Federal Reserve – The long way home

July 21, 2009

– Christopher Swann is a Reuters columnist. The views expressed are his own —

NEW YORK, July 21 (Reuters) – Seldom in its history has the Federal Reserve faced the challenge of articulating how it might conduct monetary policy a year or more ahead. But with the Fed balance sheet at an unprecedented 14 percent of GDP, markets and lawmakers are demanding assurances that the central bank will be able to slim down quickly when the time comes.

Ben Bernanke has correctly judged that the time is right to flesh out an exit strategy. In an op-ed article in the Wall Street Journal, published hours ahead of his semi-annual testimony to Congress today, Bernanke was pitch perfect. That said, he needs to follow through with even more detail soon. The more credibly the Fed can detail its eventual egress, the more flexibility it will have for a final burst of stimulus should the need arise — and it very well may.

Even for an institution so accustomed to crafting a finely balanced message, the task the Fed now faces is especially daunting. By talking too much about how rates will eventually be raised, the Fed risks giving the impression that they are poised to pull the trigger.

This could unsettle markets and push up borrowing costs. On the other hand, failure to fully lay out an exit strategy will eventually fan inflationary fears. This too could push up interest rates and stifle early signs of recovery.

The main message that Bernanke has sent today is that policy will need to remain “accommodative” for an “extended period.” In all probability it will be over a year before the Fed needs to tighten policy. The recovery is still extremely anemic and a yawning output gap means that the United States can grow above capacity for some time before inflation risks resurface.

Bernanke was also right to spell out in detail exactly how he can raise the Fed funds rate without the need for a fire sale of the central bank’s giant asset portfolio. In his testimony over coming days, the chairman should provide even more specifics.

The Fed’s ability to pay interest on bank reserves is indeed a powerful tool. It will enable the central bank to lock up liquidity without selling a single security. No commercial bank will be willing to lend in the interbank market at a lower rate of interest than it can secure risk free by parking its money at the Fed.

Even so, as Bernanke recognizes in the Wall Street Journal article, the technique is not perfect. The fact that not all financial institutions can be paid interest on reserves held at the Fed — most notably the government sponsored enterprises — creates a leakage. As a result the Fed may have to offer 2.75 percent to banks, for example, to achieve a Fed funds rate of 2 percent. To avoid this inconvenience, Bernanke should announce some alternative means of offering interest to the GSEs. This would create a harder floor under Fed funds.

Secondly, Bernanke identified reverse repos as a means of soaking up liquidity. Now he could indicate how to strengthen the Fed’s capacity to conduct these operations. This technique involves a temporary sale of securities by the Fed to the financial sector, with a promise to buy back later.
Traditionally the Fed has offered government securities as collateral to the financial system for these loans. With its balance sheet swollen with mortgage-backed securities, it should broaden the range of assets it puts out, Vincent Reinhart, a former Fed economist, told me in an interview on Monday. The central bank should also provide more details of how larger reverse repo auctions would work.
Bernanke also points to sales of government securities as a means of draining bank reserves. Since the Congress seems unwilling to give the Fed authority to issue its own bonds, the chairman suggested that the Treasury will act as their proxy. A more detailed accord might be helpful.

The Fed is now at a turning point. The political heat on the Fed has intensified at precisely the moment it is seeking new authority as a systemic regulator. This, combined with worries about the size of its balance sheet, seems to have undermined the Fed’s willingness for bold action to revive the economy.

Bernanke now has a chance to convince lawmakers and markets that the Fed is under control and can raise rates at will. Then the Fed can get back to its main job of kick-starting America’s economic recovery.

For previous columns, Reuters customers can click on [SWANN/]
(Editing by Martin Langfield)

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