Tuesday, July 21, 2009

Bernanke's Exit Strategy May Be No Strategy

The Federal Reserve Chairman Ben Bernanke testified before the House today, the first day of the semi-annual ritual before Congress on the subject of the Federal Reserve's monetary policy. (This semi-annual testimony, by the way, is about the only Congressional oversight on the Federal Reserve.)

What set today's testimony apart was in the prepared statement and his op-ed piece on Wall Street Journal: the Fed's "exit strategy" - how to shrink the Fed balance sheet once the economy gets going on its own.

I ran into two articles that say "When" is more important than "How": Here's one, by Catherine Rampell of New York Times; the other is here, by Jill Schlesinger of CBS. They both gloss over the "how", treating them as standard, run-of-the-mill tools.

Are they?

The Federal Reserve's balance sheet exploded from $900 billion in September 2008 to over $2 trillion two months later in November 2008. This is simply historically unprecedented. Don't we need to examine the tools that purportedly shrink this balance sheet, or whether it would be ever possible to do so at all? Could "standard" tools do? If not, what would happen?

I am more interested in knowing the "how"; from the recent past, I'm resigned to the probability that the Fed will get the "when" very, very wrong, unless by chance. So, let's take a look at the op-ed piece in Wall Street Journal, in his own words.

The Fed’s Exit Strategy (Ben Bernanke, 7/21/09 Wall Street Journal)

"The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

"These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages."

Many people (including myself) would question the validity of the second paragraph, but the first paragraph describes what the Fed has done. I accept that.

"My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road....

"The exit strategy is closely tied to the management of the Federal Reserve balance sheet... as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy." [emphasis is mine]

And exactly how is he going to do that?

First, it will happen automatically anyway: "To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities."

Second, he can raise the interest rate on the reserves so that the banks will keep their money at the Fed and not lend out: "we can raise the rate paid on reserve balances as we increase our target for the federal funds rate."

The first one is not a policy choice, so basically the first and foremost attack on bulging reserve is to raise interest rate on the reserve so that it will not leave the Fed and flood the Main Street and cause inflation.

Ummmm, hasn't the government been complaining that banks are hoarding the money at the Fed and not lending to Main Street?

Bernanke then cites European, Canadian, and Japanese experience where the interest rate on reserve acted as floor support for their short-term funds rates. However, despite "this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed" and the Chairman partly blames it on banks' inexperience with the new system. (Yes, it's irrational, isn't it Mr. Spock?)

If this gap between the Fed funds rate and the reserve interest rate persists, Bernanke says there are four ways to tighten the monetary policy:

  1. Large-scale reverse repurchase agreements with financial market participants;
  2. The Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline;
  3. Offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers; and
  4. Reduce reserves by selling a portion of its holdings of long-term securities into the open market.
Now, let's examine these four choices against the Federal Reserve's latest balance sheet.

1. Reverse repo agreements:

Repo agreements inject short-term credit, reverse repo agreements drain short-term credit. Currently the Fed has $66 billion reverse repo agreements on the balance sheet (liabilities), entirely with foreign and international account dealers. The Fed wants to greatly expand reverse repo agreements with a lot more institutions to drain liquidity. It is short-term and temporary.

2. Treasury sells bills and deposits the proceeds at the Fed:

That's a longer-term than reverse repo agreement, but still temporary.

3. Offer term deposit to the banks:

The Fed already pays interest on the reserves. All term deposit offers is that the Fed will be able to lock up the reserve for a specified amount of time.

4. Sell portion of long-term securities in open market:

Which long-term securities? As of Wednesday July 15, The Fed has
  • $659 billion Treasury notes and bonds and TIPS held at face value;
  • $102 billion Federal agency debt securities held at face value;
  • $526 billion Mortgage Backed Securities guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae held at current face value (=remaining principal balance of the underlying mortgages)
It seems to me that there are so many Catch-22 here.

First, Treasury notes and bonds. They are part of the collateral held against Federal Reserve notes (U.S. dollar bills, $1,054 billion outstanding). Also, if the Fed wants to vastly expand reverse repo agreements to drain liquidity, it has to post collateral, and the collateral for that operation is Treasury notes and bonds. That would mean the U.S. dollar's value would drop, as the dollar is backed less by Treasuries and more by securities of dubious quality (agency bonds and MBS).

Second, the federal government will have to issue more Treasury debt as far as eyes can see on their ambitious programs. Adding to the supply would lower the price, raising the yield and raising the cost of the debt.

Third, who in the world (literally) wants agency bonds, and who wants them at face value? No one. Ditto for MBS guaranteed by the likes of Fannie and Freddie. I don't know how much the Fed can get in the open market for these securities, but definitely NOT AT FACE VALUE.

The only method that would actually reduce liquidity seems to be the No.4, but then the house of cards would come tumbling down when the open market price discovery happens.

Luckily for Ben Bernanke, banks have very little interest in lending for now, as the economic "recovery" is seen tepid and slow. Unless they are forced to lend, like the Chinese central bank forced its banks by lowering the reserve interest, we don't need to worry about how the Fed is going to absorb excess liquidity.

I would like to know what exit strategy the Chinese central bank has, if any...


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