On Monday the Federal Reserve proposed a new term deposit facility that would allow the Fed to borrow directly from private institutions. Here I offer some thoughts on how this fits into the Fed’s long-term plans and what its implications for the rest of us might be.
Let’s begin with some background on how we got here. The Fed’s conception has been that the core problem we have been going through was a credit crisis– banks stopped lending and institutions stopped buying mortgage-backed securities, as a result of which businesses and consumers could not borrow adequate amounts. The Fed’s goal was to step in where private lenders would not, with the Fed initially lending directly to private banks through a new term auction facility and to foreign central banks through currency swaps, supporting issuers of commercial paper through the commercial paper funding facility, and lending broadly through a number of other new facilities. During 2009, these new programs were largely phased out and replaced by outright purchases of mortgage-backed securities and agency debt. The graph below details the asset holdings of the Federal Reserve over the last three years. Fed assets more than doubled in the fall of 2008 and remain at those elevated levels to this day.
Where did the Fed get the funds to do all this? At one level, the answer is simple– the Fed simply created the funds, unilaterally declaring that the seller of the asset or recipient of the loan now had a corresponding increase in that institution’s balance with the Federal Reserve. Those balances ultimately represent claims on green U.S. dollars, which the banks holding the credits could at any time request the Federal Reserve to deliver to the banks in armored vans. It is an accounting identity that any purchases or loans by the Fed necessarily have the consequence that the dollars thereby created must end up somewhere. One can therefore equivalently summarize the actions of the Fed in terms of the liability side of its balance sheet, which consists primarily of the credits created or dollars delivered. The graph below summarizes Fed liabilities over the last three years. The height of the graph for each week is by definition the same as that of the previous graph. Whereas the first graph summarizes what the Fed is holding, the second summarizes who is holding the stuff the Fed has created.
In normal times, the credits created by the Fed would not be held passively by banks at the end of the day, but would be actively lent out in a process that ultimately would result in the credits ending up as cash held by the public. However, so far there has been only a modest boost to currency, with the vast majority of the funds created by the Fed sitting idle at banks, represented by the green area in the graph above.
If banks were to return to the historical patterns of managing reserves, the trillion in excess reserves would end up as circulating currency with dramatically inflationary consequences. So there has been considerable discussion within the Federal Reserve of an exit strategy, or how to undo the doubling of the Fed’s balance sheet. Plan A is that the problem will take care of itself. As the economy improves, the need for the Fed to hold on to these loans and assets diminishes, and the Fed would stop rolling over loans and sell off assets to destroy the reserves it had previously created.
But there’s always been a serious question as to whether the Fed would risk sabotaging a fragile recovery by removing its support too quickly. For this reason, Fed officials have a number of backup plans in mind. The Fed set the stage for one of these by introducing the policy of paying interest on reserves in the fall of 2008. One of the reasons banks are content at the moment to let the reserves created by the Fed stand idle overnight is that, unlike the earlier rules, banks now earn interest on those idle balances. If banks become less willing to hold those surplus funds, the Fed could simply raise the interest rate it paid on deposits to whatever it took to persuade the banks to keep the reserves in their account with the Fed. In effect, reserves held in account with the Fed today function just like treasury bills. But whereas bills are used by the U.S. Treasury to borrow from the public, reserves are used by the Fed to borrow from banks, the proceeds of which borrowing the Fed has used to purchase MBS.
The problem with raising the interest rate as an exit strategy is the same as the problem with Plan A– the Fed is unlikely to want to raise interest rates as long as significant risk of a double downturn remains. Last summer Bernanke also detailed two other possible tactics, both of which again amount in effect to direct borrowing by the Fed. Initial steps to implement both of these have subsequently been announced by the Fed.
The first strategy would use reverse repos, which are essentially collateralized short-term loans from private institutions to the Fed. These are currently at around $60 billion, though the Fed has conducted preliminary steps for implementing these on a much bigger scale if need be.
The second strategy is Monday’s proposal for a term deposit facility:
Under the proposal, the Federal Reserve Banks would offer interest-bearing term deposits to eligible institutions through an auction mechanism. Term deposits would be one of several tools that the Federal Reserve could employ to drain reserves to support the effective implementation of monetary policy.
This proposal is one component of a process of prudent planning on the part of the Federal Reserve and has no implications for monetary policy decisions in the near term.
Like the expanded reverse repos, currently this still appears to be in the nature of contingency planning, getting the apparatus in place if needed. But it is the most direct implementation of the essence of the other two devices, namely, the proposal is for the Fed to borrow directly from the public in order to be able to support the prices of mortgage-backed securities and agency debt.
We sometimes describe fiscal policy as determining the overall level of the public debt, while monetary policy determines the composition of that debt between money and interest-bearing federal obligations. By that definition, the Fed has clearly now entered the realm of implementing fiscal policy, by issuing debt directly in the form of interest-bearing reserves, reverse repos, and now term deposits.
The Fed would no doubt argue that it is doing so wisely, and that the decision to absorb Fannie and Freddie’s debt and mortgage guarantees into the fiscal liabilities of the U.S. government has already been made by Congress and the President. The Fed is simply taking that reality as given and trying to minimize collateral damage.
Or one might see it this way: political pressures had been the cause of the quasi-nationalization and then de facto nationalization of mortgage debt in the first place, and the Fed found itself inextricably drawn into the mess. There is now political pressure to inflate the debt away, from which pressure the Fed nevertheless sees itself as immune.
But I fear that as this marriage between fiscal and monetary policy becomes consummated, an amicable divorce is not the most likely outcome.
My advice would be the sooner the Fed can return to plain vanilla central banking, the better.