Locking up bank reserves is wrong policy focus
— John Kemp is a Reuters columnist. The views expressed are his own. —
Plotting an exit strategy and shrinking the Federal Reserve’s balance sheet has become a hot topic as policymakers try to underscore their commitment to price stability and markets ponder the risk of inflation.
But micro-managing the reserve base is a curiously inadequate way to respond to medium-term concerns about inflation. Interest rates (the cost of credit) and supervision (leverage) are broader, more appropriate tools.
It is irrelevant whether the Fed sells its assets back to the market. What matters is whether and when the central bank is prepared to raise the price of borrowing.
A NEW STORYLINE
Federal Reserve Chairman Ben Bernanke is expected to use his testimony to the House Financial Services Committee on Wednesday to outline plans for taking back some of the liquidity it injected during the crisis.
There is no suggestion the Fed wants to start reducing liquidity straight away. Rather the central bank hopes a credible plan for reducing it later will head off fears about inflation and keep bond rates and borrowing costs down.
The last thing policymakers want is for the market to ramp up the long end of the yield curve even as the Fed tries to raise the short end gradually to avoid shocking the financial markets.
Senior officials have already showcased the Fed’s tools for mopping up excess funds in the banking system and preventing them leaking out into the rest of the economy once the recovery gains more traction:
(1) Most emergency lending and liquidity facilities will be allowed to expire. Some programmes have already been discontinued from February 1 following a decision by the Federal Open Market Committee (FOMC) last month. The Committee has indicated others are unlikely to be renewed when they expire later in the year.
(2) Purchases of agency mortgage-backed securities and debt will continue for now, but the pace is slowing and the Committee anticipates the programme’s current phase will be completed by the end of March. At some point, the Fed may sell part of its holdings of non-Treasury securities back to the banks, absorbing funds.
(3) The Fed will use its authority to pay interest on excess reserves to give banks an incentive to keep much of their spare cash locked up at the central bank rather than expand their loan books or securities holdings. Officials have indicated the rate of interest on excess reserves could replace the federal funds target as the main instrument of monetary policy during the next phase.
(4) The Fed may use large-scale reverse repos and possibly offer term deposits to tie up banks’ excess funds and keep liquidity trapped in the banking system. For the past three months, the Federal Reserve Bank of New York (FRBNY)’s Open Market Desk has been trialling a series of small-scale reverse repos as part of an “operational readiness programme” in case the FOMC decides to start using reverse repos to mop up liquidity as part of a tightening programme.
A QUESTION OF TIMING
Federal Reserve Bank of St Louis President James Bullard, one of the Committee’s more hawkish members, has indicated the Fed might start the process of shrinking its balance sheet in H2 2010 if the recovery is going well, perhaps with small scale asset sales to test the market’s reaction.
Bullard suggested the goal was to shrink the balance back to its pre-crisis size and return its composition to mostly Treasury securities. But he outlined a fairly modest timeline: “You’d kind of want the situation to be back to normal in some kind of time frame before the next storm comes for the economy so that at that point you’d have a fresh set of tools and can react at that point”.
Under that timeline asset sales could be gradual and could be spread out over much of the cycle.
But no significant tightening is likely for at least half a year. The Committee voted 9-1 to retain its guidance about maintaining “exceptionally low levels of the federal funds rate for an extended period” on January 27. Based on the last tightening cycle, that translates into a commitment not to raise rates for at least six months .
OLD GHOST WALKS ABROAD
Market chatter has focused on how the Fed will mop up “liquidity” (the quantity of credit) rather than raise interest rates (the cost of credit). But it is an odd focus which betrays confusion about what policymakers should be trying to achieve and the priorities for policy going forward:
(1) Focusing on winding down the emergency facilities, shrinking the Fed’s balance sheet and returning it to Treasury securities reflects a desire to revert to a more classic monetary role and pretend the moral hazard problem will go away. But the precedent has been set. The market has a reasonable expectation the Fed will resurrect these facilities to deal with the next crisis. The precedent cannot be undone simply by allowing the facilities to “expire”.
(2) Focusing on the volume of “excess reserves” reflects the old monetarist obsession about controlling the money supply to manage inflation. It is a view that ought to have been thoroughly discredited by now. There is a loose correlation in the long run. But it is far too unstable to provide a useful guide to policy (surely we worked this out in the 1980s?).
If the last decade’s boom and bust have told us anything, it is that the total credit extended by the banking system and the shadow banks is the real concern, not the volume of excess reserves held by the commercial banks at the Fed:
* While the volume of assets purchased by the Fed is large in comparison with its pre-2008 balance sheet, the resulting cash assets held by the commercial banks still form a relatively small portion of their balance sheets .
* The total volume of credit created by bears little or no relation to the amount of narrow money created by the Fed. Total bank credit has declined since April 2008 despite the Fed’s massive liquidity injections.
Credit growth is mostly endogenous. It is driven by the demand side (banks respond to demand from their customers rather than the other way around) and balance sheet innovation (how far banks can leverage their equity capital and required reserves by getting more favourable risk and accounting treatment for loans by moving into off balance sheet vehicles).
The ratio between credit and reserves (more formally the money multiplier or velocity of circulation) is not stable. It tends to fall in recessions and rise during expansions. The Fed and markets worry that as the economy picks up, velocity will accelerate, and the same level of reserves will tempt banks to create much more credit, fuelling inflation.
PRICE, NOT QUANTITY
Interest rates were cut aggressively to allow the banks to earn their way out of the credit crisis by allowing them to fatten their net interest margins; limit the default rate by cutting the cost of debt service for households and firms; and reverse the panicked flight to safety by forcing migration to riskier asset classes.
Interest rates are currently set much too low to price liquidity appropriately. They are already producing a resurgence of risky behaviour (according to the Bank for International Settlements) and frothiness in some asset markets. If left too low for too long, they will eventually encourage a renewed bout of overborrowing by households and corporations.
At some point they must rise.
The solution to these problems is not tinkering with banks’ excess reserves. It is raising rates in a timely manner and ensuring effective supervision prevents too much credit creation outside the regulated system.
The significance of raising the interest rate payable on excess reserves is not because it keeps excess reserves locked up at the Fed, but because it will ripple through the rest of the markets and help normalise the cost of credit.