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Credit and Liquidity Programs and the Balance Sheet
Longer-term issues
When credit markets and the economy begin to recover from the current financial crisis, the Federal Reserve will need to wind down some of its various lending programs and eliminate others. As conditions in credit markets improve, market participants' incentives for using some of the lending facilities will diminish. In addition, when the Federal Reserve no longer judges that conditions in financial markets are "unusual and exigent," a prerequisite for the use of the authority in Section 13(3) of the Federal Reserve Act, the facilities created under that authority will have to be discontinued. In general, the Federal Reserve will continue to monitor conditions in financial markets to assess the need for the liquidity facilities, and that assessment will be the principal factor affecting any reduction in the size of the Federal Reserve's balance sheet.
Related
The Federal Reserve's balance sheet can be shrunk relatively quickly, as a substantial portion of the assets held by the Federal Reserve--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short term in nature and can simply be allowed to run off as the programs and facilities are scaled back or shut down. Indeed, over the course of 2009, borrowing through most of the Federal Reserve's lending facilities has declined significantly. On June 25, 2009, the Federal Reserve announced modifications to many of its lending facilities, including the reduction in the auction sizes for the Term Auction Facility and the suspension of some auctions for the Term Securities Lending Facility.
The Federal Reserve has also been purchasing large quantities of Treasury securities, agency debt and mortgage-backed securities this year. The Federal Reserve is monitoring the maturity composition of the balance sheet closely and expects to be able to reduce the balance sheet to the extent necessary at the appropriate time. As the size of the balance sheet and the quantity of excess reserves in the banking system decline, the Federal Reserve will be able to return to setting a target for the federal funds rate as its primary tool in the conduct of monetary policy.
Management of the Federal Reserve's balance sheet and the conduct of monetary policy in the future will be made easier by recent congressional action to authorize the Federal Reserve to pay interest on reserve balances held by depository institutions. The Federal Reserve expects that as excess reserves decline and financial conditions normalize, the interest rate paid on reserve balances will be an effective instrument to help foster trading in the federal funds market at rates near the target.
Other tools are available or can be developed to improve control of the federal funds rate. For example, the Treasury could expand its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve, thereby effectively draining reserves from the banking system and improving monetary control. Moreover, reverse repurchase agreements and other methods could be used to drain reserves from the system.
