The Fed has a huge "balance sheet" -- It owns about $3 trillion of government bonds and mortgage backed securities, which it finances by issuing about $1 trillion of cash and $2 trillion of reserves -- interest-bearing accounts that banks have at the Fed. Is this a problem? Should the Fed trim the balance sheet going forward?
On Tuesday Dec 6, I participated on a panel at Hoover's Washington offices to discuss the book "Central Bank Governance And Oversight Reform" with very distinguished colleagues, Michael Bordo, Charles Plosser, John Taylor, and Kevin Warsh. We're not afraid to disagree with each other on panels -- there's no "Hoover view" one has to hew to, so I learned a lot and I think we came to some agreement on this issue in particular.
Me: The balance sheet is not a problem. The Fed is just one gargantuan money market fund, invested in Treasuries, with a credit guarantee from the Treasury. Interest bearing reserves are perfect substitutes to bonds. The Fed is just making change, taking $20 bills (Treasuries) and giving out $5 and $10 in return. The Fed can easily run monetary policy by just paying more or less interest on reserves.
Plosser: The balance sheet is a big problem. Yes, John's right that interest bearing reserves won't cause inflation so long as banks just sit on them. But will banks just sit on them? Right now, banks don't see enough profitable lending opportunities to care. But if they do, will the Fed really pay enough interest to keep hugely inflationary amounts of reserves from feeding the money supply? What will Congress say when the Fed is paying 3%, 4%, or more to banks to bribe the banks not to lend money to American business and consumers?
Worse, focus on what the Fed is buying not what it is issuing. If the Fed were just buying short-term treasuries John might have a point. But it's buying long term bonds, intervening in the bond market; mortgage backed securities, funneling money to houses. This is credit allocation. The ECB is buying corporate bonds and the BOJ is buying stocks. Congress already raided some of the Fed's assets. So there may not be a big economic problem but there is a huge political economy problem.
(This isn't a quote, and I'm going from memory as we don't have a record of the panel. I hope I'm not mis-characterizing Plosser's view too much. If I am, well, take it as what I learned from the discussion and my own much better sympathy for a countervailing view.)
Taylor: The Fed should not just wind down the huge balance sheet, but it should go back to a very small amount of reserves that do not pay interest. Then it should go back to controlling interest rates by open market operations, and a binding money multiplier. (Taylor, being a lot more polite than the rest of us, did not go into detail on this, but I think he's worried about the Fed being able to control interest rates under interest on reserves (IOR), and whether changing interest rates under IOR with a slack multiplier will make any difference. Again, if this isn't Taylor's view, at least it is a view that I appreciate more after the discussion.)
Well, how to we reconcile this?
I think Plosser is right about the asset side of the balance sheet, and he seems to think I'm mostly right about the liability side. How to square that circle?
I think we would all be happier if the Fed did not keep maturity and credit risk on its balance sheet. Instead, if the Fed really wants to intervene quickly in asset markets and buy anything but short term treasuries (a big if, but there seemed to be consensus that at least in a crisis such purchases might have to be made) then the Fed should swap them to the Treasury within, say, 6 months, so any long-term credit allocation and risk is in the Treasury where it belongs.
(This is, I think, illegal right now. The Fed cannot deal directly with the Treasury, one of many bright little ways our ancestors set up the system to prevent inflationary finance. But that can be fixed.)
And, granted that large amounts of interest-bearing reserves are a good thing -- lots of non-inflationary oil in the economic car -- the Fed doesn't have to be the one to provide them. I brought up again my proposal that the Treasury should issue fixed-value floating-rate small-denomination electronically-transferable debt -- i.e. reserves -- to everyone, not just banks. You should be able to go to treasury.gov and sign up for the treasury's money market fund. All the Fed is doing by buying short-term treasuries and issuing reserves is creating this new class of government debt out of other kinds of government debt. Why not have the Treasury issue it directly? Then the Fed could in fact wind down its balance sheet to near nothing, without losing any of the liquidity and financial stability benefits of interest on reserves.
Plosser seems to go along. Taylor not yet, but sitting on a panel it was hard for any of us to think how this would work in a world of very small non interest bearing bank reserves. (I think it would -- Treasury floaters would not be much different from short term treasury debt from a bank's perspective.)
So we learn from each other on the panel, as well as the sharp questions from the audience. Thanks to everyone who came (and to our second panel on the Blueprint for America), it was a very productive day.
Update
Discussion now available online, embed below, link here. Now we can see how my memory matches up with the facts.
I don't understand Plosser's first objection to a large balance sheet. The Fed has an inflation-targeting mandate. If it needs to pay 3% or 4% to meet its target, it should do that and would not face much difficulty explaining its policy actions. And such rates certainly are normal, historically speaking.
ReplyDeleteBut I do appreciate his second point that the central bank should not be deciding the allocation of credit. And if the balance sheet is not reduced during recovery, the problem gets worse with every economic cycle as the central bank owns an ever-increasing share of the economy.
It's interesting to see different viewpoints on the balance sheet of the Fed. I learned a lot from this summary.
ReplyDeleteIf the Fed were a Bank, the Fed would shut it down as being catastrophically undercapitalized.
ReplyDeleteItem 5 of the H.4.1 for 12/6/16 shows 4.6T$ of assets being carried on a balance sheet that shows capital of less than 1% of the total assets (40G$).
The only thing that saves the situation from total catastrophe is that the balance sheet carries 8,000 metric tonnes of gold (current market price $1,173/oz) at $42.22/oz. If the gold were revalued at market price, it would add ~290G$ to the capital account, yielding a capital asset ratio of about 7%, which is not great, but not immediate shut down.
A bank with such a low capital ratio would be required to either sell stock or to sell assets.
Since most the Feds assets are short term treasuries, and most of its liabilities are demand deposits,an asset reduction would be easy to accomplish. Let the treasury bills run off, stop paying interest on reserve accounts, and mail the holders of excess reserves a check as they reduce account balances.
the saving grace is much simplier than this, they can print money If they find themselves undercapitalized. Of course that will mean varying degrees of inflation will follow (poosibly too high).
DeleteIf I understand correctly, Plosser's concern is that it may be too costly for the FED to pay increasingly higher interest rates on reserves to prevent banks from loaning out their huge excess reserves and exploding the money supply.
ReplyDeleteBut it seems that this particular problem may be relatively easy to solve -- albeit in an unorthodox manner. If the FED is worried about banks loaning out huge amounts of excess reserves, the FED could simply raise the required reserve ratio. Although this monetary policy tool is rarely used, it's still in the FED's toolbox.
I'm not sure what the costs are of paying IOR when the Fed is able to create that money at will, but I'm glad you brought up the required reserve ratio. We *want* banks to lend, and keep only the minimum required reserves at the central bank. The current large balance sheet of the Fed indicates that the banking system is not functioning properly. Banks cannot lend sufficiently, and thus deposit with the central bank which must then allocate credit via unconventional monetary policy. And this is inefficient because the central bank is not a profit-maximizing institution and is not equipped to make allocation decisions very well.
DeleteAnwer,
DeleteI think you misunderstood my suggestion. In response to the financial crisis, the FED massively expanded the monetary base. The money supply did not explode because banks were not lending -- they were holding excess reserves. According to the FRED database, banks are currently holding about $2 TRILLION in excess reserves. I do not think the FED *wants* banks to rapidly lend out all $2T in excess reserves -- that would explode the money supply and could create a very real inflationary problem for the FED.
By paying IOR, the FED can manage how aggressively banks lend out their excess reserves. I think Plosser's concern is that if the FED must keep paying increasingly higher interest rates to prevent banks from lending out too many of their excess reserves, it becomes a prohibitively costly tool for the FED to use. If paying IOR becomes too costly, the FED could bump up the Required Reserve ratio (and only pay interest on excess reserves). This would reduce the cost to the FED. Presumably, if the FED raised the Required Reserve ratio, they would set it at a level that is still below the excess reserve levels to prevent the change from having a large contractionary impact on the economy. -- Rich F.
I think we agree on the inflation-targeting mandate for the Fed, and I'm trying to insert concerns about efficiency into the discussion. That $2T of credit needs to be allocated in some way, and I think many observers would prefer that it be done by profit-maximizing institutions, than through large-scale and indiscriminate asset purchases by the central bank, or through fiscal policy. So yes, let's shrink the Fed's balance sheet and let banks pick up the slack. But if that isn't happening, we need a diagnosis of the problems with bank lending.
DeleteI do agree that the total amount of credit will need adjustments now-and-then, as part of monetary policy, using tools like the required reserve ratio that you suggest. But we are currently operating in a regime of unconventional tools like LSAP, partly due to the economics profession's disagreement about the use of IOR.
Good discussion. The Fed should stay out of fiscal affairs/policy; but, its monetary role has expanded as a result of the Crisis of 2008 -- and allocation of credit throughout the yield curve is the norm when the Fed is in the role of lender of last resort, or as Perry Mehrling points out the dealer of last resort (keeping market liquidity when it freezes up). That is going to involve picking winners and losers in a crisis, but that is the way it goes -- I know of no hard fast rules whether it is J.P. Morgan (the person, private sector), Jesse Jones (with the RFC during the Depression, Fed Govt), or Uncle Ben in 2008.
ReplyDeleteBen Bernanke gave a four part lecture (I think at Geo Washington U) on the role of the Fed -- history, the Depression, the Crisis 2008, post Crisis -- its on YouTube. He goes through all the actions they had to take to stabilize the markets so they could operate as a market making enterprise. Remember all the actions the Fed was taking earlier in late 2007, 2008; and, the minutes the month before the Lehman failure show no indication of foreseeing the Crisis coming up.
Banks do not lend reserves except to other banks. No one can use reserves, except cash notes, that do not have a reserve account at the Fed.
ReplyDeleteMeh. The Fed should just go to helicopter drops. Enough theomonetarism. Let's go with what works.
ReplyDelete