the currency in circulation. They then compared their constructed reality to
actual balance sheet developments based on the FRBNY report Domestic Open Market Operations during 2012,
a projected portfolio path based on primary dealer expectations from the Desk’s
Survey of Primary Dealers, and to the exit strategy principles from June 2011
FOMC minutes. These reality-based
assumptions are called the “baseline” scenario.
To simplify the exercise and because of the difficulty of projecting what would
actually have happened the authors assumed that interest rates followed the
same path for both scenarios. In fact long
term interest rates might have been higher or lower in the absence of the Fed’s
unconventional monetary policy.
At the end of 2012, SOMA domestic securities holdings would have consisted of
roughly $1.3 trillion in Treasury securities in the counterfactual scenario
compared to the $2.7 trillion in Treasuries, agency debt, and agency MBS SOMA
actually held. The first portfolio would
have had a weighted average maturity (WAM) of 5.4 years at the end of 2012,
similar to the WAM of the outstanding supply of Treasury securities. The baseline portfolio of Treasury holding
had a WAM of 10.4 years.
The counterfactual portfolio would have continued to grow
steadily as currency grew through the end of the exercise horizon in 2025. The baseline portfolio is projected to vary
from a peak of nearly $3.9 trillion in early 2014 as the presumed asset
purchases end, then remain elevated through early 2015. A combination of redemptions and assets sales
(as envisioned from the FOMC’s 2011 exit strategy principles*) would shrink the
portfolio steadily during the policy normalization period. The sizes of the two portfolios would roughly
converge in 2019.
Although the baseline portfolio returns to a nearly all-Treasury composition in
2021, the composition of its securities holdings still has a slightly higher
WAM than the counterfactual portfolio because of the longer-term Treasury
securities that were purchased in recent years
The authors estimate that the net income generated by its
counterfactual portfolio would remain relatively steady at an average of about
$27 billion from 2008 to 2012, reflecting both the short maturities and the
small size of the portfolio. The
baseline portfolio rises steadily during the period, peaking at almost $90
billion in 2012.
But, under the assumptions for the baseline scenario, net
income will begin to fall in 2016 and remain low for several years. This reflects several factors including
higher interest payments on excess reserve balances as rates rise, declining
interest income as the portfolio shrinks, and realized capital losses as agency
MBS are sold.
In contrast, net income from the counterfactual portfolio is
projected to grow as policy is normalized.
The portfolio, heavily invested in short-term Treasury securities, will
roll those holdings over in an environment of rising rates. Moreover, because the portfolio is funded
primarily with currency it has only minimal interest expense associated with
reserves. The income from the two
portfolios is forecast to converge late in the projection period by which time
the baseline would be in a steady state, holding predominately Treasury
securities and its size once again roughly matching currency.
The income the Fed generates, minus operating costs,
dividends, and capital maintenance, is remitted to Treasury and these remittances
have been elevated since the crisis to a cumulative $325 billion from the end
of 2007. This is roughly $240 billion
above the estimated $85 billion from the counterfactual scenario. This difference exists despite higher
interest costs from funding the larger portfolio with excess reserves.
Should the Fed not generate sufficient income to cover those
above referenced expenses in future years, it would book a deferred asset and
temporarily halt Treasury remittances.
The deferred asset would have to be paid down before remittances could
resume. The projected declines in income
in the baseline portfolio suggest such a scenario for several years while the
counterfactual scenario, with a steadier projected path, would avoid that
outcome. Nonetheless the baseline is projected to remit a cumulative $820 billion
to Treasury through 2025, $315 billion more than the counterfactual
scenario. This arises from its higher overall
income even if the timing of remittances is less smooth than that of the
The authors admit their estimates of counterfactual income
and remittances are necessarily rough and depend on various assumptions, especially
the unrealistic one that interest rates would have been the same under each
scenario. Moreover, when considering the
net effects of monetary policy on the government’s fiscal position, one should
also account for the lower borrowing costs and support for the economic
recovery the Fed’s actions have produced. Nonetheless, they say their findings
broadly highlight the effect of unconventional monetary policy of cumulative
*In an addendum to the article the authors look at the June
2013 FOMC minutes which appear to portend that the Fed might not sell agency
MBS as part of the normalization process although it might reduce or eliminate
residual holdings. A sell off was
anticipated in the above analysis based on the FMOC’s June 2011 exit
strategies. The Domestic Open Market
Operations report used in part to generate the baseline considered an
“buy-and-hold” scenario that illustrates how the baseline balance sheet and
income projections change in the case of no asset sales.
Under the later assumption the general contours of the
portfolio’s size and income are projected to follow similar overall paths as
the baseline. However, the buy-and-hold portfolio is expected to take slightly
longer to converge in size with the counterfactual portfolio, at which time its
size once again roughly matches currency levels. Importantly, its composition
includes significant holdings of both agency MBS and Treasury securities. A
buy-and-hold scenario avoids capital losses on agency MBS sales but has higher
interest expense from additional reserve balances associated with a larger
portfolio, on net resulting in higher portfolio net income over the medium term
compared to the baseline and leading to roughly $55 billion cumulatively in
additional remittances to the Treasury. These are, of course, merely projections
and actual income and remittances will be influenced by the ultimate size of
the purchase program, as well as other balance sheet, interest rate, and