Ben Bernanke's 'exit strategy' will involve a sea change in the conduct of monetary policy. Just ask the European Central
By BENN STEIL AND PAUL SWARTZ
The Federal Reserve last week announced that it would reinvest proceeds from its massive mortgage-bond portfolio, sustaining what Chairman Ben Bernanke had in February called its "extraordinary lending and monetary policies." But there must eventually be an exit from such policies. And if the chairman is to be taken at his word, the Fed's exit strategy will involve a sea change in the way it conducts and communicates its policies. In particular, it implies that the Fed will no longer be able to control the critically important fed-funds rate—or indeed any interest rate at all. That would have far-reaching implications for the future of monetary policy.
Between August and November 2008, the Federal Reserve swelled its balance sheet to $2.2 trillion from $940 billion to ease a potentially catastrophic credit crunch brought on by fears of cascading defaults. The assets added to the balance sheet are today comprised overwhelmingly of mortgage securities. The purchase of these securities had the parallel purpose of shoring up a collapsing housing market.
Much of the money the Fed conjured to buy these assets made its way into reserves, which the banks chose to hold at the Fed. Excess reserves—reserves held above and beyond what the Fed requires of the banks as a minimum—soared to more than $1 trillion from $2 billion.
As long as this money remains parked at the Fed, it poses no risk of fuelling inflation—just like cars parked in garages can't tie up traffic. But at some point the banks will muster the courage to begin transforming these near zero-yielding reserves into credit, and the Fed knows it then will have to act to prevent exuberance from pushing up prices too far and too fast—in traffic terms, to stop the cars from streaming onto the roads all at once.
In normal times, the Fed would do this by selling Treasury securities from its balance sheet, which the banks pay for using the excess dollars they've parked in reserves. Those dollars are then no longer available to the banks to create credit.
But these are not normal times. The Fed doesn't have an excess stock of Treasurys to sell—its holdings are at roughly what they were before the crisis. It has only a vast excess pile of politically toxic assets—the mortgage securities it has amassed since 2008. Dumping them would depress the housing market further by pushing up mortgage rates and enrage an already Fed-wary Congress.
So what will the Fed do? Chairman Bernanke has been anxious to assure the markets that he has other tools in his chest, two in particular. The first is to entice the banks to move a portion of their reserves to term deposits, which would lock up that money for a fixed period. The second is to use "reverse repos," in which the Fed continuously borrows money from the banks, using its Treasury securities as collateral. Both strategies soak up reserves.
But both strategies have a hidden "catch"—the Fed will lose control over interest rates. Since 1994, the Fed has announced its so-called fed-funds target rate, or the rate at which it intends to see banks lend reserves to each other overnight. By buying or selling securities, the Fed jiggers interest rates to keep them at the target. But if the Fed is no longer willing to sell securities to tighten policy, and if it is instead determined to drain a specific quantity of reserves through term deposits, it will have to pay whatever rate the market demands. Logically, then, the fed-funds rate will mechanically shadow the term deposit auction rate.
Since 2000, the daily correlation between the one-month Treasury repo rate and the fed-funds rate is nearly a perfect 1.0, meaning that the reverse repo strategy is functionally equivalent to the term deposit strategy. In both cases, the Fed gives up control over rates. Simply put, the Fed must choose between managing the level of reserves and managing rates. It cannot do both.
Is this a problem? It does not have to be, because a central bank can, in principle, control inflation by controlling the level of excess reserves, and therefore the money supply, while letting the market control interest rates. But we suspect that in practice it will be a big problem. This is because the Fed will not be willing to accept impotence in determining rates. Can you imagine Mr. Bernanke telling Congress that he has no idea how high rates might rise next year, since those will be determined by term deposit auctions? We can't.
We need look no further than Frankfurt for evidence. In June, the European Central Bank (ECB) assured the markets that it would reabsorb through term deposit auctions the euros it printed to buy the bonds of fiscally challenged eurozone governments, but that it would not pay more than 1%. Thus the ECB made clear that if it had to choose between monetizing debt or letting rates go up, it would monetize debt—meaning that it would allow the money supply to rise to a level it had previously maintained would be inconsistent with stable prices. Late that month, eurozone banks decided to hold on to their cash, owing to the rate cap, and one of the auctions failed to withdraw the liquidity the ECB had injected.
We expect the Fed to behave the same way, continuing to announce a fed-funds rate that it will not allow the markets to exceed, even if this means permitting far too much money to spill out into credit growth and the broader economy.
None of this matters a lick at the present moment, with inflation barely perceptible, credit weak, and banks happy to earn infinitesimal returns on their reserves. But it does suggest that the Fed's exit strategy is not credible, and that means a serious risk of high inflation down the road.
Mr. Steil is director of international economics and Mr. Swartz is an analyst at the Council on Foreign Relations
[WSJ 18 August 2010]
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