Something for nothing is always a pretty good trade. Federal Reserve Chairman Ben Bernanke seems to have realized this hence his letter to House of Representatives Speaker Nancy Pelosi on May 13th requesting that the introduction of payment of interest on bank reserves, legislated to begin in October 2011, be bought forward with immediate effect.
To understand why the Fed is pushing for this seeming technicality at a such a critical juncture goes to the heart of its response thus far to the credit crisis and also requires us to think about the Federal Reserve’s balance sheet, the special privileges enjoyed by central banks and the constraints they face.
Like any other company, the Federal Reserve has a balance sheet with assets, liabilities and a net capital position. Unlike other institutions however the balance sheet is not an effective constraint on the activities of the Federal Reserve given its unique position as a monopoly provider of bank reserves and currency to the economy: it can issue liabilities without limit to finance purchases of assets. This is, of course, quite literally how the Fed can ‘print money’.
As with any monopolist, however, it must typically choose to control either quantity (monetary base = bank reserves + currency in circulation) or price (interest rates, specifically the Federal Funds rate). The Federal Reserve’s ability to expand its balance sheet (and so provide liquidity to the financial system) therefore is effectively circumscribed by its desire to target a specific Federal Funds rate; the overnight rate at which banks lend to each other and which, because no interest is currently paid on them, is highly sensitive to changes in the size of bank reserves. Switch on the printing presses and the Federal Reserve will quickly lose control of interest rates.
The combination of targeting the Federal Funds rate and the zero interest rate on bank reserves therefore represents a de facto balance sheet constraint. But the Fed also has control over the composition (and term structure) of assets on its balance sheet. And it is this power that underlies the strategy of ‘qualitative easing’ and the panoply of liquidity measures introduced since last August. The Term Securities Lending Facility (TSLF) is the purest example of the Fed’s ability to shift the mix assets on its balance sheet. As described above, it is literally swapping safe Treasury securities for riskier assets, leaving its balance sheet position by definition unchanged. The Term Auction Facility (TAF) and the reform of the discount window and expansion repo agreements are different in that reserve liabilities are being created: collateral is being exchanged for $s. But the Fed has sedulously ‘sterilised’ these liability creations with offsetting sales of Treasuries, particularly T-Bills, prompting a seismic shift in the composition of its balance sheet away from risk-free assets to, by definition, riskier assets. Underlining the qualitative, rather than quantitative, nature of the Fed’s liquidity measures is that adjusted monetary base growth in the year to April was just 0.7%; its most sluggish performance since September 1960 (apart from the distortions associated with Y2K). Remember this, the next time someone claims that the Bernanke Fed has recklessly been printing money!
Sterilised’ was used deliberately above as the Fed’s liquidity measures are analogous to a sterilised foreign exchange intervention. In a sterilised exchange rate intervention, the central bank sells a bond denominated in one currency and uses the proceeds to purchase a bond denominated in another. The size of the central bank’s balance sheet is unchanged but the composition of its assets is altered. Its holdings of foreign exchange are increased/reduced in an attempt to hold down/boost the external value of its currency. The monetary base is unchanged.
By shifting the mix of assets on its balance sheet away from ultra-safe Treasuries to riskier assets, the Fed is of course attempting to shift the relative price of these assets and so in turn compress risk spreads. Qualitative easing is therefore an attempt to separate and split out financial market objectives from real economy objectives: a distinction Chairman Bernanke has drawn on several occasions since the onset of the crisis. Use the balance sheet for one, interest rates for the other. While the success of the Fed’s qualitative easing strategy remains controversial (and beyond the scope of this post), this dichotomy can clearly be exploited up to the point that the Fed can make ‘sterilised’ purchases or swaps: in other words until it runs out of available Treasuries.
Before the onset of the crisis, the Fed had direct holdings of around $790bn of Treasuries. As of Wednesday 28th May, the Fed’s liquidity operations had used over half of these ‘available securities’. But this still leaves the Fed with close to $385bn of available ‘ammunition’ to further expand operations as it has pledged it will do with required.
As an aside, while an alarming ‘degradation’ of the Fed’s balance sheet seems to have taken place, it must be recognised that the Fed’s liquidity operations are thus far essentially temporary in nature rather than permanent purchases that would constitute a long-run increase in the credit risk facing the Fed’s balance sheet and, ultimately, tax payers. The Fed can relatively easily ‘re-grade’ its balance sheet by canceling the TAF and the TSLF which would allow the Treasury securities currently loaned and swapped out to the private sector to flow back onto its balance sheet. Skeptics would argue that these liquidity arrangements may well prove permanent. This remains to be seen. But in the short term concerns over the heightened credit risk facing the Fed would seem overblown.
$385bn is a lot of ‘ammo’ by anyone’s standards so that the Fed seems to be preparing for its possible exhaustion is highly prudent (worrying?). But that has to be the main motivation behind the Fed’s desire to accelerate the introduction of interest on bank reserves. Hopefully, the appeal of adopting payment of interest on reserves should be clear. By removing the de facto balance sheet constraint discussed above, it effectively yields the Federal Reserve an extra ‘degree of freedom’ in conducting monetary policy, creating separate interest rate and bank reserves channels of monetary policy transmission. The Federal Reserve would be able to have both a bank reserve target and an interest-rate target. No longer would it need to choose between the two.
In the current environment, adoption of interest on reserves also dovetails perfectly with the Bernanke Fed’s attempt to draw a distinction between the financial market and real economy objectives of monetary policy. Writing back in 2002, Marvin Goodfriend prophetically noted that payment of interest on bank reserves meant that a ‘central bank could increase bank reserves in response to negative shock to broad liquidity in banking or securities markets or an increase in the external finance premium that elevated spreads in credit markets. The increase in bank reserves would help to stabilise financial market by offsetting the temporary reduction in the private supply of broad liquidity. The latitude to pursue bank reserves policy and interest rate policy separately would be useful to the extent that shocks in financial markets and the macro-economy are somewhat independent of each other’.
The rapid introduction of payment of interest on bank reserves therefore seems a ‘win-win’ policy for the Bernanke Fed. It is ideally suited to the policy requirements of the current macro-economic conjuncture where policy makers are wrestling with exactly the type of ‘independent shocks’ referenced by Mr. Goodfriend. With the economy being simultaneously buffeted by the negative demand shock of a collapsing housing market and credit crunch but also the negative supply shock of record oil prices that further hurts demand but increases inflationary pressure, the policy trade offs facing the FOMC are increasing harsh: a theme that dominated the minutes from the April 30th FOMC meeting.
The extra degree of freedom that the policy creates removes the de facto balance sheet constraint currently in play, enabling the Fed to expand its liquidity operations almost without limit if need be. Interest rate policy will simultaneously remain to target ‘real economy’ developments. With an extra degree of freedom potentially on offer, the Fed is wise to take it. I just hope they won’t need it!