Fed Chairman Ben Bernanke was scheduled to testify on Capitol Hill this morning, but because the Capitol was frozen (by the weather, not just by filibusters) the hearing was cancelled. However, he did release his prepared testimony.
In general, in his remarks about monetary policy, Bernanke addressed the “how” of draining the huge amount of liquidity added to the system over the last 18 months or so, but he did not address the “when.” The “when” really is the most important question.
To my mind, the “when” should be a long time from now. The key problem facing this economy is not inflation, it is very low rates of resource utilization. To tighten monetary policy when the unemployment rate is at 9.7% and U.S. factories are only operating at 68.8% of capacity would be dangerous and reckless. After all, the capacity utilization rate for manufacturing is normally around 80%, and prior to the Great Recession the lowest it ever dropped to was 68.2% (November 1982).
Raising the Fed Funds rate is not the only way to tighten up monetary policy. Indeed, the Fed found that cutting the rate to zero did not provide enough monetary easing in the face of the financial meltdown a year ago.
You can’t put out a forest fire with a water pistol. There was a massive forest fire in the financial panic. It caused the private sector to want to deleverage all at once. The Federal Reserve became the balance sheet of last resort (along with the Treasury).
The monetary policy part of his testimony is presented below, along with a few comments/translations from “Central Bankerese” from me.
“In addition to supporting the functioning of financial markets, the Federal Reserve also applied an extraordinary degree of monetary policy stimulus to help counter the adverse effects of the financial crisis on the economy. In September 2007, the Federal Reserve began reducing its target for the federal funds rate from an initial level of 5-1/4 percent. By late 2008, this target reached a range of 0 to 1/4 percent, essentially the lowest feasible level.
“With its conventional policy arsenal exhausted and the economy remaining under severe stress, the Federal Reserve decided to provide additional stimulus through large-scale purchases of federal agency debt and mortgage-backed securities (MBS) that are fully guaranteed by federal agencies. In March 2009, the Federal Reserve expanded its purchases of agency securities and began to purchase longer-term Treasury securities as well.
“All told, the Federal Reserve purchased $300 billion of Treasury securities and currently anticipates concluding purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt securities at the end of March. The Federal Reserve’s purchases have had the effect of leaving the banking system in a highly liquid condition, with U.S. banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks. A range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in private credit markets and put downward pressure on longer-term private borrowing rates and spreads.”
The purchase of the Agency MBS has also been a huge prop to the housing market and the mortgage chain of companies, ranging from the agencies themselves — Fannie Mae (FNM) and Freddie Mac (FRE) — to the big originators and servicers of the residential mortgages like Bank of America (BAC).
“The FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. In due course, however, as the expansion matures the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures. The Federal Reserve has a number of tools that will enable it to firm the stance of policy at the appropriate time.”
See earlier comment about the capacity utilization levels and unemployment. Bernanke’s “in due course” does not give any real clue as to the timing of a monetary tightening. Eventually it has to happen, and the Fed Funds rate will not stay near zero forever, but forever is a long, long time.
“Most importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on banks’ holdings of reserve balances. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.”
Bank reserves only stimulate the economy, or if the economy is already overstimulated, cause inflation if they are lent out. If they sit at the Federal Reserve, they are sterile. Essentially now the Fed has the ability to bribe the banks to let the money just sit and do nothing for the real economy.
That is decidedly not the problem today. The banks have plenty of reserves, but they are just sitting on them. Perhaps Bernanke should consider imposing a negative interest rate on reserves now, and then move to a positive rate when conditions heat up.
“The Federal Reserve has also been developing a number of additional tools it will be able to use to reduce the large quantity of reserves held by the banking system. Reducing the quantity of reserves will lower the net supply of funds to the money markets, which will improve the Federal Reserve’s control of financial conditions by leading to a tighter relationship between the interest rate on reserves and other short-term interest rates.
“One such tool is reverse repurchase agreements (reverse repos), a method that the Federal Reserve has used historically as a means of absorbing reserves from the banking system. In a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future. The counterparty’s payment to the Federal Reserve has the effect of draining an equal quantity of reserves from the banking system.
“Recently, by developing the capacity to conduct such transactions in the triparty repo market, the Federal Reserve has enhanced its ability to use reverse repos to absorb very large quantities of reserves. The capability to carry out these transactions with primary dealers, using our holdings of Treasury and agency debt securities, has already been tested and is currently available.
“To further increase its capacity to drain reserves through reverse repos, the Federal Reserve is also in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as collateral in these transactions.”
This is mostly an expansion of a long-used process that the Fed has always used to manage monetary policy.
“As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions’ reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves.
“A proposal describing a term deposit facility was recently published in the Federal Register, and we are currently analyzing the public comments that have been received. After a revised proposal is reviewed by the Board, we expect to be able to conduct test transactions this spring and to have the facility available if necessary shortly thereafter. Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so.”
Of course, to do so, the Fed will have to offer more attractive interest rates on the longer-term “CDs” than on the shorter-term reserves.
“The Federal Reserve also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve’s balance sheet.”
In other words it could reverse what it has been doing, and sell off the MBS hoard it has established. That, however, would likely hammer the housing market and drive mortgage rates much higher.
“The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation.
“As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.
“I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid.
“The Federal Reserve is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities.
“Although passively redeeming agency debt and MBS as they mature or are prepaid will move us in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.”
Letting the MBS run off alone would be a nice gradual way to deflate the size of the Fed balance sheet, but it would take many years to bring the size of the balance sheet back to pre-crisis levels if this approach were to be taken.
“As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate.
“In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn.
“The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.”
The interest rate paid on reserves could become the “new Fed Funds rate” which everyone obsesses over.
It is clear that the Fed can bring its balance sheet back down to size and tighten up monetary policy; it has more than enough tools to do so. The more important question is when will it be wise to do so. That has to be dependent on the economic data.
Right now the data is practically screaming “NOT NOW, FOR GOD’S SAKE.” The day to tighten will eventually come, but it should not be for a long time, probably not until we are all writing 2011 on our checks.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
