It is well known that the Federal Reserve System expanded its assets more than four-fold during and after the 2007-09 financial crisis by making massive purchases of mortgage-backed securities and Treasuries. The balance sheet has not returned to normal since. Total Fed assets stand today at $4.45 trillion, up from less than $1 trillion before the crisis. Whether, when, and how to normalize the size of the Fed’s balance sheet have been under discussion for years.
Economist-blogger David Andolfatto — not speaking for his employer the Federal Reserve Bank of St. Louis — now offers “a public finance argument” for “keeping the Fed’s balance sheet large.” Viewing the Fed as a financial intermediary, he observes that “The Fed transforms high-interest government debt into low-interest Fed liabilities (money),” and that this is a profitable business.
Curiously, Andolfatto omits to mention two important details: the Fed enjoys such a spread only because it is — for the first times in its history — (a) borrowing short and lending very long, also known as practicing “duration transformation” or “playing the yield curve,” and (b) heavily invested in mortgage-backed securities. The Fed is borrowing short by currently paying 0.75% (not 0.50% as Andolfatto reports) on zero-maturity bank reserves. It lends long by holding 10-year and longer Treasuries (paying 2.42% and up as of 17 Feb. 2017) and long-term mortgage-backed securities.