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Brian Sack on the Fed’s Balance Sheet and How to Improve the Floor Operating System
By making a few tweaks to the Overnight Reverse Repo Facility, the Fed could greatly improve the functioning of its current operating system.
Brian Sack was recently the Director of Global Economics at the D.E. Shaw Group, and prior to that, he was the manager of the System Open Market Account or SOMA and the head of the Markets Group at the New York Federal Reserve bank, where he managed the Fed’s balance sheet. Brian joins Macro Musings to talk about the central bank’s balance sheet, its operating system, and his work at the Treasury Borrowing Advisory Committee. Specifically, David and Brian discuss the current state of the Fed’s balance sheet, Brian’s theory of QE, how to improve the effectiveness of the floor system, and a lot more.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Brian, welcome to the show.
Brian Sack: Thank you. Thank you very much for having me. I enjoy your show, so it's a real pleasure to be here.
Beckworth: Well, it's a real honor to have you on. I've had some of your former colleagues and current friends on the show, so it was only a matter of time until I got you on the show, Brian.
Sack: That may say something about your show or something about my friends. I'm not sure which.
Beckworth: No, you run in great circles. So, in fact, I've had one of your close friends, Joe Gagnon, on several times. I believe one of the papers you guys co-authored together we talked about, so he had a paper on QE and I think he threw in nominal GDP targeting, which made me very happy. He brought that together in a show some time ago. So, in fact, we'll talk about a paper that you and Joe have written on the Fed's operating system later in the show, so I'm excited to chat about that as well. But Brian, you've had a very interesting career, a storied career at the Fed. You went from the Board of Governors to the New York Fed. As I mentioned in the introduction, you managed the Fed's balance sheet and then you went to Wall Street. Walk us through your career and tell us how it unfolded.
Breaking Down Brian’s Career
Sack: As you noted, I started my career at the Federal Reserve Board down at DC. I mean, I think in general, I've just been very fortunate on my career path to have had very interesting and unique positions inside the Federal Reserve system and then to have worked at a couple of tremendous firms outside the Fed in places that just let me continue to think about policy issues. So, the Federal Reserve Board was a great place to start a career. I had tremendous colleagues there, several great bosses including Don Kohn who went on to become Vice Chair of the Fed. I think it was just a great place for learning how to think about policy issues very carefully and very deeply with lots of analytical support. That was really the foundation for everything that came next. In about 2004, I was at the Board for seven years, and then in 2004, I was pulled away to a firm called Macroeconomic Advisers. There, I worked with Larry Meyer who had been a governor at the Federal Reserve Board. What we did there was a lot of economic and interest rate forecasting for financial sector clients. So, it didn't take me very far from the policy world, but it certainly had a different focus. Larry was another great mentor of mine, just really taught me how to be directional in my thinking. No one wanted to pay for a service where you'd have a two-handed economist not making any forecasts. So, that's really what I learned there was how to be directional. Then the financial crisis came and I was pulled back into the New York Fed, as you noted.
Sack: At the New York Fed, the situation there was, Bill Dudley was the head of the Markets Group as the financial crisis unfolded. So, he was there through 2008, through the tensions in the market in 2008, and the situation after Lehman. As you know, Bill Dudley then was elevated to become the President of the New York Fed and got in touch with me and asked me if I would consider applying for the Markets Group job. This was a tremendously important position on the Fed staff, tremendously demanding as well at that time, but tremendously important because it was very involved in helping policymakers navigate through this very challenging policy situation. The Markets Group was at the center of it all. We were the primary connection of the FOMC to financial markets. We had to provide financial market expertise, financial market updates to them. But operationally, it was also very demanding. We were running six of the eight liquidity facilities that had been launched during the financial crisis, and we were conducting the large scale asset purchases in Treasuries and MBS securities. That was the first time, of course, that the Fed was doing these asset purchases in such large scale and with a very different purpose. So, this was really focused on the creation of a new policy instrument in terms of QE and figuring out how it worked, how to implement it, and all the issues associated with it. So, it's really a tremendous period of policy innovation, and it was great to be a part of that.
Beckworth: Well, let me go back to your earlier career at the Federal Reserve. You're at the Board of Governors. You're an economist there. If I recall correctly, the first time I saw your name was on a paper I think I read, you and Ben Bernanke, maybe someone else, you had a paper that you wrote with him. Is that right?
Sack: Yes, with Vincent Reinhart as well. Yeah, I was very fortunate to be able to work on that. That was a paper looking at the policy options that central banks have when interest rates get pressed up against the lower bound. This was written in 2003 and 2004. Interest rates weren't at the lower bound. So, this was really looking ahead at a risk scenario and trying to answer the question of, "Does a central bank still have tools in that situation?" So, the fact that we ended up there and we ended up there with Ben Bernanke as the Chairman of the Fed, was quite interesting for me, and I'd been thinking about those sorts of issues for a long time dating back to that paper.
Beckworth: That was an interesting paper. I remember during that time, we had Japan in our minds from the late 1990s. If I recall correctly, 2003, 2004, there was disinflation occurring and I remember I believe the FOMC was talking about the prospects of deflation eventually emerging. So, the context was very ripe for your paper at that time. So, you mentioned that eventually you went on to the New York Fed after being at Macroeconomic Advisers. Did your previous time at the Fed help that work there? Did you know people, have contacts in place that facilitated your work managing the Fed's balance sheet?
Sack: Yeah, absolutely. That's true on the staff level and also on the policymaker level. So, the New York Fed works very closely with the Board of Governors in Washington, D.C. and really with people throughout the Federal Reserve system on all of these issues. There was tremendous interaction in particular between the Markets Group that I was running in New York and the Division of Monetary Affairs at the Board. So, having those relationships and knowing the key staff members there certainly was useful. It was an extremely collaborative environment. I mean there was plenty of work to go around. Basically, we had particular expertise in terms of operational issues and interacting with markets; the Board had particular expertise in terms of analytical thinking and modeling. And it turned out to just be a great combination. If you look at many of the memos and briefings done over that period, you'll often see names on them from both Markets Group and Monetary Affairs and other parts of the New York Fed and the Board of Governors.
Sack: But then in addition to all of that, I did have a connection to the key policy makers on the FOMC. So, Ben Bernanke was chair and I had interacted with him over the years and had written the paper that you mentioned. Don Kohn was Vice Chair and he had been a boss of mine previously and someone I was very close to and interacted with extensively. Then Bill Dudley recruited me or asked me to apply and go into the process of applying for that position. The reason is, I'd had a long relationship with him just through various channels, being in similar circles, and just had tremendous respect for him. So, these three policymakers who could be considered the center of the FOMC, I had great relationships with all of them and tremendous respect for each of them as policymakers.
Beckworth: Well, that's interesting. I should note that Don Kohn is a previous guest of the podcast and I had him on, very interesting person. We talked with him. He mentioned he started way back in the '70s and he was there when Paul Volcker was there. Paul Volcker did his work on bringing inflation down and he was part of the team back then. Don mentioned that he used to go around the country, give talks when they had rates really, really high. So, Don has seen a lot and that's fantastic you got to work under him.
Sack: Then, in addition to them, in 2010, Don stepped down and retired from the board and then Janet Yellen moved in as Vice Chair. Again, very much fit that same mold as someone I was comfortable with and knew and really enjoyed working with. That's the troika, right? So, you've heard the so-called troika of the FOMC. The troika is those three groups of policymakers: chair, vice chair, and president of the New York Fed. Essentially, there's just a considerable amount of policy discussion that takes place between the troika in-between FOMC meetings. Obviously, the policy decisions are made at the FOMC meeting and they're a committee decision; but in terms of potential directions for policy and what will be put forward in the meeting and really what the leanings of that core of the committee are, for that, there was quite a bit of discussion taking place between meetings in this so-called troika process. So, that was a real treat to be part of that as a staff member because these were very interactive discussions. We got to have a lot of input.
Beckworth: Yeah. So, you were there during some historical moments that you mentioned, the QE programs. You came in, I believe, at QE 1, you were there for QE 2, the maturity extension program, laid the groundwork for QE 3. So, a couple of questions surrounding those historic changes at the Fed. Number one, did your group expand dramatically? I mean, were there a lot of changes happening at the staff level to accommodate these new innovations? Then secondly, during this time, there was a lot of commentary outside the Fed, like, “Oh, the Fed's doing QE. What are they thinking? We're going to have hyperinflation.” I mean, on the inside, you've got to just do your job, keep your mouth shut. I asked this question to Bill English when he was on the podcast. Did it ever get frustrating seeing all of this commentary from the outside and you knew better? You knew this is not going to happen. This is actually a response that's reasonable given all the context of what's happening.
Sack: Yes, I mean it was in some ways. So, to go back to your first question, the demands on the staff, I mean throughout the system, but I had obviously the direct look at the Markets Group, the demands in the Markets Group were tremendous. We did grow in size. I think at one point, we were above 410 people in the Markets Group, which sounds like quite a lot. But when you think about the responsibilities that we had, I really think we could have used a lot more staff, to be honest. So, I mentioned we were running a number of liquidity facilities. We were buying securities on a scale that had not been seen. All of these operational procedures, they have many, many dimensions that you have to consider - technology dimensions, reporting dimensions, accounting dimensions, resiliency dimensions. So, it really took quite an effort just from an operational perspective to push all of this forward. At the same time, the demand for analysis and market information and market intelligence was of course extremely high. So, I think the staff really did heroic work over that period. I think they've done it a few more times since then. It's really just a testament to how dedicated they are and how hard they work. The blowback was frustrating to me personally. I can't speak for others or for policymakers, but for me personally, it was.
Sack: So, I was there, as you said, at the tail end of QE 1, but I was actually there for the majority of QE 1. QE 1 was a long program, especially after it was extended in March 2009. It continued into 2010. To me, the first part of QE 1 was very much about market functioning, but the rest of it was about the economy. It was about providing accommodation. So, roughly, let's say a third market functioning and then the other two thirds, policy accommodation. So, when we got to the need for QE 2 and there was a decision to do QE 2, I naturally saw it as an extension of what had been previously done and by then was convinced that this was a tool that it was imperfect but had productive effects in terms of helping the FOMC meet its macroeconomic mandate.
Sack: But the blowback at QE 2 was dramatic and sharp. It came from the academic community, it came from politicians, it came from market practitioners. There was just tremendous confusion on how QE works and what its effects might be. QE 1, even though I think two-thirds of it was about macroeconomic policy and getting the right policy accommodation, I think people just associated that as, "Oh, that was a crisis program." So, when we got to QE 2 and decided we're going to use this instrument, or when the FOMC decided it's going to use this instrument in a more regular way, that's when the blowback seemed to come. And the blowback ended up being very wrong. Most of the blowback was, this is highly inflationary, you're going to destabilize the dollar, going to cause extremely high levels of inflation. It just was not how we saw QE working on the staff level. I think, ultimately, the criticism proved incorrect.
Beckworth: Yeah. An amazing time for you to be at the Fed working on its balance sheet, going through those issues. Now after that, you transitioned to D.E. Shaw Group. Tell us about that briefly.
Sack: As you mentioned, I was Director of Global Economics for the D.E. Shaw Group and sat in the firm's discretionary macro team. D.E. Shaw is a great firm. It's obviously a global investment and technology firm. My role there was to help the macro team look for investment opportunities that were based on economic views and importantly on perceived market inefficiencies within an asset class or across asset classes. Maybe what's interesting about that is the work had many similarities to my previous policy work, in the sense that I was still applying empirical analysis and critical thinking to understanding what economic and policy factors were driving asset prices and to assessing how they may evolve going forward. It had a different purpose and that different purpose added new dimensions compared to my earlier work, but the underlying foundation and approach had a lot of similarities. So, I found that transition from policy work to investment work to be very natural and really had a great term, from my perspective, at D.E. Shaw.
Beckworth: One other thing you did while you were at D.E. Shaw, and recently completed, was a term on the Treasury Borrowing Advisory Committee or TBAC. We're going to return to this later in the program, but briefly tell our listeners what does that committee do?
Sack: Okay, so the TBAC is a set of private market participants from leading financial firms that advises the US Treasury on debt management decisions. I served on it for eight years, through August of 2022, with the past couple years as vice chair. So, what happens in that group is it goes down to DC four times a year around the quarterly refunding announcements. It goes into essentially a 24-hour period where it meets with the Treasury and has a lot of discussions about debt management decisions. This is both about what should Treasury issue in the near term, but then also broader debt management questions about introducing new securities or how to think about the optimal structure of the debt and so on.
Sack: It is an advisory committee. All of those decisions reside with the Treasury completely, and the Treasury has a great staff dedicated to this area. But they look to this group for input from a group of people involved in the markets who can bring useful information into that process. It's a period of you go down there, you get sequestered actually for 24 hours. So, you're not allowed to talk to your firm. You're not allowed to talk to anyone professionally. So, it's quite a commitment by these members to participate in that, but I think we all saw it as very rewarding work, and work that really matters. It really matters in terms of minimizing the cost of the debt to the government and ensuring that the government has adequate and efficient capacity to fund itself. So, it was very important, and it was great to be able to play that role.
Beckworth: Yeah, that's a fascinating committee and one that's not understood well enough or appreciated well enough. The debt maturity structure of our federal debt, you guys helped shape that. The Treasury has to be informed, what does the market want and you're there to provide that information. There are reports that are online. I've gone back and looked at a few of them, including some of yours. We'll talk about one later and I would love to go back because I'm thinking about it now, go back and look at one where TIPS was first introduced in the late '90s. I'm sure there was some discussion surrounding those and the demand for those as well. Well, let's move on to the current situation since I have a Fed balance sheet expert with me. I want to talk about where we are today. As you know, the Fed started a tightening cycle with nearly $9 trillion of assets on its balance sheet. How do we get to this situation and what does it mean for the Fed going forward?
The Current State of the Fed’s Balance Sheet and Brian’s Theory of QE
Sack: So, of course we got to this situation because the Fed did a massive QE program in the wake of the COVID crisis. I mean, the government and the Fed launched a variety of programs after COVID, but it was the asset purchases that really boosted the Fed's balance sheet in a persistent manner. So, that asset purchase program, which I'll refer to as QE 4, that program ended up purchasing $4.6 trillion in Treasury securities and mortgage backed securities. That's much larger than any of the earlier waves of QE that were implemented after the global financial crisis. What drove that size? Well, I think there were really two issues.
Sack: One was the considerable strains in markets that we saw in 2020. You've had previous guests on who have discussed those in great detail, so I won't go through that. But the short version is the purchases ended up having to be very aggressive given the size of the pressure we were seeing in the markets and this incredible need by investors to liquidate their holdings of those securities and other securities given the uncertainties in the outlook. So, the FOMC instructed the desk to buy securities as needed to restore market function and that just ended up being a very large number. I mean there were periods of time when the New York Fed desk was buying $100 billion a day on average over periods of time.
Sack: I think if you look at it, it's a little bit hard to parse how much of the 4.6 trillion was market functioning related, but I think a reasonable guess is two and a half to three of it or something like that was directly aimed at market functioning. So, then the rest of it was what we could call regular QE. I mentioned this before in terms of the last two thirds of QE 1. The market functioning was in better balance, but the FOMC decided that it just wanted to make financial conditions more accommodative and more supportive of growth. So, it continued the QE program of course thereafter. I think that accounts for the remaining $2 trillion or nearly $2 trillion of that program.
Sack: Was that all overdone? I mean, I think it was probably a little bit larger than it needed to be. By a little bit, we're talking like a trillion dollars or something. Basically, the market functioning purchases had to be surprisingly large, but I think that part was necessary. I think the regular QE in the end continued too long. By the second half of 2021, I don't think an assessment of the economic situation and thinking in terms of a policy rule, I think it would be hard to find a policy rule that would've suggested that we needed to keep easing into early 2022. So, we probably went a little bit further, but even if they had stopped earlier, it wouldn't have mattered. We would have been in the same situation of coming up to this tightening cycle with a very large balance sheet and with a ton of liquidity in the system. So, that's how we got to that point.
Beckworth: So, what is your theory on QE? I've had a number of people on the show before. How does QE make a difference? How does it work? Particularly once you get out of these market supporting periods, you're outside of 2020, you're into 2021. You're outside of 2009, you're moving forward into just the QE 2 type programs. How does it work? I bring that up because I've had guests on the show who think it does very little. They invoke a form of Wallace neutrality and I have others who say, "Man, it really does do a lot." So where do you come down on that and what is your theory for it?
Sack: I think QE works. Well, first of all, during periods of market stress, QE works in different ways, and I think we can all agree to that. It can be most potent when it's operating in impaired markets and restoring market function. The harder issue is beyond that, what does it do? My view is QE does have effects. It does have effects on financial conditions. It does help to lower long-term interest rates and make financial conditions more accommodative. It's not as potent as the traditional policy instrument, the short-term interest rate, but that's consistent with how the Fed uses it. The Fed uses its short-term interest rates actively when it can, and QE is reserved for those situations where short-term interest rates are constrained by the lower bound and more has to be done.
Sack: I see those effects as associated with the overall size of the balance sheet rather than the monthly flow. I think that's conventional wisdom inside the Federal Reserve system as well. We've been doing QE for 15 years across a number of central banks, so we have a decent amount of evidence at this point suggesting that these balance sheet sizes do have some beneficial effects on financial conditions. That's my general view of QE. It actually brings me to a point though. If we think the effects of QE are associated with the size of the balance sheet and not the flow, I do think it's a little puzzling that we've been implementing QE, at least since QE 3, expressed in terms of this monthly flow of purchases. If we think the effect is associated with the size of the balance sheet, then we can think of the size of the balance sheet the same way we think of the level of the funds rate. The degree of accommodation is associated with that. When we think about policy, then it makes sense to have a target for the size of the balance sheet. So, when conditions weaken, you want to expand the balance sheet, but I feel like there should be a target size. Even if you're getting there in a monthly flow, you should be heading to some set, stated size, which is how QE 1, QE 2, and the maturity extension program all operated. They all had particular sizes: 1.75, 600, and 667 billion. Those were the three sizes for those programs
Sack: It was only when we got to QE 3 when we got to open-ended, we're going to purchase at this pace and we're not going to tell you how long it's going to go. So, just reflecting on that, and maybe this is an aside for this conversation, but I do wonder if that contributed to running QE longer than was really needed - in the sense that to change the flow, if the situation remains unchanged, well, in the one case, you're aiming for a size and you get to the size and you stop; in the other case, you're in his monthly flow and it has to be an active decision to change that and stop. I wonder if we're implementing QE in the right form as we did QE 3 and QE 4 and whether a form with an actual target size of the balance sheet might be better.
Beckworth: How would you determine the optimal size of the balance sheet? How would you set that target?
Sack: Yeah, so roughly speaking and this is not easy to do in practice, but I think you want to use some rule of thumb or some estimate for how the size of the balance sheet affects long-term interest rates, think about that in terms of a funds rate equivalent, and then just put that in a standard type of policy rule that you would expect for short-term interest rates. That's going to depend on your parameters, but again, if you do that exercise, I think the asset purchases through the middle of 2021 made great sense. The funds rate should have been well below zero. It couldn't be because of the lower bound, so you make it up with asset purchases. You can only purchase at a particular pace, so it takes you time to get to the target level. But when I do those exercises under that approach, it suggests by the second half of 2021, you would have gotten the balance sheet big enough. The balance sheet was very big by that point and there was not a compelling case to keep expanding it at that point.
Beckworth: Now, when we think about the size of the balance sheet, should we think about it in terms of absolute dollar size or relative to, say, GDP?
Sack: I mean, this is really getting into the details, but I think of it as 10-year equivalents, which is a way of adjusting for the duration of what you're buying, as a share of GDP.
Beckworth: Okay. So, in some ways then, the large balance sheet takes care of itself, because over time, GDP will grow and the size of it will shrink relative to GDP. So, my last question on the balance sheet was this: do we need to shrink the balance sheet to get the powder dry for the next crisis or can we stay with what we have and just keep it stable but have it shrink relative to GDP?
Sack: I think you need to shrink the balance sheet. When it's expanded as much as it was during QE 4, I think it's advisable to shrink it. They're shrinking it with a very careful plan, in a very predictable way, but I think you do want to get it down in size for several reasons, one of which, the one you mentioned, that you want to be ready for the next time. I think if you didn't shrink it, if you just waited for GDP to grow into it, it wouldn't shrink fast enough and you would have this ratchet effect where you never completely got it back to normal. Just one more comment on QE: As I said before, QE is a tool that should be used when the primary instrument is constrained, and we just had two recessions where the primary instrument was constrained. That won't necessarily be the case in every recession. So, I think it is possible to have recessions where we don't resort to QE, but I think it's advisable to retain QE as this supplementary tool if and once we get back into a situation where the short rate is constrained.
Beckworth: Okay. Well, let's move into the Fed's operating system. Its current system is a floor operating system or they like to call it an ample reserve system. I bring this up because you and Joe Gagnon had this paper we alluded to earlier that touches on the Fed's operating system. The title of it was, *Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve.* You wrote it in 2014, but some of the proposed changes in it have yet to be implemented. So, we want to talk about those and how they could improve the Fed's current floor operating system. But on this show, Brian, I've had a lot of people who are critical of the floor system as you may know, friends of yours and mine, and I want to give the floor system fair time. I want to make the case for the floor system. So, walk us through the arguments for the floor system and why we should continue to embrace it.
Making the Continued Case for the Floor Operating System
Sack: First of all, we are stuck in a floor system for now. So, we can have this debate, but given the size of the balance sheet coming into this tightening cycle, we're in a floor system. But even if we had a choice or when we have a choice, I would argue the floor system is very attractive. I think the floor system is working exceptionally well, at least for what it's designed to achieve. So, what is it designed to achieve? It is designed to achieve effective control of overnight market interest rates under a variety of outcomes for the balance sheet size. That control has been very, very strong. So, the SOFR rate, which is the benchmark repo rate, probably the most important overnight interest rate in our financial system, that has been largely pinned to the rate set on the Feds' overnight reverse repo facility or at least within a few basis points of that facility rate. And the federal funds rate has remained remarkably stable in the center of the target range set by the FOMC. So, the system is working, and I want to note that the system is working under fairly extreme conditions. We talk about stress tests for banks; if anyone thought we should apply a stress test to the operational regime, well, we've done that. We expanded the balance sheet to $9 trillion before a tightening cycle and yet control of overnight interest rates has been very effective.
Sack: I think we really should recognize that and recognize the benefits and the effectiveness of this system. Another aspect of this related to all that is the floor system… one of its advantages over a corridor system was that it would allow the Fed to use the balance sheet for other purposes. So, of course, we've been talking about QE and the Fed felt the need to expand the balance sheet dramatically in 2020 initially to support market functioning. The system allowed that. Now that would've been fine under a corridor, because the rate went to zero, so rates would've been pinned to zero. But then more recently, we have another example that shows this. So, the Fed just expanded the balance sheet by more than $300 billion to support the banking sector.
Sack: It allowed a surge in discount window lending. It launched a new lending facility, the Bank Term Funding Program, all of that to deal with recent banking strains. Being in a floor system gives the Fed the flexibility to do that and not to have to worry about how it's going to sterilize those reserve injections, whether it can continue to hit its target rate. It gives it this degree of freedom to do other productive things with its balance sheet. So, essentially, I think the system's working well. The 2014 paper with Joe… I mean, I appreciate you mentioning that, it was a Peterson Institute for International Economics policy brief... our goal in that paper really was to explain a floor system and explain how the tools the Fed has at its disposal, in particular paying interest on reserve balances and running this overnight RRP facility, how they all fit together in a way that's coherent and supports a floor system. I guess we'll get to some of these details. I mean, they didn't do everything we said in the paper, but besides those details, I think just giving the overall framework and understanding how the floor system operates with these tools, that was our broad purpose in that paper.
Beckworth: You've just explained one of the big arguments for the floor operating system and that is it separates the size of the Fed's balance sheet from the stance of policy. So, it has that extra degree of freedom. It can adjust the size of the balance sheet and still keep a certain policy rate, because now, the policy rate is an administered rate. Whereas before in the corridor system, they were linked. In order to adjust the stance of policy, you had to adjust the size of the balance sheet. So, you couldn't have that flexibility that you just alluded to, and I think you're right. What we just went through is a great textbook example of how a floor system adds that extra flexibility. The Fed didn't have to adjust its policy rate, but it did adjust the size of its balance sheet, which is a great thing. Now critics would say that could also be a downfall, because if the Fed can peg its policy rate and have flexibility on its balance sheet, it might be a tempting target for different political factions, different desires of Congress. So, I guess some of the critiques you hear about the floor system are often political ones. Does this endanger the Fed? Does it make it more susceptible to political pressure? Is Congress is trying to steal money, or to use its balance sheet for pet projects? What are your thoughts on that?
Sack: My thoughts on that are, the operating system of the central bank is not the vehicle to resist that or to try to achieve particular political outcomes. Look, Congress has given the Fed a clear macroeconomic mandate. I think that's really been the beacon for everything that the Fed does with its balance sheet. It's up to Congress and the American public to decide, is that the right objective or not? The argument of somehow constraining the Fed from doing something because you're going to be in a corridor system seems like the wrong approach for that.
Beckworth: Fair enough. So, the problem should be addressed at Congress directly, not through some mechanism imposed on the Fed. What about losses on the Fed's balance sheet? That's another critique we often hear these days and I've had people on the show recently talking about that. So, what are your thoughts on that?
Addressing the Fed’s Balance Sheet Losses
Sack: Well, changes in the income on the SOMA portfolio and also unrealized gains and losses on the SOMA portfolio, well, first of all, they aren't the primary consideration for the FOMC. The FOMC is focused on the macroeconomic mandate that we just talked about. That mandate is stable prices and full employment. So, they have the dual mandate and that is their focus. I think they regard the income stream on SOMA as a residual outcome from those efforts. Not one to be ignored, but one that falls behind actually meeting the economic mandate that they've been given. We are seeing losses on the SOMA portfolio now. Actually, the New York Fed yesterday released the annual report on open market operations for 2022. So, we have a nice timely reading and discussion on all of that. The net interest income on the portfolio turned negative in the second half of last year. This is because short rates have risen sharply, of course. So, that's the cost to the Fed of the SOMA balance sheet, the way the balance sheet is funded in some sense. In addition, it reported that SOMA has large unrealized losses on the portfolio on the order of $1 trillion dollars.
Sack: But I guess my point would be you can't have it both ways. If we think the balance sheet works by removing duration risk from the market and influencing the price of long-term interest rates because they don't have to bear that interest rate risk, well, then you can't turn around and say, "Well, this is a problem that we've had losses when interest rates moved against the portfolio." They go together. So, I think it's an unavoidable consequence of QE that the SOMA has this exposure because it's exactly how it works. Now, of course, the size of it all matters. So, in this case, the bonds are particularly large and rates had a really violent move to the upside, surprising everyone, surprising the markets and the Fed. So, the circumstances are somewhat extreme in terms of leading to the size of the loss in the books right now, but I think some exposure is unavoidable. If I could just say one more thing about the exposures, I think some have suggested that the Fed's not always transparent about these losses or maybe some have suggested they don't fully understand their meaning. I would push back on that as hard as I possibly can. I'll give you a little history, Markets Group history on this one. So, in 2009, I set up a new directorate called portfolio analytics inside the Markets Group, because obviously, the balance sheet had grown a lot, and we wanted to understand all of its attributes and all of the risks involved. It proved very valuable for assessing a lot of policy issues along the way.
Sack: One product it produced were projections for the balance sheet and projections for the income from the balance sheet. We began to publish those projections in the annual report on open market operations in 2010. It was a new thing. I went to Chair Bernanke and asked if we should include this in the report. We had a lot of discussion about that, but he agreed and thought it was a good step for transparency. So, those projections have been produced routinely and published routinely ever since 2010, as I said most recently yesterday in the most recent report. And on top of all of that, in 2013, the Federal Reserve Board put out a research paper that very extensively and thoroughly went through how to make these projections. So, I think these exposures are well understood and have been relatively transparent.
Beckworth: Okay. Well, let's talk about your paper on the floor system with Joe Gagnon, because you make the case for the floor system, but you have some specific recommendations. I think they're very relevant to today, because today, we have this really large overnight reverse repo facility. It's blown up. There's a lot of funds flowing to that and you have a proposal or suggestion on how to set the rate on that relative to the interest on reserves in terms of making the floor system more effective.
How to Improve the Floor System’s Effectiveness
Sack: Right, so we thought that the rates on the RRP facility and the rates paid on reserves should be relatively close to each other or even set equal to each other. The broad concept behind that was that the market can efficiently decide where it wants to allocate liquidity created by the Fed. So, when the Fed buys assets, it creates liquidity in the form of some overnight asset - one being bank reserves, one being overnight reverse repo transactions. That liquidity, to a large extent, has to be in one of those two forms. The RRPs were created because we wanted that liquidity to be able to be held outside the banking system.
Sack: So, what Joe and I had in mind was that the Fed creates a total amount of, let's call it Fed liquidity, that will be held in one of these two forms, and the financial system can efficiently decide what's the best way to hold that liquidity. If the banks need more liquidity, they will compete more by paying more on deposits and other ways to get the liquidity. If they don't want the liquidity, then they will compete less and you'll see the liquidity flow into money funds and into the reverse repo facility. I think conceptually, that's a very clean, efficient, equitable system. We've seen that to some degree in recent years. The QE we've been talking about was so large, it created so much liquidity that the banks didn't want all those deposits, so they actually purposefully tried to push some deposits out and then they pushed them out into the money fund sector. Then as rates have gone up, we've seen banks even lose more deposits, because money fund rates have gone up faster than bank deposit rates. But to me, I like that idea that the system can decide where to hold the liquidity and can reallocate efficiently.
Beckworth: I like that as well. I like the market solution here. Let the market determine where these resources should flow. I like the way you frame this. You prefer to call the floor system an abundant liquidity regime versus the abundant reserve regime. The Fed likes to say it's an abundant reserve, but you would prefer abundant liquidity. Is that right?
Sack: Yeah, that's right. That's exactly for this reason, I think, just to start by thinking about Fed liquidity and then letting the market allocate it. This issue is extremely relevant today, right? Because obviously, we're seeing pressure on the banking system or pressure on particular segments of the banking system. They are losing deposits, and some of those deposits are flowing into money market funds. So, the question has come up of, "Well, isn't this RRP facility dangerous and causing instability?" Or even more broadly, even before the recent pressure, "shouldn't we be actively pushing down the size of reverse repos just to get the liquidity back into the banks?" I just think that doesn't seem like a very productive policy step to me.
Sack: Basically, there are calls to reduce the RRP rate relative to the interest rate on reserves to try to push assets out of money funds and back into the banking sector, but there's a couple problems with that - the biggest problem being, if you start reducing the rate on the RRP facility, you are going to lower market interest rates and you are going to compromise your policy setting, in a way that's not clearly going to shove funds back into the banks that need them. It's not like all the money coming out of government-only money market funds is going to flow back into uninsured deposits in regional banks. So, I think it's ill-advised to start to manipulate the operating regime of the Fed, one that's proven to give very effective control of overnight interest rates, in a way that's trying to support particular banks. It's beyond the scope of what the operating system is constructed for.
Beckworth: Yeah, and we could keep talking about the Fed’s operating system for a long time. It's really fascinating to me. But for the sake of time, Brian, I want to move on to your work at the Treasury Borrowing Advisory Committee because you did some interesting work there. I've had previous guests on the show that speak to the issue of enhancing the robustness and resiliency of the Treasury market, but a number of proposals we've touched on, we won't go over all of them here, but just briefly to summarize them, increase central clearing, all-to-all trading. The Standing Repo Facility was supposed to be one partial fix. Maybe tweaking the supplemental leverage ratio would be another one. But something that you worked on that touches on this is Treasury buybacks, having the Treasury department itself participate in buybacks. You did that, I believe, as part of your last work there on the committee. So, walk us through that and how would it work?
The Case for Implementing Treasury Buybacks
Sack: Well, to start big picture, clearly the resilience of the Treasury market is a very important policy issue. This is a critical market, not just for the government and funding itself, but just for how financial markets operate. It's a benchmark market and a deep and liquid market that investors rely on. So, I think these efforts to improve its resilience are really critical. There's a lot of groups working on this, including the Interagency Working Group for Treasury Market Surveillance. Some of this was discussed at the annual Treasury Conference held at the New York Fed. Those are all important initiatives.
Sack: As you noted, the issue of buybacks has come up on TBAC. It actually came up back in 2015, there was a charge. On debt management issues, TBAC is often given a charge or sometimes two charges to address particular topics. A member will create a presentation and put forward a view. Those presentations are public. They're on the Treasury's website. So, back in 2015, this issue came up and was addressed. I would put it in a category of, I didn't go into the meeting thinking that this is a key initiative, but when you think it through, it actually makes a lot of sense. It makes a lot of sense because Treasury securities get less liquid as they age. So, basically the proposal is, Treasury could have some predictable regular policy for buying age securities and replacing them with newly issued securities, which tend to be more liquid.
Sack: It's one of those policy proposals that both makes the markets function better and probably reduces the borrowing cost to the Treasury, because you're buying things that are cheaper and less liquid and issuing stuff that's more liquid. So, it could improve market liquidity and it could also just help with debt management in terms of managing the maturity structure and when new securities have to be issued. In 2015, it seemed interesting, but it didn't prompt additional discussions or presentations. But it's come up again in recent TBAC meetings, including the last one where there was a very nice presentation, again on the website, about it.
Sack: I wasn't at those meetings, so I'm not revealing anything, but just reading the material, I think this is a proposal that has legs and has some real benefits. As I understand it, this is not a buyback program that's going to be used during financial crises. So, when you talk about the Fed having to step in 2020 and buy a couple of trillion dollars of securities, it's hard to do that through Treasury. When the Fed buys securities, it creates liquidity - it creates reserves and reverse repos. When the Treasury buys securities, it has to fund it by issuing other securities. So, it's very hard for them to ramp up a couple trillion dollars of purchases on short order. This is more of a regular, predictable presence in the market to support liquidity and help their debt management.
Beckworth: Yeah, that was my question. When would you use it? So, I was thinking, would it have been useful, for example, during March 2020 and you're saying probably not. It's more effective during normal times.
Sack: I mean, there is an open issue, perhaps, about if you need to do sizable asset purchases at times for market functioning, is that better to do through the central bank or through the fiscal authority? But I think the working assumption at this point is that falls to the central bank, and in terms of the proposals currently in front of Treasury, or the ones TBAC has been working on, it is not that. It is a smaller, more predictable buyback program.
Beckworth: So, Brian, in the time we have left, we're talking about the Treasury market, and I want to end on the Standing Repo Facility. One of the reasons it was created was to make it easier for banks to convert Treasuries into reserves and vice versa, but it hasn't had a lot of participation. A lot of banks haven't joined it. I know primary dealers are automatically a part of it, but you really need buy-in from the banks writ large and we haven't seen it. So, is this a facility that will be useful or does it need to actually go through a test, go through a crisis, to really get its teeth?
The Future of the Standing Repo Facility
Sack: I think this is a facility that is useful, and I was happy to see them launch this facility for the private sector. Then also they launched the FIMA repo facility for foreign central bank customers, which has similar effects. I think it's useful for holders of Treasuries to be able to monetize the debt in situations where they don't want to just do outright sales. This, in many ways, automates what the desk would be doing in any case, because if repo rates firm up or move higher, they're likely to drag fed funds higher, and how would the Fed respond to that and maintain the funds rate target? They would do repo to put more liquidity in the system. So, this just makes it transparent and clear. It lets them broaden the counterparty set. Maybe there's an open issue of whether the counterparty set needs to be broadened further, but I think it is productive.
Sack: I wouldn't worry so much that it's not being used. I think the whole purpose here is really to have it be a guardrail that would kick in under market stress. So, this is not a system where the RRP facility and the RP facility are symmetric and both active. The floor system means we should normally be pressed up against the RRP facility taking the funds in and only on occasion, under stress, would we need to use the RP facility, which is putting funds back out into the market. So, that's the design, and I think it's effective.
Beckworth: That would've been useful, for example, in the repo crisis of 2019?
Sack: Yes, that would've been useful in the repo crisis of 2019. Even in 2020, the desk did do large scale repos as, at least, an initial response to the events. Now, I think the pressures were so great that they had to do market purchases. The SRF doesn't mean that they will never have to do market functioning purchases again, but it's at least helpful and works in that direction.
Beckworth: Well, with that, our time is up. Our guest has been Brian Sack. Brian, thank you so much for coming on the show.
Sack: Yup, thank you, David.
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