Mechanics of monetary union
Fed interdistrict transactions through the pandemic
We are living through times in which fundamental structures of the monetary system seem very much open for discussion. While we contemplate how things might one day work, we should not forget to understand how they already do work.
It is in that spirit that I take up, in this 50th installment of Soon Parted, the Fed's Interdistrict Settlement Account.
How the Federal Reserve branches hold together
If you spend enough time reading the Fed's balance sheet, you will eventually come to Table 6 in the H.4.1 release, which shows the balance sheets of each of the twelve regional branches of the central bank. The branches manage imbalances among themselves using the Interdistrict Settlement Account (ISA). This graph shows balances in the ISA during the pandemic.
It is hard to miss that, although the branches treat one another (roughly) as peers, the New York Fed is playing a different role than the others: during the pandemic, its balance has been larger both in the positive and in the negative directions than any of the other branches. New York, of course, is the branch where the central bank interacts with financial markets. As the graph shows, the Fed's interventions in money markets have had consequences for the flows between districts.
During the early part of the pandemic, the New York Fed had a large positive balance with the other districts, just as it did after the 2008 crisis. Throughout 2020, the Fed system as a whole was buying securities, funding them with increased deposits of the banking system (reserves) and of the US government (the Treasury General Account or TGA). The New York Fed was booking more liabilities than assets, including the entire TGA, so the interdistrict account was used to allow other branches to purchase securities, in effect borrowing from New York. Taking the San Francisco Fed as an example, the transactions can be represented like this:
The T accounts above describe the situation well until March/April 2021, as you can see in the graph below (which shows just the New York side). At that point, several things change, on both sides of the balance sheet. The Treasury was spending down the TGA balance rapidly, while the Fed's asset purchases continued, both of which led to an expansion of reserves. Because banks had limited capacity to absorb more reserves, the Fed created the overnight repo facility. This created a liability that money market funds could hold, and created a channel that would allow the Fed to continue to expand its balance sheet.
The graph shows a step up in the New York Fed's holding of securities at the same time. Much, but not all, of the Fed's overnight reverse repo is booked in New York. In a reverse repo transaction with the Fed, the central bank places securities as collateral with the depositing money market fund. It seems that securities were moved from other branches to New York, in anticipation of a large need for collateral there to place in overnight reverse. The securities were paid for using the interdistrict settlement account, so the New York Fed went from having a positive to a negative balance.
From that point forward, we can see the New York Fed as doing two basic things. First, it is absorbing the TGA drawdown into reserve and ON RRP balances, which come out more or less even. Second, the New York branch continues to purchase securities, which it funds by borrowing from the other branches. Those other branches, meanwhile, are accepting RRP placements from mutual funds outside of New York. The San Francisco Fed, in particular, transacts with Wells Fargo, which is based there and whose mutual funds have made significant use of the ON RRP facility. It is enough to make San Francisco a net lender to the New York.
Throughout the pandemic, the New York Fed has been playing a special role among the branches of the US central bank. Seamless internal transactions have been an important part of carrying out monetary policy.
Large swings in the Interdistrict Settlement Account don't mean that the US monetary union is likely to come apart any time soon. To the contrary, the branches of the Federal Reserve system are willing to allow large imbalances to accumulate precisely because they do not see any credit risk there.
Those who wish to create new monetary systems should not, I think, neglect to understand the intricacies of the present one.