The more things change: Fed wrestled with same policy “exit” issues in 2009

March 4, 2015

bernanke2009.jpgThe Federal Reserve faces two big challenges in the months and years ahead: how to finally “liftoff” after more than six years of rock bottom interest rates, and how to begin drawing down its $4.5-trillion balance sheet after three massive rounds of bond purchases. But, it turns out, those questions were being raised at the U.S. central bank as far back as 2009.

That year the Fed was experimenting with what would be its first round of bond-buying known as quantitative easing, or QE. According to transcripts of its June meeting, staff made two presentations on an “exit strategy” from the unconventional accommodation, with then Fed Chairman Ben Bernanke telling colleagues: “I promised we would focus today a good bit on our exit strategy, that is, on how we’re going to unwind the policies that we have put in place.”

The outlines of the debate that continues to rage today were already there at the meeting five years ago, with Fed staff immediately pointing to an interest rate the Fed pays on excess bank reserves (IOER) as a key tool to eventually help tighten policy. Others at the meeting said QE(1) was doing its job, while Janet Yellen, the current Fed Chair who was then head of the San Francisco Fed, cautioned about the central bank getting ahead of itself: “I want to emphasize that we have to be very careful not to signal an early end to policy stimulus,” she said, adding, “the outlook over the next several years remains disturbing.”

William Dudley, the newly-installed president of the New York Fed, butted heads with Boston Fed President Eric Rosengren about how far the Fed should go in adjusting the bond purchases to target a particular level of interest rates. “I mean, talk about potentially having severe cliff effects,” said Dudley. “I’m going to buy more as rates go up? What happens if rates go up more? Then I’m going to buy more, and then I’m also going to be out of ammunition.”

Rosengren, who like Dudley has been among the most ardent defenders of aggressive easing, said the Fed should have the flexibility to respond: “We do have a long tradition of leaning against the wind, and this program seems not to be very interested in leaning against the wind,” he told Dudley. “I thought you had enough flexibility to do that. Personally I would hope that you would have the flexibility to do that and that we might do a little bit more of it.”

The Fed’s balance sheet has more than doubled from some $2 trillion in 2009, leaving the Fed open to potential losses if it decides to sell bonds in the years ahead. (The Fed has suggested it will likely just let the bonds mature naturally.) Such losses, however, would be transferred to the U.S. Treasury, a potential political headache that Dudley foresaw way back then:

“The issue from my perspective is that it’s political,” he told colleagues in 2009. “In other words, the day that you find out that you’re no longer remitting positive balances to the Treasury, there’s a nice, juicy news story, and then they go evaluate: Why did this come about?”

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