As Fed meeting looms, economists see central bank balance sheet in new light

Experts point out that the Federal Reserve’s lending to banks following the bankruptcy of Silicon Valley Bank has led to a major hole in its balance sheet reduction efforts. However, economists are not considering it as a move towards a stimulative use of its stockpile. Instead, the expansion of the Fed’s cash and bonds hold has become a vital tool to contain financial stability threats, indicating the core motive of why the central bank was established over a century ago. The discount window facilities propelled the bank’s assets to augment while allowing the Fed to move forward with rate rises and avoid standing aside, or cutting rates during periods of economic turbulence. Although the Fed may have miscalculated the effects of rates increases and bank observance on the financial system, it has institutionalized reforms to bank practices that improve stability in the aftermath of the early-COVID financial crisis. As a result, exceptional use of the discount window mirrors the desired results of those reforms.

Evercore ISI analysts report the seeming contradiction of an extensive balance sheet increase on one hand, driven by financial stability concerns, while monetary policy tightens on the other. The analysts admit that there is scarcely ever a clear separation between financial stability and monetary policy goals. Hence, real-world policymaking must encompass these contradictions.

Trillions of dollars are involved in this issue. Federal Reserve data revealed a significant spike in bank lending last Thursday, propelled primarily by $153 billion discount window credit, up significantly from $5 billion the previous week, going above the record set in the fall of 2008, from which banks took $112 billion. This borrowing, accompanied by various other large-size credit extensions, elevated the Fed’s overall balance sheet to $8.7 trillion versus $8.4 trillion the previous week. The Fed holdings of cash and bonds reached their peak at almost $9 trillion last year.

Emergency borrowing has complicated the Fed’s efforts to let some of its Treasury and mortgage securities expire every month, also known as quantitative tightening (QT), aimed at reducing inflation. This puts the central bank in an awkward position as the banking sector’s troubles raise doubts over the outcome of the rate-setting Federal Open Market Committee meeting scheduled to conclude on Wednesday. Despite the turbulence, the Fed maintains its forward momentum towards a quarter-point rate increase.

Experts discuss the importance of Fed holdings in understanding the dynamic balance sheets. Piper Sandler’s Head of Global Policy, Benson Durham, claims that it is the composition, not size, of Fed holdings that matter in balance sheet dynamics. While emergency borrowing has elevated the total level of Fed holdings, it continues to dispose of bonds and reduce banking system reserves, which has been the QT’s objective. “When it comes to the increase in the overall size, it’s hard for me to imagine that this is remotely inflationary,” Durham said. Tim Duy, Chief U.S Economist with SGH Global Advisors, agreed and said that the emergency lending is not funding banks that they can use for loans, blunting any form of new stimulus.

While the banking sectors’ demand for reserves has increased in more fragile conditions, analysts point out that the factors driving the current balance sheet surge are fluid, limiting interpretations. A note published over the weekend by a group of analysts from Wrightson ICAP emphasizes that it is still unclear how much of the Fed’s emergency lending will remain fixed. Depending on the banks’ reserve positions, the group observed some potential implications for the Fed’s balance sheet drawdown. It may allow the drawdown to end later than previously anticipated, even if, as expected, the FOMC decides at the meeting to keep the drawdown at its existing pace of $100 billion per month.

(By Michael S. Derby; Editing by Dan Burns and Andrea Ricci)

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