How does the Fed remove money?

Discussion in 'Economics' started by Spaghetti Code, Dec 17, 2021.

  1. Tl; Dr: How can the Fed raise interest rates if it has no assets on its balance sheet?

    The Fed sets the Federal Funds Rate, which is the amount it wants banks to lend money to each other. If the banks lend at too high of a rate, the Fed can increase the money supply, and then use that money to buy treasuries. This gives money to the open market, and lowers the yield on treasuries, which effectively makes it cheaper borrow. Because the risk/reward trade off is worse for treasuries, other participants now prefer other assets, and buy those instead. (or, short sell the treasuries to get cash). Money enters the market.

    When it comes time to raise interest rates, how does it work? My understanding is that the Fed can sell the treasuries and other assets back to the market at a non-competitive rate. If the Fed sells it's treasuries for a much lower value than par, it increases the yield on the bonds. The cash the Fed gets can then be destroyed, once the assets have been take off its balance sheet. But, what happens if the Fed has nothing on it's balance sheet?

    Since the Fed can't print more treasuries, it isn't clear how they can move the effective federal funds rate. If banks want to lend to each other for cheaper than the Fed wants, it would no longer have the ammo to nudge banks into raising rates. Also, in march 2020, The Fed also stopped enforcing the fractional reserve balance, lowering the requirement to 0.

    It seems like the Fed would _have_ to increase the balance sheet a lot, and _then_ raise interest rates, because otherwise it would have no way to actually cause the market to move to higher rates.
  2. I am not a Fed expert. See @piezoe for that.

    But why can't it sell whatever it has on its balance sheet? You're saying banks would want to lend to each other lower than what they could get as treasury yield in the market when Fed dumps treasuries? Why? That makes no sense to me.
  3. The Fed has a balance sheet lol and is sitting on trillions of assets it has purchased through QE and policy from the Covid disruption.

    Fed raises rates by increasing the fed funds rate which influences the overnight rate banks lend to each other (LIBOR and soon to be SOFR).

    When the Fed injects liquidity in the market, it literally creates reserves (Fed currency) out of this air and then trades those reserves to dealer banks in exchange for specific types of securities (Treasuries and others). The Fed removes excess liquidity in two ways — it was trade the securities it holds back to dealer banks (tightening), or it can let the securities mature and then just delete the cash amount (e.g. a 100m bond matures and pays out the 100m in cash, Fed collects the 100m from the bond and then deletes it). This is called a balance sheet run off.

    The right now is decreasing it’s asset purchasing (“tapering”) and will then let securities mature (and delete) a la balance sheet run off. It’s also expected to raise rates 3x next year at 0.25% each hike.
    ElCubano likes this.
  4. ElCubano


    I enjoy reading all your posts. A world of knowledge thanks.
    longandshort likes this.
  5. Thank you! Just realized all sorts of typos (wrote the post from my phone lol)
  6. This is kinda where I'm confused: It doesn't seem possible to raise the rates without having a huge balance sheet. For example, in 2007, with a much smaller balance sheet, it wouldn't have been possible for them to raise rates. Right now, sure, there are tons of assets to sell or let mature. But now it seems like the (secondary) purpose of buying the assets back in 2020 _was so that_ they could use them to raise rates later.

    Phrased differently: if they had a very small balance sheet (today), how could they raise rates?
  7. All they need to do to raise rates is to increase the "fed funds rate" which is the interest rate a bank would pay for overnight Fed lending. This rate influences short-term interest rates like SOFR (secured overnight financing rate) and LIBOR (london interbank overnight rate).

    That's it. That's how the Fed "raises" rates. It simply raises the rate it charges to banks. (No bank uses the Fed Funds Rate, as they instead use SOFR or LIBOR, but trillions of dollars are tied to SOFR and LIBOR since they are reference rates on which most financial products trade on).
    ipatent likes this.
  8. easymon1


    'Invest' it in politicians who know how to make it 'disappear'.
  9. Suppose the Fed raised the FFR to 20%. No bank would bother borrowing from the Fed, and instead borrow from any of the other banks. The EFFR wouldn't really move, since the Fed can't force banks to borrow at that rate. I realize that the Fed is made up of banks, but lets say that one of the larger banks disagrees with the chosen FFR.

    From my reading, LIBOR is on its way out, and SOFR is a backwards looking, market rate. Only market participants can move SOFR, correct? If the Fed has no assets on the balance sheet, it can't be a participant.
  10. If the Fed runs out of treasuries, it can't dump them. I don't think (and would be amazed if) the Fed could short treasuries.
    #10     Dec 17, 2021