Understand the Fed’s balance sheet
Marshall Auerback here with a few thoughts on money, the Federal Reserve’s balance sheet, and the alphabet soup of emergency liquidity facilities.
The expansion of the Fed’s balance sheet has been widely misunderstood within the economics profession, because it has been viewed through the lens of a pre-existing debate about the monetary transmission mechanism. Those who emphasized the importance of the money supply (on nominal spending) saw the expansion as quantitative easing, and warned about eventual inflationary consequences. Those who emphasized the credit channel (as Bernanke did) saw the expansion as providing credit that was temporarily unavailable in the private market. The fact that the balance sheet expanded on both sides, and in both cases with the private sector as counterparty, tells us that something else was going on.
I would argue that the Fed’s actions after Lehman should be understood as moving the wholesale money market onto its own balance sheet. Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.
Once we think about the Fed’s balance sheet expansion in this way, the doubling seems in fact rather small. After all, the wholesale money market is much larger than the mere trillion or so that Fed took on. Deleveraging provides one answer why the expansion was not even larger. But the deeper answer, I think, comes from an appreciation that the Fed was acting as lender of last resort, and in doing so supporting continued lending in the private money market that would otherwise have frozen. In effect the Fed was offering a standing facility at prices away from market prices, so only those who most needed it took advantage. Simply knowing it was there made others willing to deal privately at more reasonable prices.
Thus, the commercial paper lending facility expanded and then contracted as private lending recovered. The central bank liquidity facility has followed a similar course. The important thing to realize is that, as these temporary liquidity facilities have wound down, the Fed has ramped up additional facilities, now aimed at restarting the securitized lending system more generally.