The Economic Outlook and the Fed's Balance Sheet: The Issue of "How" versus "When" - FEDERAL RESERVE BANK of NEW YORK
Speech
The Economic Outlook and the Fed's Balance Sheet: The Issue of "How" versus "When"
July 29, 2009
William C. Dudley
, President and Chief Executive Officer
Remarks at the Association for a Better New York Breakfast Meeting, Grand Hyatt, New York
It is a pleasure to have the opportunity to speak here at the Association
for a Better New
York. This group has obviously been very successful. New York today is a far
different and
vastly superior place from what I found when I first arrived as a freshman
at Columbia
University in 1970.
Today, I’d like to accomplish two tasks. First, I’ll
comment briefly on the economy and
the economic outlook—where we have been and where we may be going. I’m
going to suggest
that the balance of risks is still tilted toward weakness in growth and employment
and not toward
higher inflation. I will also argue that it is premature to talk about “when” we
are going to exit
from this period of unusual policy accommodation.
Second, I will talk about
the impact of the Federal Reserve’s lending
facilities and
purchase programs on the size of the Fed’s balance sheet. I’ll
explain why an expanded balance
sheet does not constrain our ability to exit from the current degree of policy
accommodation. In
other words, contrary to what is sometimes argued, it is not the case that
our expanded balance
sheet will inevitably prove inflationary. It is important that this critical
issue be well understood.
The public must be absolutely confident that the Fed can meet its monetary
policy objectives of
low and stable inflation and sustainable economic growth. Before I begin to
get into these issues
in earnest, let me note that, as always, the views I put forward today are
my own and do not
necessarily reflect the position of the Federal Open Market Committee (FOMC)
or the Federal
Reserve System.
Turning first to the outlook, the economic contraction appears
to be waning and it seems
likely that we will see moderate growth in the second half of the year. The
economy should be
boosted by three factors: 1) a modest recovery in housing activity and motor
vehicle sales; 2) the
impact of the fiscal stimulus on domestic demand; and 3) a sharp swing in the
pace of inventory
investment. In fact, if the inventory swing were concentrated in a particular
quarter, we could
see fairly rapid growth for a brief period.
Regardless of the precise timing,
there are a number of factors which suggest that the pace
of recovery will be considerably slower than usual. In particular, I expect
that consumption—which accounts for about 70 percent of gross domestic
product—is likely
to grow slowly for
three reasons. First, real income growth will probably be weak by historical
standards. There
were a number of special factors that boosted real income in the first half
of the year, helping to
offset a sharp drop in hours worked and very sluggish hourly wage gains. These
factors
included the sharp drop in gasoline and natural gas prices; the large cost-of-living-allowance
increase for Social Security recipients reflecting last year’s high
headline inflation; a sharp drop
in final tax settlements; a reduction in withholding tax rates; and a one-time
payment to Social
Security recipients. These factors provided a transitory boost to real incomes,
which will be
absent during the second half of the year. As a result, real disposable income
is likely to decline
modestly over this period.
Second, households are still adjusting to the sharp
drop in net worth caused by the
persistent decline in home prices and last year’s fall in equity prices.
This suggests that the
desired saving rate will not decline sharply. That means consumer spending
is unlikely to rise
much faster than income. In other words, weak income growth will be an effective
constraint on
the pace of consumer spending.
Moreover, some sectors such as business fixed
investment in structures are likely to
continue to weaken as existing projects are completed. In an environment in
which vacancy
rates are high and climbing, prices are falling, and credit for new projects
is virtually nonexistent,
this sector is likely to be a significant drag on the economy over the next
year.
Perhaps most important, the normal cyclical dynamic in which housing, consumer
durable goods purchases and investment spending rebound in response to monetary
easing is
unlikely to be as powerful in this episode as during a typical economic recovery.
The financial
system is still in the middle of a prolonged adjustment process. Banks and
other financial
institutions are working their way through large credit losses and the securitization
markets are
recovering only slowly. This means that credit availability will be constrained
for some time to
come and this will serve to limit the pace of recovery.
If the recovery does,
in fact, turn out to be lackluster, the unemployment rate is likely to
remain elevated and capacity utilization rates unusually low for some time
to come. This
suggests that inflation will be quiescent. For all these reasons, concern about “when” the
Fed
will exit from its current accommodative monetary policy stance is, in my view,
very premature.
In contrast, I think it is important to address today the issue
of “how” the
Fed can exit
from the current stance of policy when the time comes, even if its numerous
special facilities and
purchase programs continue to keep the size of its balance sheet at an expanded
level.
Why do I believe it is so important to explain the issue of “how” having
just argued that
“when” is not yet a pressing issue? The reason is that if people
believe—correctly or
incorrectly—that the Federal Reserve could have a problem managing a
smooth exit from its
accommodative policy stance, this belief alone could have the adverse effect
of causing inflation
expectations to become less well anchored and risk premia on long-dated debt
securities and
loans to rise. These effects could conceivably make it more difficult to generate
a sustainable
economic recovery.
This risk seems significant. For example, just last week
a major bank published a survey
of a broad array of 1800 investors. Of those surveyed, 20 percent thought that
inflation might
average more than 2.5 percentage points per year above their assessment of
the Federal
Reserve’s target. This outcome presumably reflects two factors—the
balance-sheet expansion of
the Fed and the large fiscal deficit.
With this in mind, let me spend the remainder
of my time discussing the sources of
growth in the Federal Reserve’s balance sheet over the past year and
a half or so, and explain
why I am confident that the exit from our accommodative policy stance, as well
as from our
various lending facilities and purchase programs, can be handled smoothly.
As
you are aware, the Federal Reserve has been engaged in a wide array of unprecedented
activities over the past two years in response to the financial crisis. These
include:
Liquidity facilities designed to improve market function. These include
facilities oriented to banks and dealers such as the Term Auction Facility
(TAF), Primary Dealer Credit Facility (PDCF) and the foreign exchange swap
programs; and facilities designed to improve market function in impaired
parts of the money and capital markets such as the Commercial Paper Funding
Facility (CPFF) and the Term Asset-Backed Securities Loan Facility (TALF).
Purchase programs oriented to easing financial conditions. These include
the agency debt, agency mortgage-backed securities (MBS) and Treasury purchase
programs.
Several firm-specific interventions in which the Federal Reserve
has taken on
illiquid asset portfolios from Bear Stearns and AIG, with the goal of managing
and liquidating these asset portfolios over time in a manner that is in the
best
interests of the federal government and the U.S. taxpayer.
These programs
have led to significant changes in both the composition and size of the Federal
Reserve’s balance sheet. For example, in August 2007, prior to the
onset of the crisis, the
Federal Reserve’s balance sheet was about $870 billion. Currently,
the size of the balance sheet
is about $2 trillion. To gain a better understanding of how we got to where
we are now, I think
it is useful to divide the past two years into three distinct phases.
The
first stage I’ll define as the period running roughly from the
start of the crisis in
August 2007 to September 2008. During this stage, the Fed’s monetary
policy implementation
regime worked in such a way that control over the size of its balance sheet,
and more specifically
over the level of excess reserves, was essential to ensure that the Open
Market Desk could
control the fed funds rate in a manner consistent with the FOMC’s monetary
policy objectives.
Had the Fed’s special liquidity facilities grown sufficiently large
during that period, raising the
level of the excess reserves in the banking system, the fed funds rate would
likely have fallen far
below the FOMC’s target rate. To keep the fed funds rate around the
target, the only sure-fire
option was to avoid a significant expansion in the balance sheet by funding
the expansion of
nontraditional assets, such as TAF loans, FX swaps, and PDCF loans with similarly
sized
liquidations of the Federal Reserve’s portfolio of Treasury securities.
Thus, over the period
from August 2007 up through the time of the Lehman Brothers failure in September
2008, the
total size of the Fed’s balance sheet and the level of excess reserves
in the banking system
changed very little.
The second stage began in October 2008 when the Federal
Reserve gained the authority
to pay interest on reserves, including excess reserves. The addition of interest
on reserves to the
Fed’s toolkit effectively broke the link between the size of the Fed’s
balance sheet and the stance
of monetary policy. Policymakers now had the capacity to expand the size
of the Fed’s liquidity
facilities and other programs without the threat of compromising the control
of monetary policy.
This new tool immediately proved enormously helpful. The Fed was able to
respond to the
deterioration of conditions in the fall of 2008 by sharply increasing the
size of its Term Auction
Facility program and removing the limits on the size of many of the foreign
exchange swap
programs. These programs, along with the increased use of the Fed’s
standing liquidity facilities
and the start-up of the Commercial Paper Funding Facility in late October,
led to a sharp growth
in the Federal Reserve’s balance sheet beginning in late September.
The third phase is marked by the launch of the Fed’s purchase programs,
starting with the
agency debt program that began in December 2008 and extends through to the
present. During
this phase, the Fed’s overall balance sheet has actually declined slightly.
The demand for the
Fed’s special liquidity programs has diminished more quickly than the
purchase programs have
been ramped up. Although this shrinkage was not anticipated or targeted,
it is a welcome
indication that there has been improvement in the functioning of the short-term
funding markets.
1
As market function has improved and credit spreads have narrowed, many of
the Fed’s liquidity
facilities have become less attractive and there has been a corresponding
decline in usage. For
example, outstanding foreign exchange swaps have declined from a peak of
$586 billion last
December to about $110 billion currently, and outstanding commercial paper
held by the CPFF
has fallen from a peak of about $350 billion last fall to around $110 billion
currently.
Despite the recent dip in the size of the balance sheet, the size
of the purchase programs
underway makes it likely that balance-sheet growth will resume as assets
acquired in conjunction
with these programs overwhelm any further declines in the funds advanced
via the shorter-term
liquidity facilities. The size of the Federal Reserve’s balance sheet
seems likely to grow to
roughly $2.5 trillion, somewhat above the peak reached last December.
It is
no coincidence that the growth of the Federal Reserve’s balance sheet since last fall
has been accompanied by a sharp rise in the amount of excess reserves. When
the Federal
Reserve extends a loan or purchases a security, this automatically adds reserves
to the banking
system unless the Fed undertakes an offsetting reserve draining operation.
Although some of
the excess reserves that have been generated by the balance-sheet expansion
were initially
sopped up by the Treasury’s Supplemental Financing Program, total excess
reserves have
climbed to more than $700 billion from nearly zero at the beginning of the
crisis.
The sharp rise in excess reserves has caused the monetary base, which
is simply the sum
of currency plus total reserves, to expand significantly. The increases in
excess reserves and in
the monetary base generated by the Fed’s balance-sheet growth have
led some observers to
worry that this expansion will ultimately prove inflationary. Proponents
of this view say that the
monetary base, the broad monetary aggregates, total credit outstanding and
inflation have
historically tended to move together, at least over longer time periods.
Thus, if the monetary
base is growing rapidly, as it has been over the past year, the view is that
this growth will
ultimately lead to inflation.
Is this concern well founded? The answer is
that in a world where banks could not be
paid interest on excess reserves, these persistent high reserve balances
would indeed have the
potential to prove inflationary.
2
In
that world, the excess reserves are likely to lead ultimately to
an overly accommodative monetary policy. The story goes like this: If banks
are earning no
interest on their excess reserve holdings, they will be willing to lend those
reserves out to any
creditworthy borrowers as long as the interest rate is positive after adjusting
for risk. The
borrowers would then spend these monies, thereby boosting economic activity.
The funds would
not disappear, but instead would flow back into the banking system as they
were deposited by
those who had received the income generated by the increase in spending,
thus replenishing the
reserves that had been lent out in the first round of lending. This would
result in a new stock of
excess reserves that would then lead to a second round of credit creation
and a further increase in
economic activity. This cycling of excess reserves into credit creation,
and the corresponding
increase in economic activity, would continue until the excess reserves were
fully absorbed by an
increase in currency outstanding and/or an increase in required reserves
associated with the rise
in the amount of banking deposits. Inflation would rise as the excessive
credit creation generated
by the excess reserves led to an overheated economy and a rise in inflation
expectations.
But that is not the world in which we now live. Because the
Federal Reserve now has the
ability to pay interest on excess reserves (IOER), it also now has the ability
to prevent excess
reserves from leading to excessive credit creation. Because the Federal Reserve
is the safest of
counterparties, the IOER rate effectively becomes the risk-free rate.
3
By
raising that rate, the
Federal Reserve raises the cost of credit more generally because banks will
not lend at rates
below the IOER rate when they can instead hold their excess reserves on deposit
with the Fed.
Because banks no longer seek to lend out their excess reserves, there is
no increase in the amount
of credit outstanding, no redeposit of the excess reserves, no increase in
economic activity and
no risk that excessive credit creation will fuel an inflationary spiral.
For
this dynamic to work correctly, the Federal Reserve needs to set an IOER
rate consistent with the amount of required reserves, money supply and credit
outstanding consistent
with its dual mandate of full employment and price stability. If demand for
credit exceeds what
is appropriate, the Federal Reserve raises the IOER rate to reduce demand.
If the demand for
credit is insufficient to push the economy to full employment, then the Federal
Reserve reduces
the IOER rate, recognizing that the IOER rate cannot fall below zero. This
does not differ much
from how the Federal Reserve has behaved historically—set the fed funds
rate at a level
consistent with the desired level of economic activity and inflation over
time.
So how does the IOER rate relate to the fed funds rate? The two rates
are likely to track
each other closely in most circumstances.
4
First,
banks generally do not have any incentive to
sell fed funds at rates below the IOER rate. Only nondepository institutions—such
as the
government sponsored enterprises (GSEs)—that can buy and sell fed funds
but are not able to
hold excess reserves with the Fed, might have an incentive to sell fed funds
at rates below the
IOER rate. But even in this case, the fed funds rate would not likely fall
far below the IOER
rate. After all, if the fed funds rate were to fall significantly below the
IOER rate, banks could
purchase the fed funds and hold them as reserves with the Fed, earning the
difference. The
ability of banks to engage in arbitrage should limit the size of the deviations
between the IOER
rate and the fed funds rate. Thus, through the IOER rate, the Federal Reserve
can effectively
retain control of monetary policy.
In addition to paying interest on excess
reserves, the Federal Reserve also has the ability
to drain the excess reserves from the banking system. This can be done in
a variety of ways:
reverse repo transactions with dealers and other counterparties, securities
sales from the Fed’s
portfolio or bill issuance by the Treasury, with the funds deposited at the
Federal Reserve.
Although our ability to pay interest on excess reserves is sufficient to
retain control of monetary
policy, it is not bad policy to have both a “belt and suspenders” in
place. As a result, we are
working out ways to drain reserves to provide reassurance that we will not—under
any
circumstance—lose control of monetary policy.
A related concern is the
question of whether the Federal Reserve will be able to act
quickly enough once it determines that it is time to raise rates. This concern
reflects the view
that the excess reserves sitting on banks’ balance sheets are essentially “dry
tinder” that could
quickly fuel excessive credit creation and put the Fed behind the curve in
tightening monetary
policy.
In terms of imagery, this concern seems compelling—the banks sitting
on piles of money
that could be used to extend credit on a moment’s notice. However,
this reasoning ignores a
very important point. Based on how monetary policy has been conducted for
several decades,
banks have always had the ability to expand credit whenever they like. They
don’t
need a pile
of “dry tinder” in the form of excess reserves to do so. That
is because the Federal Reserve has
committed itself to supply sufficient reserves to keep the fed funds rate
at its target. If banks
want to expand credit and that drives up the demand for reserves, the Fed
automatically meets
that demand in its conduct of monetary policy. In terms of the ability to
expand credit rapidly, it
makes no difference whether the banks have lots of excess reserves or not.
Another
source of concern among some market participants has been the Federal Reserve’s
purchase of Treasury securities. The worry here is that the Federal Reserve’s
purchases are “monetizing the debt” and that therefore these
purchases will ultimately prove
inflationary.
Regarding the Fed’s Treasury purchase program, I want to make two points.
First, with
the fed funds rate constrained at zero lower bound, policymakers needed to
find other ways to
stimulate economic activity. The agency debt and agency MBS purchase programs
proved
effective in narrowing credit spreads in the debt and MBS market, but the
Federal Reserve would
have encountered diminishing returns in terms of impaired market function
if it had raised the
sizes of these two programs further. This suggested that the best course
to hold down mortgage
rates and other private borrowing rates would be to engage in a Treasury
purchase program that
would put downward pressure on Treasury rates. In this regard, the Fed’s
purchases have not
been motivated by accommodating an expansive fiscal policy and the large
fiscal deficits that are
its consequence. I can assure you that the Federal Reserve will never engage
in a program to
accommodate or facilitate an unsustainable fiscal policy program. Instead,
these programs were
designed to help ease financial conditions at a time that the Federal Reserve
could not push the
fed funds rate below zero.
Second, the program is small. So even if one were
to take a darker view of what the
Federal Reserve has done, it is important to put the purchase program in
context. Even after
completion of a purchase program of up to $300 billion of Treasuries, the
Federal Reserve’s
holdings of Treasuries will be smaller than they had been in August 2007
on the eve of the crisis.
Moreover, as a share of Treasuries outstanding, the Fed’s share will
be the lowest since the early
1990s.
Overall, the Federal Reserve’s balance-sheet expansion has had
notable benefits. The
asset purchase programs have helped to keep longer-term private interest
rates relatively low,
and the expansion of liquidity facilities has helped to restore more normal
market function.
However, this does not mean that the Federal Reserve balance-sheet expansion
and Treasury
purchase program are cost free, only that the benefits of these programs,
individually and
collectively, are seen as exceeding the potential costs.
Nevertheless, there are three issues on the cost side that deserve note.
First, policymakers need to take seriously any concerns that the Fed’s
actions might conceivably lead
to an inflation problem. After all, inflation is driven mainly by two variables—inflation
expectations and the degree of pressure on resources. It would be potentially
very damaging if
any of the Fed’s programs were to unhinge inflation expectations.
One risk with embarking on
the Treasury purchase program was that it had the potential to create the
misperception that the
Fed was providing the fiscal authorities with the means to fund a more stimulative
fiscal policy
than they would otherwise have been able to finance. This misperception around
the intent and
purpose of the program could have undermined the Fed’s credibility
and triggered a damaging
rise in inflation expectations. Indeed, one of my primary goals for this
speech is to make it clear
that we have not compromised our ability or our commitment to keep inflation
in check.
Keeping inflation and inflation expectations well anchored around a low level
is essential.
Second, the Federal Reserve’s balance-sheet expansion
does have a consequence for the
balance sheet of the banking system. The increase in the amount of excess
reserves has to be
held by banks. Excess reserves are a risk-free asset that they may not wish
to hold. More
important, to the extent that the banks worry about their overall leverage
ratios, it is possible that
a large increase in excess reserves could conceivably diminish the willingness
of banks to lend.
At present, these balance-sheet issues do not appear to be having a meaningful
effect on bank
behavior. In fact, the excess reserves serve as a liquidity buffer that many
banks find attractive
in the current environment. But that does not mean we can ignore this issue.
We need to keep
this issue in mind as we contemplate how much balance-sheet expansion might
be appropriate.
Third, the Federal Reserve is taking on some interest-rate
risk in terms of its balance
sheet. The excess reserves have an overnight maturity. These liabilities
are being used to
purchase longer-term assets. In principle, if short-term interest rates were
to move up very
sharply, the cost of funding could eventually exceed the return on the Fed’s
assets. The bigger
our balance sheet, the greater the amount of interest-rate risk we are assuming.
We
have examined this issue in detail. Suffice it to say, it is conceivable
that the Federal Reserve’s net-interest margin could be pinched in
certain environments—say
if the economic
recovery turned out to be very robust. But our analysis shows that it is
extremely unlikely that
the Fed’s net-interest margin will turn negative. In part, that is
due to the fact that the balance-sheet
risk associated with the interest-rate mismatch is offset to a large degree
by the fact that the
cost of much of the Fed’s liabilities—the amount of currency
outstanding—is
zero. So when
short-term rates rise, the cost of a significant portion of the Fed’s
liabilities is unaffected.
Making policy during a crisis involves making tough
choices. Perfect solutions are not
always achievable or even legally feasible. I can assure you that our decisions
have been made
carefully, always with an eye toward finding the right balance between the
risks and rewards of
alternative options. Most critical is our commitment never to take actions
that might
compromise our ability to retain our control of monetary policy and that
might undermine our
ability to achieve our dual mandate of full employment and price stability.
Thank
you for your kind attention. I would be very happy to take a few questions.
__________________________________________
1
However, it was anticipated that the attractiveness of the Fed’s
facilities would decline as market conditions improved. In fact, it was a key
element of the exit strategy that was deliberately built into the design of most
of the facilities.
2
That rate is unlikely to spur too much lending
right now given the constraints on credit availability, but at some future date
it undoubtedly would be too low once the recovery is sufficiently advanced and
credit conditions improved.
3
For a more detailed discussion of monetary policy
implementation under a regime in which the central bank pays interest on reserves,
see: Todd Keister, Antoine Martin, and James J. McAndrews (2008), "Divorcing
Money from Monetary Policy," Federal Reserve Bank of New York Economic Policy
Review, Vol. 14 (2), 41-56; and Todd Keister and James J. McAndrews (2009), "Why
Are Banks Holding So Many Excess Reserves?" Federal Reserve Bank of New
York Staff Reports, no. 380.
4
In a world of excess reserves and a positive
IOER, either the IOER or the fed funds rate could conceivably be used as the
primary instrument of monetary policy. The Federal Reserve would have precise
control over the IOER and this would lead to some variability in the actual
fed funds rate. This would not be much of a departure from the
recent past in which the actual fed funds rate has tended to fluctuate closely
around the fed funds target.
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