The Great Debate

Fed sets out exit strategy

March 26, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

Intense criticism of the Fed’s role in the financial rescue program and the decision to triple its balance sheet, including monetizing a portion of the Treasury’s debt, has forced the central bank to issue an unusual defense of its actions (http://www.federalreserve.gov/newsevents/press/monetary/20090323b.htm).

It attempts to placate critics by acknowledging the real risk of inflation, and marks the Fed’s first attempt to set out an “exit strategy” for ending quantitative easing and other credit programs once the crisis is safely passed.

The joint statement issued with the U.S. Treasury reflects “the common views of the Treasury and the Federal Reserve on the appropriate roles of the Federal Reserve and the Treasury during the current financial crisis and in future.”

The last time the Fed and Treasury were forced to reach such an agreed statement defining their respective responsibilities was in 1951. Over the previous 15 years, monetary and fiscal policies had largely become fused as a result of the Great Depression (with interest rates kept artificially low to support recovery, then abandoned as a tool of monetary management in favor of reserve requirements) and World War Two (with rates repressed to help finance the government’s massive borrowing program).

Even after the war had finished, the Fed held short-term interest rates at just 1 percent. Rates did not begin to rise until the start of 1948, and they were still at just 2 percent by the end of 1952 (https://customers.reuters.com/d/graphics/WARTIMEFINANCE.pdf).

Crucially, the Fed also enforced a 2.5 percent ceiling on long-term Treasury yields through open market operations to hold rates down and support the federal government’s massive wartime borrowing program and the need to refinance the debt at low cost. Precisely what the Bernanke Fed is now doing through its Treasuries purchase program.

The distortions created in financial markets as a result of a long period of ultra-low rates and massive government borrowing made an “exit” from the program extremely difficult.

One result was the huge bout of post-war inflation in the late 1940s, when the massive amount of liquidity in the system intersected with the removal of price controls, industries geared to wartime rather than consumer production, and the outbreak of the Korean war.

Copper prices, for example, doubled between 1946 and 1948 and there were smaller but sharp increase in the price of most other raw materials (https://customers.reuters.com/d/graphics/METALSPRICES.pdf).

Not until 1951 were the Fed and Treasury able to reach an accord on their respective roles, and was the Fed able to start gradually normalizing interest rates. The Fed gradually loosened its control over long-term rates and allowed them to drift upwards.

The joint statement issued by the Federal Reserve and Treasury on Monday evening reiterates that “Actions that the Federal Reserve takes … such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy.”

It notes that the Treasury has a “special financing mechanism” which helps the Fed manage its balance sheet. The Treasury used this supplementary financing program to sterilize the Fed’s asset purchases during the early stages of the crisis in September and October 2008 by issuing extra cash management bills to soak up the additional liquidity the Fed was pumping into the system and prevent a build up of (potentially inflationary) bank reserves.

The supplementary financing program was subsequently abandoned in favor of a more expansionary policy of unsterilized asset purchases. But it could be reintroduced to issue new Treasury securities and drain excess bank reserves and liquidity from the system if necessary.


But the most important part of the joint statement notes “the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.”

What this last point means, in plain English, is that the Fed recognizes that the massive increase in bank reserves caused by its purchases of financial assets for cash or easily marketable securities does pose an inflationary risk once the heightened demand for cash is saturated, or starts to fall back to more normal levels.

The Fed wants to head off this risk by being able to sterilize some of the excess bank reserves at the appropriate time in future. In particular, it wants the ability to replace the bank reserves (which are cash-like instruments that banks can tap on demand) with longer-term liabilities (which will tie up bank funds and cannot be accessed immediately).

One option is to have the U.S. Treasury issue debt to the market (draining excess funds from the banking system) and depositing the proceeds with the Fed (where they will be under the control of the government, rather than the banks, so pose less inflationary risk).

The total volume of Fed liabilities would still be the same, but ownership would switch from the private sector (where it might be inflationary) to the government (where it would simply represent an inter-governmental transfer that would allow the Treasury to fund some of its massive borrowing requirement). This is what the Fed means about the Treasury being able to help the Fed manage its balance sheet.


The other option is for the Fed itself to start issuing debt securities to the banks, which they would buy with cash and excess reserves. The Fed would essentially swap one form of liabilities (excess reserves) for another (Fed debt). If the debt was structured appropriately, it could be much less “money-like” and liquid, absorbing some of the excess liquidity in the system.

What the Fed is hinting at in this statement is that it will ask Congress for the (unprecedented) power to issue its own debt securities. The advantage of these Fed securities would be threefold:

(1) Because they would be issued by the Fed rather than the Treasury, they would not count toward the federal government’s debt ceiling. Since they will in fact be contingent liabilities of the United States government, Congress might choose to impose some restrictions on the amount of debt the Fed can issue, and other oversight requirements. Fed officials are likely to oppose this, however, arguing they must preserve maximum operational “flexibility” to respond to crises and changing conditions.

(2) By design, Fed securities will be less liquid than cash, bank reserves or U.S. Treasuries. Various restrictions could be placed on how they are traded. For example, the Fed might insist that they can only be held by member banks of the Federal Reserve System. This would make them less money-like and reduce the risk that banks would be able to use their holdings as quasi-reserves against which they can safely extend new loans. Or they could simply be made non-tradable like U.S. savings bonds. The key point here is that the Fed securities have to be less liquid and money like than the bank reserves they will be replacing. They will be a very special form of debt.

(3) Banks will probably be compelled to hold some of these new securities as part of regulatory reforms that will oblige them to hold more capital. That would give the Fed a guaranteed market into which it could sell these securities. It would help drain liquidity from the system by replacing excess reserves (which the banks are holding optionally) with special Fed securities (which they would have to hold as a matter of law).

2 comments so far | RSS Comments RSS

Smart moves;
Question is will it work this time the same way it did over 50 years ago?
The fifties were a period of growth where a lot of pent up demand was satisfied, allowing the fed and treasury to release/distroy this hot air as needed without creating inflation.
How will this be possible today with lower growth rates?
I do not know the how much money was involved then, but I would think it will take a long(er) time this time. In my opinion, they are playing with fire here, but is there another choice?

Posted by Hans | Report as abusive

Dear Sir

I understood from your article that FED is planning to reduce liquidity by selling long-term debt type instruments. Please correct me if my understanding is wrong.

If so, what if no one wants to buy such instrument at the very moment when FED wants to step in to absorb liquidity?

Here is a possible scenario:
FED faces a political pressure to maintain interest rate at low level simply because of the natural fear to lose its control over the size of its liability. By the time FED wants to operate their measure to absorb liquidity,a strong inflation expectation prevails among market participants. Under such a circumstance, at low interest rate, such an instrument could fail to win popularity in the market.

I must be missing some important elements in their plan, since they are smart enough to take such simple risks into consideration.

Thanks in advance for your advice.


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