Today, Federal Reserve Chairman Ben Bernanke released a speech transcript that provided the most comprehensive blueprint for the Fed's exit strategy that we've seen to date. The speech was set to be made today before the House Financial Services Committee, but Washington has a snow day. So Bernanke released it anyway. I hope Congress will use the extra time they have to read and understand the speech. It's pretty complicated, but also hugely significant. Let's look at Bernanke's plans.
First Step: Ending Emergency Facilities
Bernanke begins by explaining what we already know: that he's winding down all of the emergency lending facilities put in place to stabilize the credit markets. About this, he says:
These changes, like the closure of a number of lending facilities earlier this month, should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets; they are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC.
I have my doubts that what he's saying here is accurate. If consumer credit is still largely dependent on the Term Asset-Backed Securities Loan Facility (TALF) and the mortgage-backed security purchases, then how does he expect banks and finance companies lending to be unaffected when they end? Unless investors pick up all the slack, ending these programs will certainly "lead to tighter financial conditions for households and businesses." But let's hope my pessimism about investors' appetite for asset- and mortgage-backed securities is wrong, and Bernanke's optimism is right.
Step Two: Raise The Discount Rate
Bernanke says that he expects to raise the discount rate (the interest rate the Fed charges banks for borrowing money) before it raises the fed funds target rate (the interest rate that banks lend to each other overnight at the Fed). This should soak up some credit in the market, since banks would be discouraged from borrowing from the Fed's discount window. He didn't indicate exactly when the Fed intended to raise the discount rate, but said it would be "before long."
Right now, not many banks are borrowing from the discount window, since the Fed's Term Auction Facility, introduced during the crisis, has taken its place. But that ends in March. At that time, discount window borrowing could begin again, and at higher rates. So a discount rate increase is not meaningless.
Step Three: Forget About The Fed Funds Rate
For years, the federal funds rate has been the prevailing tool for Fed monetary policy. But lately, the fed funds market has sort of dried up. One way the Fed is distancing itself from utilizing the fed funds rate was just explained: it intends to start its tightening by raising the discount rate. But there's more. In his penultimate paragraph, Bernanke explains:
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.
So he hopes to replace that policy tool with a new one: the rate of interest that the Fed began paying banks on their reserve balances during the financial crisis. He continues:
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.
The logic is simple: the more interest the Fed is willing to pay on banks' reserves, the less money they will unleash on the market. And the money they do lend, they will want more interest for, since they can do pretty well at the Fed. That will increase market interest rates and reduce monetary supply.
My concern here, however, is that this could still lead to some inflation down the road. When banks lend to consumers or businesses, the interest they collect is already a part of the monetary supply. But when banks get interest from the Fed, it's printing money to pay that interest. If these interest rates are pushed higher, and the reserve balances grow larger, then wouldn't this cause the Fed to print even more money? The short-term monetary supply tightening would lead to more monetary supply in the longer-term.
Step Four: New Exit Strategy Tools
In addition to these measures, the Fed hopes to employ three key exit strategy tools:
The idea here is that the Fed would sell interest-bearing securities to counterparties, but promise to buy them back. So this would reduce the monetary supply in the short-term, since the Fed would get a cash inflow, and the market would experience a cash outflow. This is a good short-term tactic -- but that's all that it is. In the long-term, the Fed will eventually have to actually sell some assets or more permanently soak up monetary supply.
Term Deposits For Banks
Here's an interesting idea: the Fed is planning on offering banks term deposits -- sort of certificates of deposits (CDs) for banks. This is kind of like when banks are paid interest on their reserves, but the term deposits will not be able to count as reserves, so they're more like an actual investment. The more term deposits banks make, the less they can lend, curbing credit availability. I have the same worry here as I did interest on reserves, since the Fed will need to print money to pay interest on term deposits.
Bernanke also mentions that the Fed could begin selling some of the trillions of dollars in securities that it's accumulated since the financial crisis. But he doesn't anticipate doing so anytime soon. What he will do now is allow any securities the Fed owns that mature, to run off accordingly. That's sensible. This won't result in an excess supply of securities in the market like selling would, but it would slowly reduce some the assets on the Fed's balance sheet.
My general assessment is that these are mostly good ideas for short-term credit tightening. The question, of course, is the timing. If Bernanke waits too long, inflation may result. If he starts too soon, he might choke the recovery. But as mentioned, in the longer-term, some of these methods worry me, as they appear to imply that the Fed will be printing more money in order to tighten credit in the near-term.
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