The Federal Reserve began to consider just how far its balance sheet consolidation should go well before the tapering actually began nearly a year ago. Earlier staff analyses pointed to a gradual runoff of long-term debt that could take years to reduce Fed assets to a new long-run equilibrium. More recently, market observers have speculated about an early end to consolidation that would result in a higher steady-state level.
Yet, as a recent Wall Street Journal article highlights, policymakers and analysts have devoted less attention to the mix of assets that the Fed should select once the balance sheet shrinks to its long-run equilibrium and policymakers allow it to expand slowly—say, in line with the increase of demand for currency.
In this post, we argue that the Fed should aim in normal times—when the economy is expanding and absent any financial strains—for a portfolio that has minimal liquidity, maturity and credit risk. In practical terms, this means that their portfolio should be composed largely of Treasury bills and short-term notes, with an average maturity that is very short….
Changes in financial regulation are having a profound impact on the demand for safe assets—assets with a fixed nominal value that may be converted at all times without loss into the means of payment. Not only is demand for safe assets on the rise, but the ability of the private sector to produce them is being constrained by new rules that limit the extent and nature of things like securitizations.
So far, the fallout from increased demand and constrained supply looks reasonably benign. But for several years now, broad financial conditions have been very calm, with measures of financial volatility and stress at or near long-term lows. What will happen when the financial system comes under stress again? What if there is a drop in risk tolerance (or a surge in risk awareness) and a flight to safety that causes a jump in the demand for safe assets or a plunge in the supply? Or, as in 2008, what will happen if both materialize at the same time? We need to be ready.
As we will explain in more detail, central banks in advanced economies can satisfy the heightened need for safe assets under stress (as well as the precautionary demand in normal times) by offering commercial banks committed lines of credit for a fee against collateral, as the central banks in Australia and South Africa currently do. In our view, this mechanism for ensuring sufficient supply of safe assets in a crisis has important advantages compared to one in which the central bank operates perpetually—in good times and bad—with a very large balance sheet.
To see how this would work, we start with an explanation of post-crisis liquidity regulation....
