Tag: Federal Reserve

Does Fed Leverage and Asset Maturity Matter?

Debate over whether to subject the Federal Reserve to a policy audit has occasionally focused on the size and composition of the Fed’s balance sheet. While I don’t see this issue as central to the merits of an audit, it has given rise to a considerable amount of smug posturing. Let’s step beyond the posturing and give these questions some of the attention they deserve.

First the facts. The Fed’s balance sheet has ballooned over the last few years to about $4.5 trillion. And yes, the Fed discloses such. No argument there. The Fed, like most central banks, has traditionally conducted its open-market operations in the “short end” of the market. The various rounds of quantitative easing have changed that. For instance the vast majority of its holdings of Fannie & Freddie mortgage-backed securities ($1.7 trillion) have an average maturity of well over 10 years. Similarly the Fed’s stock of treasuries have long maturities, about a fourth of those holdings in excess of 10 years.

Now the leverage question. We all get that the Fed cannot go “bankrupt” like Lehman. But that’s because “bankrupt” is a legal condition and one from which the Fed has been exempted. Just like Fannie and Freddie cannot go “bankrupt” (they are considered legally outside the bankruptcy code). The eminent economist historian Barry Eichengreen tells us the Fed’s leverage doesn’t matter as “the central bank can simply ask the government to replenish its capital, much like when a government covers the losses of its national post office.” Some of us would say that’s a problem not a solution, just like it is with the Post Office.

Others would suggest the Fed’s leverage doesn’t matter because “the Fed creates money”. Again that misses the point. Any losses could be covered by printing money, but isn’t that inflationary?  And that, of course, is just another form of taxation. So it seems Senator Paul’s primary point, that the Fed’s balance sheet exposes the taxpayer to some risk has actually been supported, not discredited, by these supposed rebuttals.

Let’s get to another issue, the maturity of the Fed’s assets. There’s a good reason central banks generally stay in the short end of the market. It avoids taking on any interest rate risk.  When rates go up, bond values fall. Yes the Fed can avoid recognizing those losses by simply not selling those assets. But that creates problems of its own. If we do see inflation, normally the Fed would sell assets to drain liquidity from the market. But would the Fed be willing to sell assets at a loss? At the very least there would be some reluctance. And yes they could cover those losses by printing money, but that’s hardly helpful if the Fed finds itself in a situation of rising prices.

The point here is that the Fed’s balance sheet does raise tough questions about its exit strategy.  Perhaps the economy will remain soft for years and the Fed can exit gracefully.  Perhaps not.  I raised this possibility before Congress a year ago.  I don’t know anyone with a crystal ball on these issues.  But one thing is certain, this is a debate we should be having.  Its the “nothing to see here, move along” crowd that poses the true risk to our economy.

Fact Checking the Fed on “Audit the Fed”

With the introduction of bills in both the House (H.R. 24) and Senate (S.264) allowing for a GAO audit of the Federal Reserve’s monetary policy, officials at both the Board and regional Fed banks have launched an attack on these efforts.  While we should all welcome this debate, it should be one based on facts.  Unfortunately some Fed officials have made a number of statements that could at best be called misleading. 

For instance Fed Governor Jerome Powell recently claimed “Audit the Fed also risks inserting the Congress directly into monetary policy decisionmaking”.  I’ve read and re-read every word of these bills and have yet to find such.  H.R. 24/S.264 provide for no role at all for Congress to insert itself into monetary policy, other than Congress’ existing powers.  I would urge Governor Powell to point us to which particular part of the bill he is referring to, as I cannot find it.

The Fed Should Quit Making Interest-Rate Promises

If there’s anything we ought to have learned from the recent boom and bust, it’s that a Fed commitment to keep interest rates low for any considerable length of time, like the one Greenspan’s Fed made in 2003, is extremely unwise. 

The problem isn’t simply that interest rates should be higher, or that the Fed should have a different plan for how it will adjust them in the future.  It’s that the Fed shouldn’t be making promises about future interest rates at all, because it can’t predict whether a rate chosen today will be consistent with stability in six months, or in one month, or even in a week.

Instead of making promises about future interest rates, the Fed should promise to change its interest rate target whenever doing so will serve to maintain a reasonable level of nominal spending or nominal gross domestic product, which is the best way to avoid causing either a boom or a bust.

Bankers Advise Fed to Regulate Bitcoin

Four times a year members of the Federal Reserve Board are scheduled to meet with members of the banking industry, as represented by the Fed’s Federal Advisory Council.  This, of course, does not include all the many other occasions that the Fed meets with bankers.  These meetings allow the banking industry to express its views to the Fed on a wide range of issues.  Summarized records of those meetings are released to the public.  In the most recent meeting, bankers raised, among other topics, the issue of Bitcoin. 

While the bankers did not yet view Bitcoin as a viable competitor to their role in the payments system, the bankers did express that Bitcoin “regulation is advisable.”  Those soft-hearted bankers expressed a concern that without adquate consumer protections, users of Bitcoin would be vulnerable to fraud and theft.  Bankers also suggested, presumably out of a concern for national security, that Bitcoin be subject to the same anti-money-laundering procedures, including Know-Your-Consumer, that banks are subjected to.  Bankers explicitly suggested that Bitcoin be subjected to the suspicious activities reports (SARs) that banks must currently file. Personally, this all sounds like an attempt at “raising rivals’ costs” to me.

Interestingly banks also suggested that in “an economy hypothetically dominated by Bitcoin, its finite number (21 million) would prevent the application of traditional monetary policy tools to provide support…” In other words banks are concerned that a Bitcoin world would be one where bank bailouts and assistance were more difficult to achieve.  I guess one man’s bug is another man’s feature.

The Federal Reserve’s “Foreign Banking Organization” Rule Is Unnecessary

Last November, Arthur Long and I released a policy study on the likely impact of the Federal Reserve’s 2012 “Foreign Banking Organization” proposal.

We argued – along with many others – that the proposal amounted to little more than a costly corporate reshuffling exercise. Of even greater concern, we suggested that the proposal threatened the ability of global banks to allocate capital and liquidity in an efficient manner, would increase financial instability, and dampen economic growth.

Yesterday, the Federal Reserve released a final rule that is essentially the same as the original proposal. The final rule is more lenient only in the sense that it increases the timeframe for compliance, simplifies the leverage requirements a little, and impacts fewer organizations. To that end, the fundamental criticisms still apply, as does the confusion around why such a proposal is necessary.

Governor Tarullo – a leading proponent of the rule – has argued that the Federal Reserve extended financial “support” to foreign banks at unprecedented levels during the crisis and therefore should be given greater oversight of these banks’ activities. That sounds reasonable. But upon closer review, the support he refers to was limited to liquidity provided through the Fed’s discount window. Foreign banks were not eligible to receive TARP or other forms of bailout assistance.

Fed officials have gone to great lengths to argue that providing liquidity through the discount window (which may be provided only to otherwise solvent institutions on a fully collateralized basis) is a legitimate central bank function and is NOT financial assistance constituting a bailout.

I agree (although on this point, I note that I depart quite radically from some of my contemporaries). However, this argument does undermine the central pillar supporting the Fed’s new rule. In addition, if protecting U.S. taxpayers is the fundamental aim, why implement a rule that will close-off the channels of liquidity and support that the U.S. subsidiary could receive from the foreign parent? 

The Fed’s rule may well spark retaliatory actions from foreign regulators, who are even more annoyed about it than the banks they oversee. The losers will be both local and foreign banks and, most importantly, consumers of credit. Governor Tarullo himself noted during yesterday’s open meeting that the rule “may not strike the right balance indefinitely.” The Fed had an opportunity to lead from the front. That it failed to do so is unfortunate. 

Yellen and the Fed

The Senate Banking Committee just voted 14 to 8 to confirm Janet Yellen’s nomination to be the new Chair of the Federal Reserve. She will likely go on to be confirmed by the full Senate.

Much of the coverage has focused on Yellen as a person, when the real story is on the Fed as an institution. Sometimes individuals have profound influence on Fed policy, such as Paul Volcker  in the late 1970s and 1980s. Over time, however, the institutional structure of the central bank and the incentives facing policymakers matter more.

The Federal Reserve famously has a dual mandate of promoting maximum employment and price stability. The Federal Open Market Committee, which sets monetary policy, has great discretion in weighting the two policy goals. As a practical matter, the vast majority of the time, full employment receives the greater weight. That is because the Fed is subject to similar pressures as are the members of Congress to which the Fed must report. In the short run, voters want to see more job creation. That is especially true today. The United States is experiencing weak growth with anemic job creation.

Never mind that the Fed is not capable of stimulating job creation, at least not in a sustained way over time. It has a jobs mandate and has created expectations that it can stimulate job growth with monetary policy. The Fed became an inflation-fighter under Volcker only when high inflation produced strong political currents to fight inflation even at the cost of recession and job creation.

The Federal Reserve claims political independence, but it has been so only comparatively rarely. Even Volcker could make tough decisions only because he was supported by President Carter, who appointed him, and President Reagan, who reappointed him. Conventionally defined inflation is low now, so the Fed under any likely Chair would continue its program of monetary stimulus. Perhaps Yellen is personally inclined to continue it longer than might some other candidates. But all possible Fed chiefs’ would face the same pressures to “do something” to enhance job growth, even if its policy tools are not effective.

The prolonged period of low interest rates has made the Fed the enabler of the federal government’s fiscal deficits. Low interest rates have kept down the government’s borrowing costs, at least compared to what they would have been under “normal” interest rates of 3-4 percent.

Congress and the president have been spared a fiscal crisis, and thus repeatedly punted on fiscal reform. They are likely to continue doing so until rising interest rates precipitate a crisis. How long that can be postponed remains an open question.

Does Janet Yellen Know What a Bubble Looks Like?

With Larry Summers withdrawing from the race for Federal Reserve chair, current Fed vice chair Janet Yellen has pulled into the lead to become Ben Bernanke’s replacement. Previous to her current appointment, Yellen served as president of the San Francisco Federal Reserve Bank  The SF Fed’s district includes three of the worst states in the housing crisis – California, Arizona and Nevada.  I think its fair to say that without the housing boom and bust in these states we wouldn’t have had a mortgage crisis.  Given that Yellen was the top banking regulator for this geography, one has to wonder whether she was asleep at the wheel.  

This issue wasn’t ignored at her confirmation hearing for Fed vice chair.  Here’s a little of her exchange with Sen. Richard Shelby (R-Ala.):

SHELBY: And regarding your tenure as president of the 12th District, I have two questions. First, what role do you believe a breakdown in regulatory oversight played in the failure of the institutions in your district? And secondly, were you raising any warning flags with respect to speculative excesses or lax monetary policy during that period?

YELLEN: So the first question was to the breakdown – to the breakdown in…

SHELBY: Do you believe a breakdown in regulatory oversight – what role do you believe that a breakdown in regulatory oversight played in the failure of the institutions in your district?

YELLEN: Working with other regulators, I think that our regulatory oversight was careful and appropriate, but I believe that the…

SHELBY: Well, excuse me. You say it’s careful and appropriate, and you – most people believe…

YELLEN: Given the…

SHELBY: … it was lax and inappropriate.

YELLEN: Well, I – in the institutions that have failed in my district are mainly community banks with high exposure to commercial real estate.

SHELBY: OK.

YELLEN: And when I say careful and appropriate, I mean that as early as 2001…

SHELBY: OK.

YELLEN: … people in the Federal Reserve System, and particularly in my bank, were at the forefront of focusing on high concentrations that existed in the banks we supervised in commercial real estate. We saw that these exposures and concentrations could be a source of vulnerability, and we monitored this carefully throughout.

Interestingly enough she never touches on the topic of monetary policy and its impact on housing prices.  When the Fed hasn’t been complicit in generating bubbles, they’ve generally just turned a blind eye to them.  If one cannot from the perch of San Francisco identify the perverse impact of loose money on housing prices, then you’re likely to miss it from D.C. as well.

If you think bubbles are a great avenue for wealth creation, then Yellen is the Fed chair for you.  If you, however, suspect bubbles are damaging to our economy, then you might rightly be concerned that she repeats her San Francisco performance on a national level.

Pages