Central bank preparedness for market-functioning asset purchases as a consideration for long-run balance sheet composition

This paper proposes an approach to enhance the Federal Reserve's readiness to undertake market-functioning asset purchases during Treasury market disruptions. It notes that by tilting the SOMA Treasury portfolio toward bills rather than maintaining a maturity structure proportionate to that of outstanding Treasury debt—often viewed as the most neutral portfolio—the Fed can create a larger volume of reinvestments each month that can serve as a “war chest” for undertaking market-functioning asset purchases. This structure of the SOMA Treasury portfolio enables market-functioning asset purchases to be made without expanding the balance sheet or increasing reserves. This avoids the need for close monitoring of reserves when asset purchases are eventually unwound, while also allowing for a clearer differentiation between asset purchases undertaken to support market functioning and asset purchases undertaken to ease financial conditions. Under reasonable assumptions, bills portfolio shares ranging up to around 40 percent—that is, twice that of the 20 percent proportionate portfolio—could be desirable. We also consider approaches for restoring the SOMA Treasury portfolio and, thereby war chest, back to its pre-stress composition. We find that, if the full monthly war chest is depleted to undertake market functioning purchases, restoring it to its pre-stress composition by allowing purchased coupon securities to mature and reinvesting these proceeds into bills, would take 2½ to 5½ years. These lengthy timeframes would limit for many years the Federal Reserve’s ability to respond to Treasury market disruptions without expanding its balance sheet.