OPINION
March 12, 2013, 7:06 p.m. ET
Easing the Angst About Fed Easing
By paying less interest on excess bank reserves, the Federal Reserve would reduce its liabilities. Then it could sell an equal amount of assets.
By ALAN S. BLINDER
Last month, a flurry of ill-informed speculation swept through the markets: The Federal Reserve might start backing away from its program of large-scale asset purchases ("quantitative easing"), or maybe even begin to raise the federal funds rate, before the end of the year. The talk was fueled by the release, on Feb. 20, of the minutes of the Federal Open Market Committee's January meeting.
Those minutes included these words: "Many participants also expressed some concerns about potential costs and risks arising from further asset purchases." Many?
Might Chairman Ben Bernanke's dovish majority be losing its hold on the Fed's policy-making body? Turns out he isn't, as Mr. Bernanke made clear in his testimony to the Senate Banking Committee on Feb. 26.
"The FOMC has indicated that it will continue purchases until it observes a substantial improvement in the outlook for the labor market," he said, making it clear that no such improvement has been seen. He also asserted that "the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery."
Mr. Bernanke acknowledged that "highly accommodative monetary policy also has several potential costs and risks," but he immediately and emphatically debunked them. Basically, he didn't give an inch.
This is not at all surprising. Fed watchers should have remembered the FOMC's last published Survey of Economic Projections, issued in December. Only two of the committee's 19 participants thought any sort of Fed tightening was appropriate in 2013. Two is a long way from "many." Could Fed opinion have changed massively between December and January? If so, on what grounds?
Which brings me to the main point: The fundamental case for extreme monetary ease has hardly changed. Mr. Bernanke and the FOMC majority believe deeply in the Fed's dual mandate, to keep both inflation and unemployment low. They know they are succeeding on the first but failing on the second. They also learned long ago that cutting the federal funds rate by over 500 basis points (five percentage points) was inadequate to combat the recession. Rather than give up, they opted for "unconventional" monetary policies like quantitative easing.
Mr. Bernanke's testimony also conveyed to Congress, albeit subtly, that fiscal policy is now restraining growth via higher taxes and lower spending. When it comes to supporting growth, the Fed is the only game in town.
These "fundamentals" apply just as well today as they did six and 12 months ago. So what has changed?
Well, the Fed's balance sheet keeps growing, currently at a rate of about $85 billion a month. It's now about $3.1 trillion but rising steadily. Critics claim that this growth will make the eventual exit more difficult. In some tautological sense, they must be right: If the Fed wants to get back to, say, a $1 trillion balance sheet, it has more work to do if it starts from $4 trillion than if it starts from $3 trillion.
Yet the basic exit mechanism is the same. The Fed built a big balance sheet by buying assets. It will shrink this balance sheet by selling assets and by letting assets run off as they mature.
Mr. Bernanke has noted repeatedly that, when the time for exit from super-easy monetary policy comes, the Fed can induce banks to hold on to more reserves by paying higher interest rates on those reserves. The more reserves the banks keep idle at the Fed, the less the Fed's balance sheet must shrink.
These arguments have not convinced everyone, however. Some—check that, "many"—people remain worried. Why?
First, the Fed faces a potential hazard in persuading banks to hold more reserves by paying them more interest. If the necessary interest rate turns out to be high relative to what the Fed earns on its portfolio, the central bank could find itself transformed from a highly profitable operation—to the tune of nearly $90 billion last year—to a loss-maker. That means less (or no) money flowing into the Treasury's coffers.
Second, the more bonds the Fed sells, and the more quickly it sells them, the more it will drive down bond prices. That, in turn, will inflict capital losses on bondholders—a diverse group that includes individual investors, most pension funds, many foreign governments, and the Fed itself. In worst-case scenarios, the central bank could wind up with negative net worth on a mark-to-market basis.
At first glance, that sounds horrible. A central bank with negative net worth and losing money? But hold on. The Fed isn't a private corporation that seeks profits and goes out of business once its net worth turns negative. It can still perform all of its essential functions with negative net worth. Indeed, some central banks have done so.
But bondholders will lose a lot of money when interest rates return to normal. That's for sure. The only questions are when and how fast the losses will accrue.
It's not a pretty picture. But then again, neither is unemployment lingering above 7% indefinitely. This is why Ben Bernanke and the FOMC majority keep plugging away.
Is there a way out? Here's one thing that could help. As I have argued for some time, the Fed should reduce the interest rate it pays on the roughly $1.7 trillion of banks' excess reserves. If it did so, banks would keep less cash on deposit at the Fed. The liberated funds would probably flow mainly into the money markets, but some would probably find their way into increased lending—which would give the economy a little boost.
In either case, if banks wanted to hold fewer reserves—a Fed liability—the Fed could, and naturally would, shrink its assets by an equal amount. Balance sheets do, after all, balance. And that would make the eventual exit easier.
Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of "After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead" (Penguin, 2013).
Those minutes included these words: "Many participants also expressed some concerns about potential costs and risks arising from further asset purchases." Many?
"The FOMC has indicated that it will continue purchases until it observes a substantial improvement in the outlook for the labor market," he said, making it clear that no such improvement has been seen. He also asserted that "the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery."
Mr. Bernanke acknowledged that "highly accommodative monetary policy also has several potential costs and risks," but he immediately and emphatically debunked them. Basically, he didn't give an inch.
This is not at all surprising. Fed watchers should have remembered the FOMC's last published Survey of Economic Projections, issued in December. Only two of the committee's 19 participants thought any sort of Fed tightening was appropriate in 2013. Two is a long way from "many." Could Fed opinion have changed massively between December and January? If so, on what grounds?
Which brings me to the main point: The fundamental case for extreme monetary ease has hardly changed. Mr. Bernanke and the FOMC majority believe deeply in the Fed's dual mandate, to keep both inflation and unemployment low. They know they are succeeding on the first but failing on the second. They also learned long ago that cutting the federal funds rate by over 500 basis points (five percentage points) was inadequate to combat the recession. Rather than give up, they opted for "unconventional" monetary policies like quantitative easing.
Mr. Bernanke's testimony also conveyed to Congress, albeit subtly, that fiscal policy is now restraining growth via higher taxes and lower spending. When it comes to supporting growth, the Fed is the only game in town.
These "fundamentals" apply just as well today as they did six and 12 months ago. So what has changed?
Well, the Fed's balance sheet keeps growing, currently at a rate of about $85 billion a month. It's now about $3.1 trillion but rising steadily. Critics claim that this growth will make the eventual exit more difficult. In some tautological sense, they must be right: If the Fed wants to get back to, say, a $1 trillion balance sheet, it has more work to do if it starts from $4 trillion than if it starts from $3 trillion.
Yet the basic exit mechanism is the same. The Fed built a big balance sheet by buying assets. It will shrink this balance sheet by selling assets and by letting assets run off as they mature.
Mr. Bernanke has noted repeatedly that, when the time for exit from super-easy monetary policy comes, the Fed can induce banks to hold on to more reserves by paying higher interest rates on those reserves. The more reserves the banks keep idle at the Fed, the less the Fed's balance sheet must shrink.
These arguments have not convinced everyone, however. Some—check that, "many"—people remain worried. Why?
First, the Fed faces a potential hazard in persuading banks to hold more reserves by paying them more interest. If the necessary interest rate turns out to be high relative to what the Fed earns on its portfolio, the central bank could find itself transformed from a highly profitable operation—to the tune of nearly $90 billion last year—to a loss-maker. That means less (or no) money flowing into the Treasury's coffers.
Second, the more bonds the Fed sells, and the more quickly it sells them, the more it will drive down bond prices. That, in turn, will inflict capital losses on bondholders—a diverse group that includes individual investors, most pension funds, many foreign governments, and the Fed itself. In worst-case scenarios, the central bank could wind up with negative net worth on a mark-to-market basis.
At first glance, that sounds horrible. A central bank with negative net worth and losing money? But hold on. The Fed isn't a private corporation that seeks profits and goes out of business once its net worth turns negative. It can still perform all of its essential functions with negative net worth. Indeed, some central banks have done so.
But bondholders will lose a lot of money when interest rates return to normal. That's for sure. The only questions are when and how fast the losses will accrue.
It's not a pretty picture. But then again, neither is unemployment lingering above 7% indefinitely. This is why Ben Bernanke and the FOMC majority keep plugging away.
Is there a way out? Here's one thing that could help. As I have argued for some time, the Fed should reduce the interest rate it pays on the roughly $1.7 trillion of banks' excess reserves. If it did so, banks would keep less cash on deposit at the Fed. The liberated funds would probably flow mainly into the money markets, but some would probably find their way into increased lending—which would give the economy a little boost.
In either case, if banks wanted to hold fewer reserves—a Fed liability—the Fed could, and naturally would, shrink its assets by an equal amount. Balance sheets do, after all, balance. And that would make the eventual exit easier.
Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of "After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead" (Penguin, 2013).
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