Worth a quick look at how I saw it in April 2006.
Turns out I was right about demand weaking from that date, but wrong about the Fed reaction function.
I thought they’d follow the mainstream view and respond to elevating inflation expectations.
Instead, Bernanke and Kohn subsequently looked past sharply elevating inflation expectations to the output gap when they first cut rates.
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The big concern is managing inflation expectation not realizing that inflation is not a function of inflation expectations:
The Fed’s Exit Strategy
By Ben Bernanke
July 21 (WSJ) — 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.
There is no evidence of that.
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.
Yes. Though the measures taken missed the direct approach and instead involved a myriad of complex and expensive programs that burned through precious political capital and delayed the repair of those markets.
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.
They continue to believe that lower interest rates fan inflation and higher interest rates fight inflation.
I suggest theory and econometric evidence show that with current institutional arrangements the opposite is true.
The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.
Nothing could be easier. This is a non issue.
The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.
What else could they do? Lending doesn’t diminish reserve balances in aggregate. This is accounting, not theory. And clearly the FOMC doesn’t know this.
But as the economy recovers, banks should find more opportunities to lend out their reserves.
Again, that doesn’t diminish total reserves held by the banks at the fed.
That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—
Only if the borrowing to spend increases aggregate demand, which is certainly possible.
unless we adopt countervailing policy measures.
Those would be rate hikes, which add income to the non govt sectors and can add to inflation via the cost channel as well as the fiscal channel.
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.
They have no effect on the economy in any case.
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, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid.
These are just exchanges of financial assets which have no effect on the economy.
However, reserves likely would remain quite high for several years unless additional policies are undertaken.
Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.
Yes, increasing interest rates is a simple matter operationally.
Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.
Yes.
Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.
Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.
Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.
Yes, for many, many years. It’s the obvious way to go.
Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.
However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.
Yes, someone in government who did not understand reserve accounting and monetary operations excluded those accounts at the Fed.
Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.
First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.
Yes, offers interest bearing alternatives to reserve balances.
Second, 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.
Yes, offers interest bearing alternatives to reserve balances.
The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.
Why??? It’s all the same government.
Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.
Yes, and, more important, this can be used to set the term structure of rates the same way treasury securities do. They are functionally identical.
Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.
Yes, which also support longer term rates at higher levels.
Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.
And only limits the growth of broad money (which presumably matters even though the fed stopped publishing M3 because they found no evidence it did matter) if the higher rates limit borrowing.
Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.
—Mr. Bernanke is chairman of the Federal Reserve.
[top]
Karim writes:
Bernanke Testimony (All quotes in italics)
- We are likely to see further sizable job losses and increased unemployment in coming months
- Recent data also suggest that the pace of contraction may be slowing, and they include some tentative signs that final demand, especially demand by households, may be stabilizing. In coming months, households’ spending power will be boosted by the fiscal stimulus program, and we have seen some improvement in consumer sentiment. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market and the declines in equity and housing wealth that households have experienced over the past two years. In addition, credit conditions for consumers remain tight.
- The housing market, which has been in decline for three years, has also shown some signs of bottoming
- The available indicators of business investment remain extremely weak.
- Conditions in the commercial real estate sector are poor.
- We continue to expect economic activity to bottom out, then to turn up later this year.
- The supply of mortgage credit is still relatively tight, and mortgage activity remains heavily dependent on the support of government programs or the government-sponsored enterprises.
- Investors seemed to adopt a more positive outlook on the condition of financial institutions after several large banks reported profits in the first quarter, but readings from the credit default swap market and other indicators show that substantial concerns about the banking industry remain.
The section below appears to warn about the impact of rising rates, wider credit spreads, and weaker equities. i.e., the Fed wont be looking to snuff out any rallies. Also, slack to expand even after recovery takes hold, meaning disinflation continues, with ‘expectations’ being main factor preventing deflation.
- An important caveat is that our forecast assumes continuing gradual repair of the financial system; a relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall.
- Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.
- In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some over the next year relative to its pace in 2008. However, inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation.
[top]
(email exchange)
Thanks!
Got it on my blog yesterday and added it to the attached draft in progress as well.
I cut his response a bit short to save the point that he missed the point ‘fundamentally’ even though he got this operational point right.
While in the operational sense ‘taxpayer money’ is never spent per se, in the macro sense tax liabilities function to reduce demand which is the real tax, and allows
government to buy the unsold output and move those goods and services to the public domain.
So in that sense, any government spending that buys goods and services is ‘spending taxpayer money’.
So the ‘right’ answer is that when the Fed buys financial assets, and not goods and services, it is not ‘spending tax payer money’ but merely exchanging one financial asset- balances in a fed bank account- for another- the financial asset it purchases. And the further economic effect of purchasing financial assets is that of lower interest rates than otherwise.
It’s about price, not quantity!
Best!
Warren
>
> On Tue, Mar 17, 2009 at 2:50 AM, Felipe wrote:
>
> Hi Warren,
>
> I am sending the link of the “60 Minutes” interview of Bernanke
> by journalist Scott Pelley. In particular, pay attention to his interview
> Part I around 8:00 min. Bernanke explains how the Fed buys assets.
> He admits that it is not taxpayer’s money; but it is just numbers on
> Fed’s balance sheet.
>
> Best,
> Felipe Rezende
>
Part I
Part II
[top]
Financial Reform to Address Systemic Risk
Bernanke:
In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations.
This is not a good start. There were no ‘imbalances’ nor can there be for a nation like the US with floating exchange rates and non convertible currencies.
The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances.
He’s saying we should have done more to reduce the trade deficit.
The macroeconomic fundamental is that exports are real costs and imports real benefits.
Reducing our trade deficit reduces our standard of living and real terms of trade.
However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States.
Stuck in loanable funds theory.
He still thinks the US somehow uses ‘imported dollars’ for funding purposes.
He’s got the causation backwards.
Causation runs from ‘loans to deposits’ and not vice versa.
The details of the story are complex, but, broadly speaking, the risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets.
So in his world view we get dollars from overseas to invest, and the problem is we failed to do it prudently?
This is not how the monetary system works.
In certain respects, our experience parallels that of some emerging-market countries in the 1990s, whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad.
Those flows were in external currencies.
Again, he’s got it all very much confused.
When those failures became evident, investors lost confidence and crises ensued. A clear and highly consequential difference, however, is that the crises of the 1990s were regional, whereas the current crisis has become global.
No, the difference was that of external vs domestic currency.
And here is the 7th deadly innocent fraud to be added to my draft:
Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort. In that regard, the Federal Reserve, other federal regulators, and the Treasury Department have stated that they will take any necessary and appropriate steps to ensure that our banking institutions have the capital and liquidity necessary to function well in even a severe economic downturn.
Yes, the payments system is useful, as are banks that service deposits and originate and hold loans for housing and consumer credit.
Beyond that, however, little or none of the rest of the financial infrastructure is a necessary to support a ‘sustainable economic recovery’. In fact, the reverse is largely true- it’s the real economy that supports the financial infrastructure. Failure to recognize this means a continuation of nominal wealth flowing to the ‘investor class’ as the economy recovers, while high unemployment helps insure those working for a living struggle with downward pressure on real incomes.
At the same time that we are addressing such immediate challenges, it is not too soon for policymakers to begin thinking about the reforms to the financial architecture, broadly conceived, that could help prevent a similar crisis from developing in the future.
Yes, like doing away with most of it?
Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task.
Only because they have been allowed to engage in activities far beyond any concept of public purpose.
In light of the importance of money market mutual funds–and, in particular, the crucial role they play in the commercial paper market, a key source of funding for many businesses–policymakers should consider how to increase the resiliency of those funds that are susceptible to runs.
No, policy makers should consider alternative funding models, such as a return to using banks- the designated agents of the Federal Reserve- to accommodate lending and depository functions deemed to serve public purpose.
Procyclicality in the Regulatory System
It seems obvious that regulatory and supervisory policies should not themselves put unjustified pressure on financial institutions or inappropriately inhibit lending during economic downturns.
Banks are pro cyclical, as is the private sector in general, and forcing them to act otherwise is counterproductive.
Only the public sector can act counter cyclically, and should stand by to do that to sustain aggregate demand, output, and employment at desired levels.
Another potential source of procyclicality is the system for funding deposit insurance.
Why not eliminate it entirely??? What public purpose does it serve???
The financial crisis per se was the direct result of people not making their payments for a variety of reasons.
The direct way to address it was to restore aggregate demand from the ‘bottom up’ rather than from the ‘top down’.
That’s why I was recommending an immediate payroll tax holiday, revenue sharing with the states on a per capita basis with no strings attached, and a federally funded, $8 per hour job that included full health care benefits for anyone willing and able to work.
[top]
(email exchange)
The Fed already has thousands of designated agents, the banks, to lend and take in deposits.
If I were in charge I’d eliminate the cap on FDIC insured bank deposits and legislate any insured pension funds keep their excess cash in insured deposits.
And borrowers can go to the banks as well.
And if I wanted spreads narrower that could also be done via adjusting capital requirements and risk weights as desired.
>
> On Tue, Mar 10, 2009 at 10:00 AM, Pat wrote:
>
> Bernanke is lending credence to our idea of a centralized, regulated exchange for repo which
> we have been calling the RPX project.
>
Chairman Ben S. Bernanke — At the Council on Foreign Relations, Washington, D.C.
Mar 10 (Federal Reserve) — The Federal Reserve and other authorities also are focusing on enhancing the resilience of the triparty repurchase agreement (repo) market, in which the primary dealers and other major banks and broker-dealers obtain very large amounts of secured financing from money market mutual funds and other short-term, risk-averse sources of funding.
[top]
Let your Washington contacts know I’m available to help them formulate their questions!
SENATE COMMITTEE ON THE BUDGET HOLDS A HEARING ON ECONOMIC AND BUDGET CHALLENGES
MARCH 3, 2009
WITNESSES:
FEDERAL RESERVE SYSTEM BOARD OF GOVERNORS
CHAIRMAN BEN BERNANKE
GREGG: Thank you, Senator Wyden.
And thank you, Mr. Chairman, for attending this hearing today.
I think Senator Wyden, as acting chairman, has touched a core of one of the primary issues I’m interested in, which is the question of confidence. Whether or not the economy recovers depends in large part on the confidence of the American people in the value of their homes and in the fact that they’ll keep the job, confidence of those people
who buy our instruments that are debt is solid and sound, confidence that our currency is strong.
Wrong. It depends on having sufficient income to buy their own outputs and to net save as desired.
In the short run, one can accept the fact that debt is going to go up significantly because of the need to address this economy with the liquidity that only the government can put into it.
But in the long run, one has to ask how can this country sustain a debt to GDP ratio of 67 percent, deficits of over 3 percent, or as far as the eye can see, and expect to maintain the value of the dollar or the ability of people to come and buy our debt?
Like Japan? The yen seems strong enough to me with ratios twice that high.
There is a tsunami of debt headed at us — $66 trillion in unfunded liability. It will essentially overwhelm the capacity of our children to pay it and the ability of this nation to sustain it.
The usual mainstream nonsense.
BERNANKE: By December the Federal Open Market Committee had brought its target for the federal funds rate to an historically low range of zero to .25 percent, where it remains today.
(Which has removed maybe $200 billion annually in net interest income for the non government sectors)
Unfortunately,
Here we go. Deficits per se are bad.
the spending for financial stabilization, the increases in spending and reductions in taxes associated with the fiscal package, and the losses in revenues and increases in income- support payments associated with the weak economy will widen the federal budget deficit substantially this year. Taking into account these factors, the administration recently submitted a proposed budget that projects the federal deficit to increase to about $1.8 trillion this fiscal year and to remain around $1 trillion in 2010 and 2011.
As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to more than 60 percent over the next several years, its highest level since the early 1950s, in the years following the massive debt buildup
during World War II.
Of course, all else equal, this is a development that all of us would have preferred to avoid.
He’s obviously in a fixed FX paradigm
We are better off moving aggressively today to solve our economic problems. The alternative could be a prolonged episode of economic stagnation that would not only contribute to further deterioration in the fiscal situation,
As if that’s the larger issue
but would also imply lower output, employment and incomes for an extended period.
Of secondary importance to the deficit issue.
With such large near-term deficits, it may seem too early to be contemplating the necessary return to fiscal sustainability. To the contrary, maintaining the confidence of the financial markets requires that we begin planning now for the restoration of fiscal balance.
Not true.
As the economy recovers and resources become more fully employed, we will need to withdraw the temporary components of the fiscal stimulus. Spending on financial stabilization also must wind down. If all goes well, the disposition of assets acquired by the Treasury in the process of stabilization will be a source of added revenue for the Treasury in the out years.
How about instead:
Whatever it takes to sustain output and employment is the right fiscal and policy.
Determining the pace of fiscal normalization will entail some difficult judgments. In particular, the Congress will need to weigh the costs of running large budget deficits for a time
What costs?
against the possibility of a premature removal of fiscal stimulus that could blunt the recovery.
That’s a real cost.
We at the Federal Reserve will face similar difficult judgment calls regarding monetary policy.
In particular, policy-makers must remain prepared to take the actions necessary in the near term to restore stability to the financial system and to put the economy on a sustainable path to recovery. But the near-term imperative of achieving economic recovery and the longer-run desire to achieve programmatic objectives should not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances.
Why are they imbalances???
There are no gold reserves that can be depleted due to a convertible currency.
Without fiscal sustainability,
Fortunately, that isn’t an operational issue.
in the longer term we will have neither financial stability nor healthy economic growth.
Thank you for your attention. I’m happy to take your questions.
Senator Gregg?
GREGG: Thank you, Mr. Chairman.
And after that is all said and done, four years from now, when one certainly hopes, presumes and expects that we will be beyond these dire economic situations, we will be looking at a government which is taking up 22 percent of the gross national product,
(Probably the lowest in the world)
has a 67 percent ratio of publicly held debt to the GDP, and no end in sight and, in fact, it continues to work its way up, with deficits running at three to four percent, minimum, from 2013 to 2019, which is the end of the
window for this budget.
Reads like conditions for stability to me.
BERNANKE:GREGG: But your place is to protect the value of the dollar and protect the ability …
GREGG: … to sell the debt…
BERNANKE: … go on to say my concern here, as I expressed, was that there needs to be fiscal sustainability. If government spending is higher, it needs to be recognized that that will involve higher taxes in order to maintain a close reasonable balance between revenue and outlays.
So his target is a ‘close reasonable balance’.
That does have some implications for efficiency of the economy.
Does have some implications for efficiency? Is that all? Not that there is such a thing in the first place.
BERNANKE: Well, Senator, the CBO, for example, has done simulations which show that in 2030, under current laws, Medicare, Medicaid and Social Security would take up about, alone, would take up about 16 percent of GDP, which is pretty close to non-interest spending. It’s pretty close to the entire federal non-interest budget.
So it’s clear that in order to get control over the overall budget situation, we’re going to need to look at entitlements.
We don’t have the real resources to give the elderly a modest minimum standard of living and we don’t have the real resources to look after our health???
The current excess capacity alone is more than enough to do both.
If we don’t get a sustainable fiscal situation and deficits continue in large amounts for a long period, then it will become more difficult to sell our debt and interest rates will rise and it will be counterproductive.
Like Japan?
BERNANKE:Yes. So there’s been a lot of talk about banks and their ability to lend. In fact, for many types of credit, nonbank securitization markets are the main source of funding and those markets have largely closed down.
And so by restoring and re-stimulating activity in securitization markets, we hope to get credit flowing for a number of different critical areas.
We can’t ‘get credit going’ without securitization?
Of course we can!
The Fed could easily enable the banks, their legally designated agents, to do this with similar funding and guarantees.
Senator Cardin?
GRAHAM: Thank you, Mr. Chairman.
I’m trying to ask Senator Gregg’s question a little bit differently. Is there any outer limit on the federal government’s ability to borrow money?
BERNANKE: Certainly, there are outer limits.
Really??
GRAHAM: What are they and how close are we to them?
BERNANKE:Well, it’s — it’s hard — it’s hard to — to judge in any kind of explicit way, since we don’t — don’t know. I mean there are countries have clearly — for short periods of time has clearly had very high levels of debt.
Like Japan? For almost 20 years?
The United States had more than 100 percent debt to GDP ratio during World War II. The Japanese during their financial crisis raised the debt to GDP ratio above 100 percent.
Above 150% for considerable periods of time.
But clearly, that’s not a healthy situation.
Clearly?
It’s one in which interest payments can become a very important part of the — of the government’s outlays.
The Fed sets those interest rates. And Congress taxes interest income.
Nor operationally is the ability to make payments revenue constrained.
We had been — over years had been bringing our debt to GDP ratio down to about 40 percent. Now we’re going to see a jump to 60 or 65 percent.
We need to be I think looking for a — what’s called a primary deficit — that is, the deficit excluding interest payments, a somewhere close to balance. That would be sufficient to stabilize our debt to GDP ratio. I think that would be a good objective.
Interesting, more gold standard rhetoric.
How about an objective like optimal output and employment?
It’s very hard to know how much higher — how much higher the debt to GDP ratio could be before the international financial markets begin to — to balk. And so I think the prudent thing to do is to try and maintain stability of the debt to GDP ratio.
Like Japan, where 10 year JGB’s are under 1.5%, outstanding securities are over 150% of GDP, deficits range to over 8% of GDP, and they’ve been downgraded below Botswana???
Government rates go to where the CB sets them, end of story.
GRAHAM: Has there always been a buffer zone to — between reality and this magical place? And is there a buffer zone today?
BERNANKE: Well, as — as I think the recent experience is showing, confidence and expectations are critical.
Yes, he truly believes this.
And I think the markets will be quite able to absorb, for example, the large amount of issuance we’re seeing in the next couple of years, if there is a reasonable expectation and confidence in the same markets that the United States is serious about getting its budget position under control in the longer-term.
He truly believes that’s the case.
GRAHAM: There are some projections that exist that in 2050 the debt to GDP will be 300 percent. What kind of effect will that have, if that became a reality?
BERNANKE: Well, I don’t think that’s going to happen. It can’t happen, because things would break down before then.
GRAHAM: Something has to change first.
BERNANKE: Something…
GREGG: Happen, but not to change.
BERNANKE:That’s right.
GREGG: For it not to happen, right? Something has to change.
BERNANKE: Something would change, whether it was either change in policy or change in the willingness of the — of the lenders to finance the debt.
What generally changes is inflation keeps the nominal debt to GDP ratio down, but that’s another story that he knows well. And the reason he doesn’t want to go there is because that story says the risks are inflation and not solvency or the ability to sell securities.
GRAHAM: I’ve only got 15 seconds. My question, basically, is will we ever know in this country whether or not we’re repeating the Japanese mistake? Do you have any test out there to let us in Congress know that we’re throwing good money after bad, when it comes to certain institutions?
BERNANKE: The Japanese mistake was not acting quickly enough or aggressively enough, and I think that’s not our problem.
Yes, on fiscal policy.
SANDERS: Thank you, Mr. Chairman.
ALEXANDER: But — but they are (inaudible) to — to specify — the first risk is that you don’t get your money back. You think you will. The second risk would be that you’d — the more paper — the more money you print, the more likely we have inflation down the road…
(CROSSTALK)
BERNANKE: Senator, that’s aptly correct. So you’re absolutely right that in order for us to begin to raise interest rates and begin to stabilize the economy.
Now that they can pay interest on reserves they don’t have to ‘shrink the balance sheet’ to raise rates. Bernanke should know that.
At that time when the economy begins to grow again, we’re going to have to shrink the balance sheet and we are very comfortable — we’re watching that very, very carefully. It’s very important. We spend about half of our time at FOMC meetings, looking at the balance sheet and trying to make that evaluation.
Interesting use of FOMC time!
Worrying about something of no consequence whatsoever.
[top]
BROWN: Specifically, what worked that Roosevelt did? What did we learn from that? What worked that applies to now?
BERNANKE: Well, there were two things that he did almost within months of taking office that were extremely important. One was the bank holiday and the subsequent measures, like the deposit insurance program that stabilized the banking system.
Yes, deposit insurance allowed banks to fund themselves on an unsecured basis via federal deposit insurance.
The lesson was the liability side of banking is not the place for market discipline.
Which is why I’ve been proposing all along that the Fed needs to get immediate permission from Congress to lend to member banks on an unsecured basis. This would instantly clear up the interbank lending issues.
The problem is the FOMC doesn’t understand reserve accounting and how the monetary system actually works.
And it’s a point I’ve been making all morning, that we need to stabilize the banks.
And they need borrowers to have sufficient net incomes to make their payments. Hence my payroll tax holiday.
The second thing he did was to take the U.S. off the gold standard, which allowed the Federal Reserve to ease monetary policy, allowed for a rise in prices, which, after three years of horrible deflation, allowed for recovery.
Yes, it removed the supply side constraints on the ‘money supply’ with the gold standard this constraint makes it problematic for even the Treasury to fund its deficit spending, as competition to borrow a finite amount of reserves drives up interest rates.
When the currency is instead allowed to float interest rates are then instead set by the government rather than market forces. This allows the Fed to cut rates and the Treasury to deficit spend without risking the loss of gold reserves.
So those were the two perhaps most important measures that he took.
He did some counterproductive things, like the National Recovery Act, which put the floors under prices and wages and prevented necessary adjustment.
Excuse me??? His new Keynesian roots are showing. They believe lower wages will allow labor markets to ‘clear’ when deficits are too small to support demand.
The most controversial issue recently, of course, has been fiscal policy and I think there are two sides to that.
The classic work on this by an old teacher of mine from MIT, E. Cary Brown, said that fiscal policy under Roosevelt was not successful, but only because it wasn’t tried, and he argued that it wasn’t big enough relative to the size of the problem.
True!
Other people, other writers have argued that this wasn’t the right medicine.
So that one is more controversial, but if you ask me what I think the most important things were, I think they had to do with stabilizing monetary policy and stabilizing the financial system.
Which he hasn’t yet been able to do.
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Yes, and this is a massive political risk.
The deficit is getting large enough to stabilize the economy at high levels of unemployment.
With flat employment growth, and 2% productivity growth, real GDP grows at 2% and unemployment stays north of 8%.
And the equity markets are in a very good place with costs under control and sales stabilized and rising.
So the financial sector booms while the real economy stagnates.
And fuel prices move higher as well.
Bernanke Offers Jobless Recovery as Humphrey-Hawkins Hopes Fade
by Craig Torres
Feb 23 (Bloomberg) — Bernanke Offers Jobless Recovery as Humphrey-Hawkins Hopes Fade delivering semiannual testimony required in legislation written by the late lawmakers, will describe a U.S. economy returning to growth next year without generating many new jobs. Even with credit markets thawing, Fed officials see unemployment persisting at 8 percent or higher through the final three months of 2010.
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Chairman Ben S. Bernanke- At the Stamp Lecture, London School of Economics, London, England
Jan 13, 2009
The Crisis and Policy Response
(Some text omitted)
Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence and precipitated a sharp slowing in global economic activity. The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial.
Yes, they have reduced aggregate demand. The question is what the Fed can do, if anything, to restore demand?
The global economy will recover, but the timing and strength of the recovery are highly uncertain.
Yes, after the federal budget deficit gets large enough to restore aggregate demand.
The Federal Reserve’s Response to the Crisis
The Federal Reserve has responded aggressively to the crisis since its emergence in the summer of 2007. Following a cut in the discount rate (the rate at which the Federal Reserve lends to depository institutions) in August of that year, the Federal Open Market Committee began to ease monetary policy in September 2007, reducing the target for the federal funds rate by 50 basis points.1 As indications of economic weakness proliferated, the Committee continued to respond, bringing down its target for the federal funds rate by a cumulative 325 basis points by the spring of 2008.
Maybe some day the underlying assumption that lower rates adds to aggregate demand will fall by the wayside.
The ‘math’ shows lower rates takes more income from savers than it adds to borrowers, as government is a net payer of interest.
The different propensities to consume between borrower and savers would have to be far wider than ever measured by econometrics to result in lower rates adding to demand.
In other words, there’s a good chance lower rates have made things worse.
In historical comparison, this policy response stands out as exceptionally rapid and proactive. In taking these actions, we aimed both to cushion the direct effects of the financial turbulence on the economy and to reduce the virulence of the so-called adverse feedback loop, in which economic weakness and financial stress become mutually reinforcing.
Lower rates have failed to do this. Maybe their ‘interest rate theory’ is backwards, as all evidence and logic shows???
These policy actions helped to support employment and incomes during the first year of the crisis.
No, incomes suffered from lower interest income. Employment was sustained from what was a temporary boom in exports and government spending.
Unfortunately, the intensification of the financial turbulence last fall led to further deterioration in the economic outlook. The Committee responded by cutting the target for the federal funds rate an additional 100 basis points last October, with half of that reduction coming as part of an unprecedented coordinated interest rate cut by six major central banks on October 8. In December the Committee reduced its target further, setting a range of 0 to 25 basis points for the target federal funds rate.
And all their economies got worse.
The Committee’s aggressive monetary easing was not without risks.
The largest risk was that Congress would believe they might help and not implement large enough fiscal measures, which is exactly what happened.
During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation. These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities.
As costs of production, lower interest rate reduce costs of national output.
The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations. However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies,
And pension funds and trend followers- don’t they know about that?
in combination with constraints on the supply of these materials, rather than general inflationary pressures. Committee members expected that, at some point, global economic growth would moderate, resulting in slower increases in the demand for commodities and a leveling out in their prices–as reflected, for example, in the pattern of futures market prices. As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation has already declined significantly and appears likely to moderate further.
No talk of the Great Mike Masters Futures Led Inventory Liquidation triggered in July.
It had nothing to do with monetary policy or the economy.
The Fed’s monetary easing has been reflected in significant declines in a number of lending rates, especially shorter-term rates, thus offsetting to some degree the effects of the financial turmoil on financial conditions.
They do control interest rates, whether they know it or not, and whether they know what buttons to push or not.
However, that offset has been incomplete, as widening credit spreads, more restrictive lending standards, and credit market dysfunction have worked against the monetary easing and led to tighter financial conditions overall. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Thus, in addition to easing monetary policy, the Federal Reserve has worked to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector. In doing so, as I will discuss shortly, the Fed has deployed a number of additional policy tools, some of which were previously in our toolkit and some of which have been created as the need arose.
Beyond the Federal Funds Rate: The Fed’s Policy Toolkit
Although the federal funds rate is now close to zero, the Federal Reserve retains a number of policy tools that can be deployed against the crisis.
One important tool is policy communication. Even if the overnight rate is close to zero, the Committee should be able to influence longer-term interest rates by informing the public’s expectations about the future course of monetary policy.
It can also directly set risk-free long term rates by intervening in the treasury markets and/or swap markets, targeting rates and letting quantity fall where it may.
To illustrate, in its statement after its December meeting, the Committee expressed the view that economic conditions are likely to warrant an unusually low federal funds rate for some time.2 To the extent that such statements cause the public to lengthen the horizon over which they expect short-term rates to be held at very low levels, they will exert downward pressure on longer-term rates,
Why not just have a bid for long term rates at their target rate of choice?
stimulating aggregate demand.
This assumes aggregate demand is a function of rates, and in the direction they think it is. I would argue they are most likely backwards in that respect.
It is important, however, that statements of this sort be expressed in conditional fashion–that is, that they link policy expectations to the evolving economic outlook. If the public were to perceive a statement about future policy to be unconditional, then long-term rates might fail to respond in the desired fashion should the economic outlook change materially.
Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has–and indeed, has been actively using–a range of policy tools to provide direct support to credit markets and thus to the broader economy. As I will elaborate, I find it useful to divide these tools into three groups. Although these sets of tools differ in important respects, they have one aspect in common: They all make use of the asset side of the Federal Reserve’s balance sheet. That is, each involves the Fed’s authorities to extend credit or purchase securities.
The first set of tools, which are closely tied to the central bank’s traditional role as the lender of last resort, involve the provision of short-term liquidity to sound financial institutions. Over the course of the crisis, the Fed has taken a number of extraordinary actions to ensure that financial institutions have adequate access to short-term credit.
They are actually reversing extraordinary actions taken in the past to obstruct bank access to short term credit.
In particular demanding collateral from member banks when the Fed lends to them. This is both redundant (FDIC already insures bank deposits and regulates assets, etc.) and obstructive.
These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed’s discount window.3 For example, since August 2007 we have lowered the spread between the discount rate and the federal funds rate target from 100 basis points to 25 basis points;
Why is it above the Fed funds rate and not the same rate? The idea of a ‘penalty rate’ is a result of a lack of understanding of monetary operations with a non-convertible currency.
increased the term of discount window loans from overnight to 90 days;
Yes, this hints at what I was saying before- they can set the entire term structure of rates at will.
created the Term Auction Facility, which auctions credit to depository institutions for terms up to three months;
But sets a quantity and lets an auction process determine the rate. This is backwards. They should always set a rate and let the quantity fall where it may.
put into place the Term Securities Lending Facility, which allows primary dealers to borrow Treasury securities from the Fed against less-liquid collateral;
This is better done by having the Fed lend against that collateral directly. Not sure why they do it this way.
and initiated the Primary Dealer Credit Facility as a source of liquidity for those firms, among other actions.
That should have been done via their designated agents, the banks, via qualified guarantees.
Because interbank markets are global in scope, the Federal Reserve has also approved bilateral currency swap agreements with 14 foreign central banks. The swap facilities have allowed these central banks to acquire dollars from the Federal Reserve to lend to banks in their jurisdictions, which has served to ease conditions in dollar funding markets globally. In most cases, the provision of this dollar liquidity abroad was conducted in tight coordination with the Federal Reserve’s own funding auctions.
Yes, this was an act of madness- functionally unsecured loans of over $600 billion to foreign CBs.
Congress has no idea what’s going on, and I suspect they would put quick halt to this if they had any understanding of it.
There are far less risky alternatives to bringing LIBOR down to the Fed’s targets for it..
Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm.The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers. In the case of currency swaps, the foreign central banks are responsible for repayment, not the financial institutions that ultimately receive the funds; moreover, as further security, the Federal Reserve receives an equivalent amount of foreign currency in exchange for the dollars it provides to foreign central banks.
This is no different than the Fed buying foreign ‘dollar bonds’ from the foreign governments, which have repeatedly gone bad in the past.
Is he really thinking foreign governments ‘automatically’ are good credit risks?
The line to Mexico is $30 billion, for example, and the ECB line is actually stated to be ‘unlimited’.
The currency the Fed ‘receives’ is nothing more than a deposit on the foreign central banks own books.
And the outstanding total is over $600 billion!
How does he miss all this???
Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confidence, financial institutions will be able to meet the resulting demands for cash without resorting to potentially destabilizing fire sales of assets.
True. It should have been set up years ago to make sure the liability side of banking is not the place of market discipline.
Moreover, backstopping the liquidity needs of financial institutions reduces funding stresses and, all else equal, should increase the willingness of those institutions to lend and make markets.
On the other hand, the provision of ample liquidity to banks and primary dealers is no panacea. Today, concerns about capital, asset quality, and credit risk continue to limit the willingness of many intermediaries to extend credit, even when liquidity is ample. Moreover, providing liquidity to financial institutions does not address directly instability or declining credit availability in critical nonbank markets, such as the commercial paper market or the market for asset-backed securities, both of which normally play major roles in the extension of credit in the United States.
Lending is pro-cyclical, get over it! Only government can be counter cyclical with fiscal policy.
To address these issues, the Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets.
Actually addresses interest rates.
Notably, we have introduced facilities to purchase highly rated commercial paper
Are these the same guys that were critical of investors relying on ratings agencies???
at a term of three months and to provide backup liquidity for money market mutual funds. In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve’s credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a “haircut” and the Treasury is providing $20 billion of capital as supplementary loss protection. We expect this facility to be operational next month.
Interesting how he explains how the Fed is safe at least partially because it shifted risk to the treasury.
Seems they are both on the same team in the same game???
The rationales and objectives of our various facilities differ, according to the nature of the problem being addressed. In some cases, as in our programs to backstop money market mutual funds, the purpose of the facility is to serve, once again in classic central bank fashion, as liquidity provider of last resort. Following a prominent fund’s “breaking of the buck”–that is, a decline in its net asset value below par–in September, investors began to withdraw funds in large amounts from money market mutual funds that invest in private instruments such as commercial paper and certificates of deposit. Fund managers responded by liquidating assets and investing at only the shortest of maturities. As the pace of withdrawals increased, both the stability of the money market mutual fund industry and the functioning of the commercial paper market were threatened.
It was part of the ongoing process of shifting funding back to the banking system as risk was being re-priced.
The Federal Reserve responded with several programs, including a facility to finance bank purchases of high-quality asset-backed commercial paper from money market mutual funds. This facility effectively channeled liquidity to the funds, helping them to meet redemption demands without having to sell assets indiscriminately.
This obstructed the process of moving funding back to its own banking system. The assets were moving to spreads wide enough to be held in bank portfolios. The Fed could have facilitated that process rather than obstructing it.
Together with a Treasury program that provided partial insurance to investors in money market mutual funds, these efforts helped stanch the cash outflows from those funds
Outflows to the Fed’s member banks.
and stabilize the industry.
Which can only compete with banks with help from the Fed.
The Federal Reserve’s facility to buy high-quality (A1-P1) commercial paper
Again with the ratings agencies!
at a term of three months was likewise designed to provide a liquidity backstop, in this case for investors and borrowers in the commercial paper market. As I mentioned, the functioning of that market deteriorated significantly in September, with borrowers finding financing difficult to obtain, and then only at high rates and very short (usually overnight) maturities.
The Fed could have facilitated the transition back to the banking system with provisions for banks to obtain Fed funding for the assets moving in their direction. Again, they got it wrong.
By serving as a backup source of liquidity for borrowers, the Fed’s commercial paper facility was aimed at reducing investor and borrower concerns about “rollover risk,” the risk that a borrower could not raise new funds to repay maturing commercial paper. The reduction of rollover risk, in turn, should increase the willingness of private investors to lend, particularly for terms longer than overnight. These various actions appear to have improved the functioning of the commercial paper market, as rates and risk spreads have come down and the average maturities of issuance have increased.
Would have been more constructively accomplished via the banking system.
In contrast, our forthcoming asset-backed securities program, a joint effort with the Treasury, is not purely for liquidity provision. This facility will provide three-year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans.
Again, part of the Fed’s position of rate setter, and again, could have been better done via its member banks.
Unlike our other lending programs, this facility combines Federal Reserve liquidity with capital provided by the Treasury, which allows it to accept some credit risk.
You’re on the same team, guys!
By providing a combination of capital and liquidity, this facility will effectively substitute public for private balance sheet capacity, in a period of sharp deleveraging and risk aversion in which such capacity appears very short.
The banking system is already public balance sheet as banks have unlimited access to a variety of federally insured liabilities.
Why not use the banks for the purpose they are designed for? They already have the infrastructure necessary to manage this.
Instead, the Fed hires private managers!!!
If the program works as planned, it should lead to lower rates and greater availability of consumer and small business credit. Over time, by increasing market liquidity and stimulating market activity, this facility should also help to revive private lending. Importantly, if the facility for asset-backed securities proves successful, its basic framework can be expanded to accommodate higher volumes or additional classes of securities as circumstances warrant.
Nothing the banks can’t do given the same guarantees from the Fed.
The Federal Reserve’s third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed’s portfolio. For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. Notably, mortgage rates dropped significantly on the announcement of this program and have fallen further since it went into operation.
Hopefully no surprise! Again, the Fed is rate setter for the entire term structure as desired.
Lower mortgage rates should support the housing sector. The Committee is also evaluating the possibility of purchasing longer-term Treasury securities.
It would be functionally identical for the treasury simply not to issue them, as proposed by the BOE’s Goodhart today.
In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.
These three sets of policy tools–lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities–have the common feature that each represents a use of the asset side of the Fed’s balance sheet, that is, they all involve lending or the purchase of securities. The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound.
Yes! It’s about price (interest rates) and not quantity.
Credit Easing versus Quantitative Easing
The Federal Reserve’s approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach–which could be described as “credit easing”–resembles quantitative easing in one respect: It involves an expansion of the central bank’s balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is incidental. Indeed, although the Bank of Japan’s policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve’s credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.
Another similarity is that neither did much for credit demand.
Note that the Fed’s ‘expanded balance sheet’ means that over $2 trillion of financial assets have been shifted to the Fed in exchange for a like amount of excess reserves and treasury securities being held by the private, non-government sectors.
If the average coupon on the securities the Fed removed (purchased) from the private sector was maybe 2% (more for some securities, less for others) that means this Fed action has removed over $40 billion per year of income from the private sector. This means about that much aggregate demand was removed which can only be ‘replaced’ by private credit expansion.
Seems this policy might not have been all that well thought out.
While I support the lower interest rates, I also recognize they probably do not add to demand and instead require a fiscal adjustment to sustain demand.
The stimulative effect of the Federal Reserve’s credit easing policies depends sensitively on the particular mix of lending programs and securities purchases that it undertakes. When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market.
Most likely none of them change demand enough to even offset the loss of interest income to the private sector as above.
Because various types of lending have heterogeneous effects, the stance of Fed policy in the current regime–in contrast to a QE regime–is not easily summarized by a single number, such as the quantity of excess reserves or the size of the monetary base. In addition, the usage of Federal Reserve credit is determined in large part by borrower needs and thus will tend to increase when market conditions worsen and decline when market conditions improve. Setting a target for the size of the Federal Reserve’s balance sheet, as in a QE regime, could thus have the perverse effect of forcing the Fed to tighten the terms and availability of its lending at times when market conditions were worsening, and vice versa.
Finally, the Fed setting ‘price’ rather than ‘quantity!’ too bad it hasn’t figured this out for the TAFF and other operations.
The lack of a simple summary measure or policy target poses an important communications challenge. To minimize market uncertainty and achieve the maximum effect of its policies, the Federal Reserve is committed to providing the public as much information as possible about the uses of its balance sheet, plans regarding future uses of its balance sheet, and the criteria on which the relevant decisions are based.
We’ve seen the max effect.
Exit Strategy
Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money,
Only by narrow definitions of ‘money’ as below. Net financial assets held outside of government are always unchanged by Fed operations.
an action that will ultimately be inflationary.
Another questionable theory. But the Fed is worried about inflation expectations, which is yet one more questionable theory.
The Fed’s lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed’s balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed.
There is no other option for the banking system as a whole.
Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.
Right, as long as commodities keep going down.
However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize. In addition, some programs–those authorized under the Federal Reserve’s so-called 13(3) authority, which requires a finding that conditions in financial markets are “unusual and exigent”–will by law have to be eliminated once credit market conditions substantially normalize. However, as the unwinding of the Fed’s various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee’s assessment of the condition of credit markets and the prospects for the economy.
As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds–including loans to financial institutions, currency swaps, and purchases of commercial paper–are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down.
It will be interesting to see how the currency swaps run off. In the past governments with that much in dollar loans have not paid them off.
As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy–namely, by setting a target for the federal funds rate.
Why would it not continue to set the term structure of rates??? (Though again, personally I’d leave a zero rate policy in place at all times)
Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters. Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term, which will slow the rate at which our balance sheet can shrink. We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.
Importantly, the management of the Federal Reserve’s balance sheet and the conduct of monetary policy in the future will be made easier by the recent congressional action to give the Fed the authority to pay interest on bank reserves. In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors.
Yes, like a few institutions that still do not earn interest on reserves.
However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate.
Moreover, other tools are available or can be developed to improve control of the federal funds rate during the exit stage. For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system. In considering whether to create or expand its programs, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster full employment and price stability.
How about asking Congress for permission to trade Fed funds directly with member banks? Again, requiring collateral is redundant with FDIC insurance and regulation already in place. That way the Fed could simply bid and offer Fed funds at its target rate and the Fed funds rate would be perfectly stable, with little or no interbank trading required.
Stabilizing the Financial System
The Federal Reserve will do its part to promote economic recovery, but other policy measures will be needed as well. The incoming Administration and the Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity. In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.
I don’t agree. Ongoing attention to fiscal balance that sustains output and employment will do just that, with or without the financial sector ‘operating efficiently,’ whatever that means.
In the United States, a number of important steps have already been taken to promote financial stability, including the Treasury’s injection of about $250 billion of capital into banking organizations,
Doesn’t hurt but doesn’t address the real problem- banks need borrowers with sufficient income and income prospects to make their payments.
a substantial expansion of guarantees for bank liabilities by the Federal Deposit Insurance Corporation,
Another half measure. They need to remove the cap on the size of FDIC insured deposits at the same time they remove the collateral requirement at the discount window, and drop the discount rate to their target rate.
and the Fed’s various liquidity programs. Those measures, together with analogous actions in many other countries, likely prevented a global financial meltdown in the fall that, had it occurred, would have left the global economy in far worse condition than it is in today.
It didn’t need to happen at all.
However, with the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions’ balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered. Public purchases of troubled assets are one possibility.
And highly problematic. They only ‘help’ if prices are above ‘market value,’ which means a direct subsidy.
Another is to provide asset guarantees, under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks.
Government already stands to ‘absorb’ all the losses in excess of bank capital via deposit insurance.
Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank.
Same issue as public purchases, above.
These methods are similar from an economic perspective, though they would have somewhat different operational and accounting implications. In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.
Banks need for borrowers to have sufficient income to make their mortgage payments.
Nothing the Fed does address this.
Only a fiscal adjustment can add net financial assets and income to the non-government sectors.
The public in many countries is understandably concerned by the commitment of substantial government resources to aid the financial industry when other industries receive little or no assistance. This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt. Indeed, the destructive effects of financial instability on jobs and growth are already evident worldwide. Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest.
If government understood the role of fiscal policy in sustain aggregate demand and thereby output and employment, with or without the financial sector, this would be mostly moot.
Even as we strive to stabilize financial markets and institutions worldwide, however, we also owe the public near-term, concrete actions to limit the probability and severity of future crises. We need stronger supervisory and regulatory systems under which gaps and unnecessary duplication in coverage are eliminated, lines of supervisory authority and responsibility are clarified, and oversight powers are adequate to curb excessive leverage and risk-taking.
Helpful, but more helpful is to understand the role of fiscal policy.
In light of the multinational character of the largest financial firms and the globalization of financial markets more generally, regulatory oversight should be coordinated internationally to the greatest extent possible. We must continue our ongoing work to strengthen the financial infrastructure–for example, by encouraging the migration of trading in credit default swaps and other derivatives to central counterparties and exchanges.
Right, that will bring back home buyers in droves…
The supervisory authorities should develop the capacity for increased surveillance of the financial system as a whole, rather than focusing excessively on the condition of individual firms in isolation; and we should revisit capital regulations, accounting rules, and other aspects of the regulatory regime to ensure that they do not induce excessive procyclicality in the financial system and the economy. As we proceed with regulatory reform, however, we must take care not to take actions that forfeit the economic benefits of financial innovation and market discipline.
What benefits? In 1972 housing starts were 2.6 million with a population of 215 million, and all we had were a bunch of sleep savings and loan associations taking in deposits and making mortgages, with modestly paid bank officers playing golf at 3:30 every day (I was one of them in 1973-75). A couple of years ago we peaked at 2 million housing starts with over 300 million people and called it ‘gangbusters’ and an unsustainable ‘bubble.’ And let’s just leave it at ‘a much larger and more highly paid’ financial sector dominating housing.
That’s progress?
Particularly pressing is the need to address the problem of financial institutions that are deemed “too big to fail.” It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period. The existence of too-big-to-fail firms also violates the presumption of a level playing field among financial institutions.
Not true. The ‘institution’ might be too big to fail, but not the shareholders, which is what matters regarding risk taking.
In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking. Also urgently needed in the United States is a new set of procedures for resolving failing nonbank institutions deemed systemically critical,
True!
analogous to the rules and powers that currently exist for resolving banks under the so-called systemic risk exception.
Conclusion
The world today faces both short-term and long-term challenges. In the near term, the highest priority is to promote a global economic recovery. The Federal Reserve retains powerful policy tools and will use them aggressively to help achieve this objective. Fiscal policy can stimulate economic activity, but a sustained recovery will also require a comprehensive plan to stabilize the financial system and restore normal flows of credit.
Despite the understandable focus on the near term, we do not have the luxury of postponing work on longer-term issues. High on the list, in light of recent events, are strengthening regulatory oversight and improving the capacity of both the private sector and regulators to detect and manage risk.
Finally, a clear lesson of the recent period is that the world is too interconnected for nations to go it alone in their economic, financial, and regulatory policies. International cooperation is thus essential if we are to address the crisis successfully and provide the basis for a healthy, sustained recovery.
No, any nation can independently sustain domestic demand, output, and employment with appropriate fiscal policy.
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