Which way out for the Fed?

Via:  The Economist

Central banks' exit strategies
This way out

Jun 4th 2009 | WASHINGTON, DC
From The Economist print edition

The Federal Reserve weighs plans to unwind its unconventional stimulus

A FIREFIGHTER’S first rule of survival is “know your way out”. The same can be said of financial firefighting. Though it has no intention of exiting soon, the Federal Reserve is planning its path out from the extraordinary measures it has taken to free credit markets and boost demand.

With other central banks, the Fed is under growing pressure to explain its exit strategy in order to allay fears that its policies will produce inflation. On June 2nd Angela Merkel, the German chancellor, launched an astonishing attack on the Fed, the Bank of England and the European Central Bank (ECB) for their loose monetary policies. Mrs Merkel’s outburst, which trampled on a German political tradition of not commenting on the actions of independent central banks, makes life awkward for the ECB, which was due on June 4th to announce details of a plan to buy €60 billion ($86 billion) of covered bonds. But her most pointed barbs were aimed elsewhere. “I am very sceptical about the extent of the Fed’s actions and the way the Bank of England has carved its own little line in Europe,” she said.

The Fed did most to unsettle Mrs Merkel and its other critics when it said on March 18th that it would buy $300 billion in Treasuries by September, plus $200 billion in bonds issued by Fannie Mae and Freddie Mac, America’s two housing-finance giants, as well as $1.25 trillion of their mortgage-backed securities by December. The purchases are meant to drive down long-term interest rates, and at first they did. Ten-year Treasury yields fell to 2.5% from 3%. But by June 3rd they were back up to 3.5%.

Some of this increase is indeed down to higher inflationary expectations. Inflation-protected bonds now imply future inflation of 2%, up from close to zero late last year, according to Barclays. On June 3rd Ben Bernanke, the Fed chairman, put some of the increase in yields down to concern about surging government borrowing.

But the Fed attributes most of the increase in yields to investors abandoning the safety of Treasuries for riskier investments as economic optimism rises. By itself, that is not a reason for the Fed to step up bond purchases, an option it has kept open. “The aim of the programme was mostly to bring down mortgage rates and generate another wave of refinancing, which it did,” says William Dudley, president of the Federal Reserve Bank of New York*. “That said, if the choice were to keep mortgage rates lower for longer or have a recovery, I’d pick the latter.” But there may be a case for the Fed to schedule extra, smaller purchases to avoid a sharp rise in yields when the current programme ends.

The Fed has financed its loans and securities purchases in the past year by creating new reserves for the banking system (in effect, printing money). Reserves have rocketed, to almost $900 billion now from an average of $11 billion in the year to September. Many analysts see these excess reserves as a pool of inflationary fuel just waiting for the match of credit demand.

The Fed considers this analysis flawed. It sees excess reserves as a problem only if they overwhelm its ability to raise the federal funds rate when need arises. That risk has shrunk since the Fed received authority in September to pay interest on reserves, as other major central banks have long been able to. That in theory should put a floor under the Fed funds rate. Banks should not lend excess reserves at, say, 1%, if they can earn 2% from the Fed.

That said, the Fed cannot be certain that paying interest will work as planned, so it would also like to be able to soak up some reserves. Some were created by the Fed’s myriad loans to banks, issuers of commercial paper and others to unfreeze the credit markets. Those liquidity facilities charge borrowers a penalty rate which makes them less attractive as private credit returns. That is now happening, and the liquidity facilities have begun to shrink (see chart). The Fed could hurry that process up by raising the penalties.

Managing its growing securities holdings will be tougher. The Fed could simply sell them but that would create waves. “The day you sell will be a big market event,” says Mr Dudley. “Historically, the Fed has been buy and hold.” Since the average maturity of the Fed’s bond holdings is five to ten years, the Fed will have to find a way to mop up, or “sterilise”, the related bank reserves for a long time. The usual approach is to conduct reverse-repurchase agreements, borrowing from one of its 16 primary dealers for short periods of time in order to finance the assets on its balance-sheet. But dealers may not have the necessary capacity for the task.

The Fed is currently absorbing reserves by having the Treasury issue more debt than it needs. When dealers purchase the debt, cash shifts from their reserves accounts to Treasury deposits at the Fed, where they remain, unspent. But the Treasury itself is constrained by the debt ceiling set by Congress, and an independent central bank should not rely on the fiscal authority for one of its tools.

A better solution would be for the Fed to issue its own bills, as other central banks do. It could rely on a wider variety of investors, not just primary dealers, to manage its balance-sheet. It would restrict the maturity of such bills to less than 30 days to avoid interfering with Treasury’s longer-dated issuance. The hitch is that Congress has to authorise it. It may come to that. “As long as people are worried about whether we have adequate tools, it makes sense for us to get more tools even if we don’t think we need them,” says Mr Dudley.

Will paying interest on reserves prevent a new carry trade if an asset inflation heats up?  I doubt it.