The Case of the Treasury Account at the Federal Reserve
Details of central bank balance sheets once were reserved for people who have a taste for policy minutiae. In fact, until 2008, monetary policy was entirely about interest rates, with quantities adjusting to meet the desired target. But, once interest rates neared their effective lower bound, things changed. When central banks introduced large-scale asset purchases, attention shifted to the overall size and composition of the balance sheet.
While it is surely important to consider the Federal Reserve’s securities holdings and lending, its liabilities are important as well. Here, analysts tend to focus on one of two things: some look at the path of commercial bank reserves, while others add currency in circulation to focus on the monetary base.
Rarely, however, does anyone (including us) look at the size of the U.S. Treasury account. In this post, we explain why we believe it is now quite important.
Over the past few months, this Federal Reserve liability has exploded. The last reading shows a Treasury balance of $1.65 trillion. That is a huge amount, even for the federal government. We find it difficult to explain the benefits of such a massive account balance. Moreover, should the Treasury wish to start draining this account, there could be costs.
We begin with a chart of weekly data on the Federal Reserve’s liabilities divided into four categories. Currency in circulation (blue) rises steadily from $820 billion in January 2007 to $2.04 trillion today. (As we note in an earlier post, over 80% of currency is in $100 bills.) Interestingly, the rate of accumulation rose with COVID.
Next come commercial bank reserve deposits (in orange). In 2007, these were in the range of $8 billion to $15 billion—that is with a “b”. Prior to the Great Financial Crisis, reserves paid no interest, so banks minimized their holdings. Starting in autumn 2008, two things changed. First, in October the Fed began paying interest on reserves; and second, in November the Federal Open Market Committee initiated the first of three rounds of pre-COVID quantitative easing. Reserve levels surged, peaking in August 2014 at $2.8 trillion. The level gradually fell until August 2019, when it became clear that banking system reserve balances of $1.4 trillion were insufficient to keep interest rates from rising above target levels. To steady money markets, the Fed expanded reserve supply moderately. When COVID hit in March of this year, the response prompted a new surge. As we write this, reserves are just shy of $3 trillion.
Federal Reserve liabilities (Trillions of dollars, weekly), Jan 2002- Oct 2020
Source: FRED and Federal Reserve H.4.1.
This brings us to the Treasury Account—the red area in the chart.
Now, everyone needs a banker, including the Federal Government. Vast amounts of money course through the Treasury. During the federal fiscal year prior to the COVID crisis (October 2018 to September 2019), the government had $3.42 trillion of revenue and outlays of $4.41 trillion, resulting in borrowing of $985 billion. To put this into perspective, in an average pre-COVID week, the U.S. government received $68 billion, spent $88 billion, and borrowed $20 billion.
But, as in the case of a household budget, government income tends to be lumpy, while expenditures are smooth. And, like a household, the government wants to avoid having payments rejected for insufficient funds. To prevent such a calamity, the Treasury keeps a buffer either as deposits in Treasury Tax and Loan (TT&L) accounts at commercial banks (see here), or at the Fed.
Other things equal, when the Treasury makes a deposit in its Federal Reserve account, this reduces reserves in the banking system one for one. That is, a $1 billion increase in the Treasury account immediately drains $1 billion in reserves; conversely, a decrease in government deposits adds reserves. Prior to 2008, when reserve levels were very low, a change of $1 billion was a big deal as it could move interbank lending rates substantially. To avoid unpleasant surprises, the Treasury and the Fed agreed to target an account level of $5 billion at the end of every business day. If the government thought they would miss, officials would alert the Fed staff in the morning so that they could use open-market operations to adjust.
Over the years, the Treasury account grew. We can see this in the following chart, where we show the fraction of Federal Reserve liabilities accounted for by each of four categories (the colors match those in the previous chart). Focusing on the red portion, note that in 2007, when the target was $5 billion and the Fed’s liabilities were a relatively modest $750 billion, Treasury deposits accounted for less than 1 percent of the total. In the decade starting in 2008, Treasury balances rose to around $400 billion, accounting for an average of 5% of Fed liabilities. Since June 2020, there has been an enormous change, so that the Treasury deposits at the Fed now account for a whopping 23% of total liabilities.
Composition of Federal Reserve liabilities (Percent of total), 2007-2020
Note: All data are for the annual averages of weekly data, except for 2020, which is for end-October. Source: FRED and Federal Reserve H.4.1.
The initial shift made some sense. Average holdings of $400 billion corresponded to 6 to 8 weeks of outlays. Over such an interval, the Treasury can alter the size of auctions, adjusting public borrowing to ensure that it has adequate funds. While we could quibble over the need for this large a balance, the Treasury does require liquid assets to fund day to day operations—especially since the Fed is not allowed to make loans directly to the government.
This brings us to 2020. Over the past six months, from the beginning of April to the end of October, the Treasury account has ballooned from $400 billion to $1.65 trillion. Of course, the CARES Act sharply boosted federal outlays, roughly tripling the spending pace for three months starting in April. Since August, however, Federal expenditure levels have been only slightly higher than they were last year.
So, how might we justify the explosion of the Treasury’s account at the Fed? One possibility is that the Treasury’s debt management office is taking advantage of very low long-term interest rates through abundant issuance of long-term debt. If that were true, then the maturity of their debt should have risen. In fact, over the past six months, the average maturity of marketable Treasury debt outstanding has fallen from 70 to 63 months (see here). So, this cannot be the reason.
A second possibility is that Treasury officials wish to be ready if Congress passes an additional stimulus bill directing them to send out payments immediately. This seems possible, but as far as we can tell, the Treasury had no problem coming up with the cash to meet the demands of the CARES act. In fact, from April to June, outlays rose by over $600 billion on top of the $500-billion surge of the Treasury account at the Fed. And, while there definitely were disruptions in the Treasury market, the jump in issuance is not a key suspect (see our earlier post). So, this also does not seem to be the reason.
Putting everything together, the Treasury has been overfunding its spending needs by issuing securities, and then depositing the excess proceeds at the Fed. To accommodate this, the Fed has increased its secondary market purchases of Treasurys. Netting out the Treasury account, the Fed’s balance sheet is $5.6 trillion rather than $7.2 trillion. Moreover, the post-COVID balance sheet expansion was $1.7 trillion, not $3.0 trillion.
Beyond distorting our impression of the size and growth of the Fed’s balance sheet, the expansion of the Treasury account raises several serious concerns. First, it fuels perceptions of monetary finance, or even helicopter money (see our primer). While we support cooperation between the Fed and the Treasury amid a crisis, suggestions that the Fed is directly financing the government foster uncertainty about central bank independence.
Second, we worry that a sudden Treasury withdrawal could become a source of financial disruption. Imagine that the government withdrew and spent $1 trillion over a few weeks—something that is conceivable if Congress were to pass legislation authorizing a sufficiently large additional stimulus. The Fed has two options for how to manage this. First, it could passively let commercial bank reserves rise by the amount of the withdrawal. Doing so would effectively allow the Treasury to induce further quantitative easing, adding to concerns about monetary finance. Second, the Fed could sell Treasury securities into the market to sterilize the impact on commercial bank reserves. However, just as with conventional Treasury debt management, the shorter the time window within which the Fed would have to announce and complete this “re-issuance” of Treasury debt, the greater the risk of market disruption.
A third scenario may be better classified as a nightmare. Imagine the Treasury continues to increase the size of its balances at the Fed, and the Fed invests the proceeds through special purpose vehicles like those they are currently using to purchase corporate bonds. Over time, this would convert the central bank into a combination of a sovereign wealth fund and a state bank. This may seem like a remote possibility, but as the Treasury account grows, so does its potential influence over Fed balance sheet management.
To conclude, the Treasury’s massive balances at the Fed blur the lines between monetary policy and debt management. The uncertainties that this creates are unnecessary and easy to address if the parties explain recent developments. In a joint announcement with the Fed, the Treasury should explain why it is amassing $1.6 trillion in deposits, what it expects to do with the funds, and what effects its actions will have on future debt issuance plans. At the same time, the Fed should clearly state their intention to invest the Treasury account dollar-for-dollar in relatively short-term U.S. Treasury securities regardless of how big or small the balance. By allowing banks and financial markets to prepare for shifts in both the level of reserves and the quantity of Treasury securities they will need to hold, as well as reinforcing the perception of Fed independence, such a disclosure would help ensure long-run stability.
Acknowledgement: We thank our friend Peter Fisher for helping us to understand both the mechanics and the political economy of Federal Reserve and Treasury operations.