Monday, October 18, 2010

At the Fed are painted into a corner?

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A couple of articles in the Wall Street Journal, reporting on a conference at the Boston Fed, indicates that some people at the Fed may recognize that the central bank has boxed itself in more than a tad.

The first is on the question of whether the Fed is in a liquidity trap. A lot of people, based on the experience of Japan, argued that resolving and restructuring bad loans was a necessary to avoid a protracted economic malaise after a severe financial crisis. But the Fed has consistently clung to the myth that the financial meltdown of 2007-2008 was a liquidity, not a solvency crisis. So rather than throw its weight behind real financial reform and cleaning up bank balance sheets (which would require admitting the obvious, that its policies prior to the crisis were badly flawed), it instead has treated liquidity as the solution to any and every problem.

Some commentators were concerned when the Fed lowered policy rates below 2%, but there we so many other experiments implemented during the acute phases that this particular shift has been pretty much overlooked. But overly low rates leaves the Fed nowhere to go if demand continues to be slack, as it is now.

Note that the remarks by Chicago Fed president John Evans still hew to conventional forms: the Fed needs to create inflation expectations, and needs to be prepared to overshoot.

This seems to ignore some pretty basic considerations. First, the US is suffering from a great deal of unemployment and excess productive capacity. The idea that inflation fears are going to lead to a resumption of spending (ie anticipatory spending because the value of money will fall in the future) isn’t terribly convincing. Labor didn’t have much bargaining power before the crisis, and it has much less now. Some might content the Fed is already doing a more than adequate job of feeding commodities inflation (although record wheat prices are driven by largely by fundamentals).

From the Wall Street Journal, “Fed’s Evans: U.S. in ‘Bona Fide Liquidity Trap’”:

The Federal Reserve may have to let inflation overshoot levels consistent with price stability as part of a broader attempt to help stimulate the economy, a U.S. central bank official said Saturday.

“The U.S. economy is best described as being in a bona fide liquidity trap,” and given the challenges now faced by the nation, “much more policy accommodation is appropriate today,” Federal Reserve Bank of Chicago President Charles Evans said….

Mr. Evans said that such a regime, which he called price-level targeting, “would be a helpful complement to our current and prospective strategies in the U.S. There are quite a number of academic studies of liquidity-trap crises that find either price-level targeting or temporary above-average inflation to be nearly optimal policies.”…

Mr. Evans said that when a central bank “is missing both components of its dual mandate by a large margin, there is justification for targeting a higher price-level path in an effective, disciplined and limited fashion.”…

Mr. Evans gave a nod toward the delicate nature of the Fed’s relationship with the inflation outlook, saying “clearly communicating an expected path for prices would help guide the public’s understanding of the Fed’s intentions while we carry a large balance sheet and promise continued low interest rates for an extended period.”

Yves here. Note the Fed’s with markets-centric view of the world. The Fed may be able to convince investors it is going to do whatever it takes to generate inflation. That will at a minimum lead to a steeper yield curve, which will help banks rebuild their balance sheets on the sly. But the deflationary forces at work are powerful, and it isn’t clear that all the Fed’s chatting up its sincere intent to create inflation is going to move the needle as much as it hopes in the real economy.

The second sighting is more amusing. The Fed is starting to think forward to the date when it has to realize losses on all that stuff it bought during the crisis and still has on its balance sheet. Losses were baked in from the beginning, yet people at the central bank appear, weirdly, to be focusing on that issue only now.

The Fed was quite deliberately forcing the prices of credit markets instruments up via massive and sometimes rather indiscriminate purchases. It wants to unwind those positions only when it is ready to soak up liquidity, in other words, when there is meaningful inflation. But higher interest rates mean high bond yields mean lower bond prices, which mean portfolio losses.

The Fed is going to find itself in the same position as the PBoC on its dollar foreign exchange reserves. Both central banks made those purchases to pursue specific policy goals, and the monies spent were guaranteed to produce losses if and when unwound. Both institutions have allowed themselves to have these expenditures depicted as investments, which open them up to criticism (I’m not saying I am fan of either central bank’s intervention; I’m merely focusing on the political problem each faces).

Note this problem is acknowledged in a backwards fashion: the Fed should stoke up reserves now in anticipation of future losses. From the Real Time Economics blog:

A senior Federal Reserve economist says the Fed should be setting aside more of its immense profits as a safeguard against future potential losses.

“The Fed is earning and turning over to the Treasury an enormous amount,” James McAndews, co-head of research at the Federal Reserve Bank of New York, said….

However the Fed could easily one day turn losses. Say, for instance, inflation starts rising and the Fed needs to sell some of its immense portfolio of bonds to push interest rates up in order to counter inflation. It could lose money on the bonds it sells. It also pays interest to banks for reserves that they keep with the Fed. If interest rates move higher, the Fed’s interest outlays on these reserve could rise too.

Some Fed officials say they aren’t worried about this … Big losses wouldn’t be the same catastrophe for the Fed that they are for commercial banks. That’s because unlike commercial banks, the Fed can print its own money. It doesn’t have to worry about running short of funds the way commercial banks do…

Still, some economists counter that the Fed could use a bigger buffer against potential losses, if for no other reason to avoid bad appearances in the future. Its total capital, at $57 billion, is just 1.1% of total assets. If it runs through all of its capital, that wouldn’t look very good for the central bank, even though it can print all of the money it wants.

Marvin Goodfriend, an economist at Carnegie Mellon’s Tepper School of Business, noted another complication at the Boston Fed panel. Say the Fed has to push up the interest rate it pays on bank reserves to fight inflation and at the same time it is running big losses because its older bonds don’t pay much interest. It could be in the unusual position of printing money to cover its costs at the same time that it is trying to tame inflation.

Mr.Goodfriend the Fed should get a capital transfer from the U.S. Treasury. Laurence Meyer, of Macroeconomic Advisers, shot back, “absolutely not.” Mr. McAndrews said retaining more of its present profits would be a “good risk management approach,” which would ensure it has a bigger buffer for a rainy day in the future.

Yves again. This presentation is more than a tad disingenuous. First, the Fed can’t print on an unlimited basis. Even the oft unfairly pilloried Modern Monetary Theory types are quick to point out that the constraint on central bank money-creation is inflation. So big enough balance sheet losses would generate unacceptable levels of inflation, and would necessitate a recapitalization of the Fed by the Treasury, aka a bailout.

Willem Buiter, a former central banker and now chief economist of Citigroup, was as usual was years ahead of the Fed on this one, and saw the risk of the Fed needing a recapitalization as a result of its creation of an alphabet soup of rescue facilities. He was a fierce critic of these programs as an abuse of normal budgetary processes, as well as for their implication for central bank independence:

I consider this use of the Federal Reserve as an active (quasi-) fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US.

There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – taxpayers’ money.

As for the Fed’s independence (whatever independence remains), first, even if the central bank prices the private securities it purchases appropriately (that is, there is no ex ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player or a debt collector. The ex post transfers or subsidies involved in writing down or writing off private assets are (quasi-)fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework.

As usual, Buiter’s concerns are spot on, yet the Fed remains in denial about the fix it has gotten itself into. It’s remarkable that the crisis has had so little impact on its thinking.

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