Bernanke Provokes Mystery Over Fed Stimulus ExitCaroline Salas Gage and Joshua Zumbrun
When Ben S. Bernanke asserted last month that the Federal Reserve doesn’t ever have to sell assets, he raised questions about how the central bank can withdraw its record monetary stimulus without stoking inflation.
The Fed may decide to hold the bonds on its balance sheet to maturity as part of a review of the exit strategy Bernanke expects will be done “sometime soon,” he told lawmakers in Washington on Feb. 27. This would help address concerns that dumping assets on the market will lead to a rapid rise in borrowing costs. It also allows the Fed to avoid realizing losses on its bond holdings as interest rates climb.
Removing asset sales from the exit plan Fed officials agreed to in June 2011 means the central bank would stop prices from accelerating by relying primarily on its ability to pay interest on the cash it holds for banks. Given that the Fed’s total assets have reached an unprecedented level of more than $3 trillion, leaving them untouched when the economy picks up may stoke inflation, according to Dean Maki, chief U.S. economist at Barclays Plc in New York.
“If the Fed doesn’t withdraw quickly enough, there’s a risk of overshooting,” Maki said. “If the Fed gets rates back to a typical level and the economy is back to what’s regarded as normal, does having an expanded balance sheet have a notable effect on the economy, on asset markets, even once rates are normalized? We haven’t really had that situation in the U.S. before.”
No country has ever had a comparable increase in the size of its portfolio and unwound it “in the precisely analogous way,” Bernanke said in response to questions from members of the House Financial Services Committee. Japan was the only nation to use asset purchases, or quantitative easing, before the U.S. and is “still in that situation,” he said.
The Fed isn’t planning an immediate exit and continues to add to its stimulus, buying $85 billion of mortgage-backed securities and Treasuries each month. It has left the duration and size of the program open-ended.
Policy makers in December linked their benchmark borrowing cost to economic indicators for the first time, pledging to hold the rate near zero as long as projected inflation isn’t more than 2.5 percent and joblessness exceeds 6.5 percent. Unemployment was 7.7 percent in February.
Still, the tools the U.S. central bank plans to employ, such as paying interest on reserves, “have been used quite frequently by central banks and they seem to work,” Bernanke told the House committee. The Fed finances the expansion of its portfolio by creating bank reserves. While policy makers gained the ability to pay interest on this cash in 2008, they’ve never used it to tighten policy.
Under the current exit strategy, the Fed would cease reinvesting some or all principal payments from its securities, revise its interest-rate outlook, raise the federal funds rate and then start selling housing debt to eliminate it from its holdings in three to five years.
Central bankers have kept the target on overnight loans between banks at zero to 0.25 percent since December 2008. They plan to help move the effective rate by changing the interest on excess reserves, at 0.25 percent since 2008, and using so-called reserve-draining tools, according to the minutes from the Federal Open Market Committee’s June 2011 meeting.
“The one thing we could do differently” is “hold some of the securities a little longer,” Bernanke said Feb. 27. “We could even let them just run off.”
Policy makers are reconsidering bond sales in response to criticism that their third round of purchases is exacerbating the potential for the central bank to, “in a robotic fashion, dump assets” on the market, causing interest rates to climb rapidly, said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York.
The Fed could refrain from selling bonds for this reason and to avoid taking losses on its securities holdings, Governor Jerome Powell said in a Feb. 22 speech in New York. Given the increase in the Fed’s balance sheet, the period of time during which it’s appropriate to unload assets “probably has lengthened,” San Francisco Fed President John Williams also told reporters after a Feb. 21 New York speech.
“They’re trying to address the new favorite concern, which is: ‘The exit will be disruptive to markets, so stop buying those assets because you’re making the exit even harder,’” said Harris, a former New York Fed researcher and author of “Ben Bernanke’s Fed: The Federal Reserve After Greenspan.”
With the chance of large asset sales receding, the yield on 10-year Treasuries probably will remain between 1.8 percent and 2.25 percent this year, said Krishna Memani, the New York-based chief investment officer of OppenheimerFunds Inc.’s $79.1 billion fixed-income portfolio.
Benchmark 10-year Treasury yields climbed one basis point, or 0.01 percentage point, to 2.05 percent at 1:05 p.m. in New York, according to Bloomberg Bond Trader data.
“The Fed is saying that if the economy stabilizes, yes, rates will rise, but it’s not imminent and don’t panic about the fact we’re going to sell trillions of securities,” Memani said. “The last thing the Fed wants to do is snuff out the recovery in the housing market” by putting pressure on mortgage bonds.
Bernanke said Feb. 27 it’s “worth discussing” whether the Fed should use guidance on how long it plans to hold its securities as a “substitute” for asset-purchase stimulus.
While Harris said he expects interest on reserves to be an effective tightening tool, it’s still “unlikely, frankly” the Fed will hold assets to maturity because elevated bank reserves, while not currently inflationary, may cause the economy eventually to overheat.
“If the Fed were to leave reserves in the banking system too long, and there were to be a big surge in spending -- absolutely, we have an inflation problem,” he said.
Not all policy makers are convinced that holding onto the bonds is a viable strategy. Philadelphia Fed President Charles Plosser told reporters after a March 6 speech in Lancaster, Pennsylvania, that it’s too soon to know whether the Fed can withdraw its easing this way.
“I don’t know how we can commit to never selling,” Plosser said. “We don’t know the answer to that, so it’s hard to pre-commit, to say we can’t sell assets even in the face of rising inflation.”
Robert Eisenbeis, a former research director at the Atlanta Fed, also said he doubts the central bank can control inflation just through paying interest on reserves.
“You can’t do it,” said Eisenbeis, who’s now chief monetary economist at Cumberland Advisors in Sarasota, Florida. “They’re naive in that sense. Their models are one thing, but the real world is another.”
Eisenbeis said the Fed doesn’t “know what the elasticity of demand” is for reserves in the banking system and proposed that policy makers raise reserve requirements to a very high level now. Then they could commit to reducing the requirements as the economy expands, regulating the amount of cash banks have to lend out, he said.
Returning the balance sheet to normal would “make the whole exercise of controlling the funds rate a lot cleaner,” said Antulio Bomfim, a senior managing director at Macroeconomic Advisers LLC in Washington and a former Fed economist.
The fed funds effective rate traded at 0.15 percent on March 8. That’s 0.1 percentage point less than financial institutions earn for parking their cash at the central bank.
“There is always some slippage between the funds rate and the IOER rate,” Bomfim said. “So you might say that’s not a big deal now, but once you start raising rates, you might want the link to be a little bit tighter. One way is to take the reserves out of the system.”
Bomfim forecasts the Fed ultimately will go ahead with sales that “would be gradual and well-communicated in advance.” Given it’s an untested tool, the Fed would “want to tread lightly.”
Bernanke said Feb. 27 that it would “be maybe an extra year” before the central bank’s balance sheet got “back down to a more normal size” if policy makers choose not to sell securities.
“Most on the FOMC and outside the Fed agree it would be best for the balance sheet to get back to normal,” Barclays’ Maki said. “The disagreement comes about how quickly, over what kind of time frame that normalization should occur.”