Here we provide numerical estimates of the size and composition of a normalized balance sheet, based on the framework presented in an earlier commentary [link].1 We also include a link to an Excel spreadsheet so that you can see the assumptions we have made in estimating the size of the hypothetical normalized balance sheet in 2017 and 2023 as well as replace our assumptions with your own [link].
FOMC participants have indicated that they would like to continue to implement policy in an operating framework like the current one, in which the policy rate—which we will assume will continue to be the fed funds rate—is managed in a narrow range between the interest rate paid on reserves (IOER rate) and the overnight reverse repo rate (ON RRP rate), both of which are set by the Fed. They have noted that the balance sheet, when normalized, could be “much smaller” than today, but would likely need to be “at least somewhat larger than in the years before the financial crisis, reflecting trend growth of balance sheet items such as currency as well as a larger supply of reserves.”
In Table 1 we present our estimates of two normalized balance sheets: a hypothetical balance sheet if we were at a normalized balance sheet today and a balance sheet when we assume it will actually be normalized, in 2023.
The Pre-Crisis Balance Sheet
In column 1 of Table 1, we show the pre-crisis balance sheet, taken to be the balance sheet in early 2007 before it grew sharply as a result of both the emergency facilities introduced during the financial crisis and the various asset purchase programs that followed. The balance sheet at that time was smaller than $900 billion. For our purposes, the important features of the pre-crisis period are the very low level of reserves―just $16 billion―and the absence of overnight reverse repos. The low level of reserves allowed the New York Fed to hit the target funds rate by making small adjustments to the level of reserves, while the overnight reverse repos were introduced as part of the current floor system for managing the fund’s rate.
The Adjustments to the Pre-Crisis Balance Sheet
The consensus among participants appears to be that they want to remain in an operating regime where active management of reserves is not necessary and that this will require a balance sheet that is “at least somewhat larger” than the pre-crisis balance sheet because of “trend growth of balance sheet items such as currency as well as a larger supply of reserves.” While participants recognize that the normalized balance sheet will be larger than before, they appear to want to shrink it as much as possible. We focus initially on the liability side of the balance sheet because that’s where the critical items are, such as currency and reserves, and make adjustments to the pre-crisis balance sheet consistent with participants’ guidance.
1 This commentary is a joint product of Jonathan Wright, a senior adviser to LH Meyer, and the LH Meyer team.
The currency will be whatever the public demands. The level of reserves will be what the Committee believes is necessary to operate in the current regime. The adjustments must also take into account the presence of overnight reverse repos on the balance sheet. The Fed will then adjust its asset holdings to reach the size balance sheet necessary to accommodate the liability side of the balance sheet.
Composition of Asset Holdings: We expect that the normalized balance sheet will contain only Treasuries and no MBS.
Currency: We simply use the current actual amount of currency outstanding in our hypothetical 2017 balance sheet. We assume currency outstanding grows at the projected rate of growth of nominal income through 2023.2
Reserves: The adjustment for the supply of reserves is not as straightforward. In our previous commentary, we explained that we initially looked at the actual level of reserves in December 2008 when the Committee was transitioning to the new operating regime as the minimum level for operating in that regime. The level of reserves at that time was about $800 billion. However, markets were very stressed at that point, likely increasing the demand for excess reserves. So we assume that, in the absence of that greater stress, the level of reserves that would have satiated demand in December 2008 would have been lower, $500 billion. We assume that the target level of reserves in the normalized balance sheet—again, the amount that would just let the FOMC continue to implement policy in the current operating regime—grew from the late-2008
2 This is the conventional assumption. However, currency grew at close to a 7% rate from 2007 through 2016, likely in part a consequence of faster growth in currency held abroad.
base through 2017 at the rate of growth of nominal income. Then we assume it will grow at the projected rate of growth of nominal income, roughly 4%, from 2017 through 2023.3
Treasury General Account: The size of the Treasury General Account (TGA) varies considerably. In March 2007, it was only $5 billion. It increased to $71 billion in March 2017. However, it has been much larger than that in recent years, averaging about $150 billion in 2015 and $300 billion in 2016. We assume the size of the TGA is $150 billion in our hypothetical 2017 normalized balance sheet, in line with the most recently announced Treasury policy.4 We assume it increases at the projected rate of growth of nominal GDP through 2023.
Reverse Repos: There are two kinds of reverse repos on the balance sheet today: reverse repos associated with a standing facility for foreign official and international accounts and those with the overnight reverse repo (ON RRP) facility. Looking back to the pre-crisis balance sheet, in March 2007, foreign and official reverse repos totaled only $38 billion, and there were no overnight reverse repos yet.
The key assumption about the treatment of overnight reverse repos in the normalized balance sheet in 2017, as we discussed in more detail in our earlier commentary, is that their size is independent of the target level of reserves. So one of our adjustments will be just to add them to the pre-crisis balance sheet. There was about $220 billion of ON RRPs on the Fed’s balance sheet in March 2017, but we judged that its underlying level, based on the averages in 2015 and 2016, was lower, and therefore use $150 billion as the level in the hypothetical 2017 balance sheet. We then assume it grows at the rate of growth of nominal income through 2023.
There was also about $250 billion of reverse repos for foreign official and international accounts on the balance sheet in March 2017. But we used $150 billion in the hypothetical normalized balance sheet because we judged that was more representative of its underlying level. Again we assume that grows at a 4% rate through 2023.5
Other liabilities: The other liabilities on the Fed’s balance sheet are principally other non-reserve deposits held at the Fed, including by GSEs and foreign official and international institutions. These liabilities totaled only $6 billion in March 2007 but totaled $81 billion in March 2017. The Fed’s other non-reserve deposits category, which makes up most of our other liabilities item, has grown over the last couple of years, and in March was about $25 billion larger than its average in 2016. So for the March 2017 hypothetical balance
3In the annual report on Domestic Open Market Operations in 2016, the New York Fed presents a simulation of a progression to a normalized balance sheet. The report states: “In the absence of more specific guidance, the baseline scenario in this projection exercise assumes a long-run level of $500 billion in reserve balances—a level that falls within a range of estimates amid uncertainty about the future operating framework and demand for reserve balances.” We made an explicit assumption about the long-run operating framework, that it is similar to the current one, which leads us to estimate a higher level of reserves in a normalized balance sheet. The simulation assumes, based on the median of a survey of primary dealers, that the balance sheet will be normalized by 2021. The simulation projects that the size of the normalized balance sheet in 2021 is $2.8 trillion.
4 Treasury policy (adjusted in May 2015) is that it will hold a “level of cash sufficient to cover one week’s outflow, subject to a minimum balance of roughly $150 billion.”
5 As we noted in our earlier commentary, the FOMC might be uncomfortable with a very large normalized balance sheet, and, were this the case, the Fed could take steps to reduce its size. One part of the balance sheet that might be most amenable to managing might be the size of reverse repos. The FOMC could, for example, limit the usage of reverse repos by setting binding caps. Foreign official usage is at the discretion of the Fed and could certainly be managed lower. However, given that the underlying levels assumed in the hypothetical normalized balance sheet in 2017 are much lower than actual recent levels, we did not make any further downward adjustment.
the sheet we mark down other liabilities by that amount and then assume growth at the rate of growth of nominal income.
These assumptions leave our estimate of the hypothetical normalized balance sheet in 2017 at $2.7 trillion. Our estimate of the size of the normalized balance sheet in 2023 is $3.4 trillion. Note, however, the high degree of uncertainty surrounding our predictions, especially about the target level of reserves. Ultimately, the size of the normalized balance sheet will depend to a significant extent on the experience of the FOMC in implementing policy as it allows the balance sheet to shrink.
How We Get From Here to There
Our next commentary on balance sheet-related topics will look at how the FOMC might get to its normalized balance sheet. We will set out a couple of scenarios, each of which will have a different date at which the balance sheet is normalized. One scenario is shrinking the balance sheet by runoff and prepayments alone. The other includes MBS sales after the fund’s rate is normalized. Given that we estimate that the level of Treasuries in the normalized balance sheet will be greater than today, the FOMC must resume Treasury purchases at some point.
An Excel Spreadsheet Balance Sheet Calculator
We include a simple Excel spreadsheet that incorporates our assumptions about the adjusted pre-crisis balance sheet, the hypothetical normalized balance sheet in 2017, and the normalized balance sheet in 2023 [link]. You can change the assumptions, for example, about the base level of reserves in December 2008, the rate of growth of currency, and the level of reverse repos in the normalized balance sheets.