Economy

Here's how the Fed's balance sheet expansion that's got the market excited is going to work

Key Points
  • Federal Reserve officials later this month are likely to make a formal announcement about balance sheet expansion.
  • Wall Street estimates that the central bank will buy $250 billion to $330 billion worth of short-term Treasury bills.
  • The move will be an effort to provide ample bank reserves and keep the Fed's benchmark interest rate within its target range.

Investors likely will have to wait a few weeks before finding out how the Federal Reserve will resume its asset purchase program, but Wall Street already is beginning to handicap what it expects — and what to call it.

Key issues will be how ambitious the program will be, and how the market will perceive what the Fed is doing: Is this another attempt at the Fed to start the quantitative easing "money-printing" program to goose a slowing economy, or is it just taking care of business as it did in the days before its unprecedented financial crisis-era efforts to manage growth?

What is already known is that the central bank will be buying hundreds of billions of dollars in short-term Treasury bills, denominated in months rather than years, then crediting banks with reserves at the Fed. The intent will be to find the right amount of reserves to pump into the system and to keep its benchmark funds rate within its target range.

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So operationally, it will look a lot like QE.

But in terms of the end goal, there's a big difference between wanting to rescue a sliding economy and looking to keep interest rates in check and liquidity flowing through the banking system.

"This is not QE or even QE lite," wrote Krishna Guha, head of global policy and central bank strategy for Evercore ISI, though he noted that "the additional flow may still be welcomed by market participants."

"This is night and day with their previous QE attempt," observed Peter Boockvar, chief investment officer at Bleakley Advisory Group, who called the process "just modern day open market operations and nothing more." Boockvar noted that prior to the financial crisis, the Fed's balance sheet generally expanded about in step with GDP growth, so this process shouldn't be much different.

From QE to SOAP

Ultimately, what the operation is called will matter less than how it is executed and communicated.

"In some sense it doesn't matter why they're doing it or what they call it. What matters is that they are creating base money and expanding their balance sheet, and those repercussions aren't going to depend on what they call it," George Selgin, senior fellow and director of the libertarian Cato Institute's Center for Monetary and Financial Alternatives, said in an interview.

"There is an important issue of public perception here," he continued. "I suppose calling it QE would give people the impression that the Fed is fighting a recession again, or thinks it is fighting a recession again, and trying to create a positive stimulus for the economy. Neither of these things is true. Their concern is trying to avoid the cash shortages that are causing rates to rise above their target."

Indeed, the talk of balance sheet expansion has accelerated over the past month, since the mid-September cash crunch in overnight lending markets caused a spike in very short-term rates and the Fed's own benchmark funds rate to climb above its target rate by 5 basis point.

However, the issue has been popping up periodically since last year when the funds rate started to edge near its upper border. The Fed made a couple "technical adjustments" to the interest rate it pays on bank reserves stored at the central bank, but that was not enough to address the issue completely.

Selgin, in fact, coined his own term for what is ahead: "Supplementary Organic Asset Purchases," or SOAP. Fed officials have stressed the "organic" nature of balance sheet growth as opposed to QE.

Expansion estimates vary

Fed Chairman Jerome Powell's announcement Tuesday that the Fed would begin expanding the balance sheet has triggered a round of speculation as to how ambitious the program might be.

Morgan Stanley estimates that the Fed will purchase up to $330 billion in Treasury bills over the next six months, and will add $15 billion a month thereafter as it looks to determine the proper level of reserves. Strategist Kelcie Gerson wrote that the "optimal" level of reserves is likely around $1.45 trillion, though that will be a "much more of a moving and opaque target."

That total would actually be somewhat below the current $1.52 trillion in reserves, though the Fed's emergency repo operations since the September funding shortage have added $179 billion.

Getting the number right, and communicating the strategy, will be tricky, Gerson said, adding that there could be a bout of market volatility on Oct. 30 between the time the New York Fed likely makes a formal announcement at 2 p.m. ET following the scheduled Federal Open Market Committee meeting, and when Powell holds a news conference 30 minutes later explaining the Fed's moves.

"Despite the fact that the size and intention of the Fed purchases would not be in line with those of a QE program, we do believe the market could interpret it as such," Gerson said.

In a public appearance Tuesday, Powell emphasized that this "in no sense is this QE."

Selgin said he anticipates that the T-bill purchases will be closer to $250 billion, a number also mentioned by Steve Blitz, chief U.S. economist at TS Lombard, who noted that the market may not believe Powell that this is not QE. Instead, the market will read "this for what it is (ease) and bill yields [would] drop below the two-year note," meaning that "perhaps some planned rate cuts won't happen – all else being equal."

The September meeting minutes, in fact, pointed out that some members felt the market was getting ahead of itself in terms of rate-cut expectations.

It's conceivable, at least, that the Fed skips the anticipated rate cut at the October meeting and instead keeps the focus on the balance sheet and its efforts to make sure liquidity and reserves are ample.

"The Fed is learning that it's not so easy as they thought to keep the banking system as a whole flush with reserves," Selgin said. "We may end up seeing SOAP 1, SOAP 2 or SOAP 3."

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