Email of the day on Fed balance sheet contraction and liquidity
Comment of the Day

December 21 2018

Commentary by Eoin Treacy

Email of the day on Fed balance sheet contraction and liquidity

I understand the problem about reducing the FED balance sheet and raising rates at the same time.

The impact on liquidity is however less intuitive to me. While the effect of interest rate hikes is clearer, the effect of a Balance Sheet reduction is less so.

Am I wrong to assume that what technically happens when the FED reduces i.e. sell bonds is that the private sector, through the banking system, receives these bonds? In exchange banks reduce the account balance that they hold at FED.

If banks get Treasuries in their book, they also receive more interest income (coupons) that goes into the system. This money was blocked in the book of the FED until then.

Why is this necessary bad?

Eoin Treacy's view

Thanks for this question which I’m sure others have an interest in. Since the financial crisis banks have been paid interest on the excess reserves, they hold at the Fed. Against an uncertain environment in the real world they therefore had an incentive to park vast sums at the Fed. In return they received interest income on that money in line with the Fed’s Funds rate. 

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