Fed Chairman, Bernanke in his recent speech says:
the expansion of the Federal Reserve’s balance sheet has raised some concerns–and led to some misconceptions–about the credit risk being taken by the Fed. I will address the issue of credit risk today.
Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation…..However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities.
I was quite excited at the beginning to see how Bernanke saw Fed getting out of all the programs it has started. However was disappointed, as like his previous speech he again relies on markets. His idea is market returning to normalcy would lead to unwinding of programs. It is all like watching a gripping mystery movie not knowing what would happen and just hope all is well at the end (i.e. we don’t have hyper inflation etc).
I came across this recent useful speech from St Louis Fed President, James Bullard. He has titled his speech as Dial M for Monetarty Policy, which is based on the title of the famous Alfred Hitchcock movie – Dial M for Murder. In the movie, murder is solved however, we do not know how Fed will solve the problem of its balance sheet. Anyways, Bullard provides some clarity. He tries to be the detective in the Fed’s movie and time will tell whether his analysis would be correct.
He divides the various Fed Programs (also see Yellen speech and St Louis Fed) into two types – temporary and permanent. Obviously temporary ones would go away (just like what Bernanke says) but Permanent ones would still remain.
….events have left the Fed with an expanded balance sheet. The question is, how much of the balance sheet expansion is temporary, being merely associated with the lender-of-last-resort function in this time of extraordinary crisis?
To keep the discussion simple, let us consider just three programs that are currently some of the largest contributors to the increased size of the balance sheet. These are the CPFF at $251 billion, the TAF at $413 billion and the swap lines at $391 billion, a total of more than $1 trillion.….The CPFF and TAF programs score high marks on this criterion.
Outstanding TAF lending is under direct Fed control: The maturity of the outstanding loans is 84 days at a maximum, and the size and timing of future auctions are policy parameters. This facility can be phased out quickly at any time it is deemed appropriate.
The Commercial Paper Funding Facility deals in short-term money market instruments and can also be phased out, if desired, in a short period of time. Indeed, as elevated risk aversion recedes and market functioning improves, the use of this facility may atrophy naturally.
The duration of swap-line programs is somewhat more problematic. While all temporary swap lines have sunset dates, phasing them out cannot realistically be done unilaterally by the Fed, but will require discussion with the foreign central banks involved. Still, the swap lines are clearly intended for temporary use.
hmm. What about permanent ones?
Now let me turn to the persistent components of the balance sheet. To keep the discussion simple, I will discuss just three items: The Fed’s holdings of Treasury securities, the agency MBS purchase program and the TALF program.
Fed holdings of Treasury securities in July 2007 were about $800 billion. As liquidity programs were introduced during the crisis, this portfolio was sold off, and it now stands at $475 billion. This creates some room on the balance sheet.
In November 2008 the Federal Reserve announced a program to purchase direct obligations of housing-related government-sponsored enterprises (GSEs) and MBS backed by those GSEs. The future liquidity of secondary markets for longer-term agency debt and agency MBS has yet to be determined, and it is not completely clear that large holdings of these securities could be readily sold back to the market before maturity.
The remaining program is the Term Asset-Backed Securities Loan Facility (TALF). Maturities of assets that will be purchased under the TALF will extend up to several years, and the current sunset date for new purchases under this program is the end of 2009. This program is not operational yet. The intent is to provide support to the securitization process, which has broken down, and the sunset clause indicates the temporary nature of the program. The multi-year maturities of the loans and the potential size of the program—up to $1 trillion—make the impact on the monetary base more persistent than for some of the other liquidity programs.
This is another interesting way to separate all Fed Programs. Bullard touches on few and we can think and separate all the others in the two categories (PDCF, TSLF, MMIFF etc). This is a neat way to think of the exit strategy for Fed (and others like Bank of England, Bank of Japan as well who have started similar programs as well).
Apart from this Bullard raises deflation concerns in US and his “Dial M” means Fed should use Monetary Easing (Quantitaive easing) to infuse more money in the system. As rates have touched zero, this is a way to get rid of deflation. Interestingly, this point was also made by Jeff Lacker in his recent FOMC vote (Lacker has also begun to dissent):
Mr. Lacker dissented because he preferred to expand the monetary base by purchasing U.S. Treasury securities rather than through targeted credit programs. Mr. Lacker was fully supportive of the significant expansion of the Federal Reserve’s balance sheet and the intention to maintain the size of the balance sheet at a high level. However, while he recognized that spreads were elevated and volumes low in many credit markets, he saw no evidence of market failures that made targeted credit programs, including the forthcoming TALF, necessary.
Moreover, he was concerned that such programs channel credit away from other worthy borrowers, amount to fiscal policy, would exacerbate moral hazard, and might be hard to unwind. He supported, instead, maintaining the size of the balance sheet at a high level through purchases of U.S. Treasury securities. In his view, such purchases would limit distortions to private credit flows, minimize adverse incentive effects, and maintain a clear distinction between monetary and fiscal policies.
Like UK, the need for quant easing is being felt in US as well.