Should the Fed keep its balance sheet large? - Brookings

Today, Federal Reserve notes are still a large item (about $1.4 trillion), but the largest category of Fed liabilities is bank reserves ( ... Skiptomaincontent FacebookTwitterLinkedInPrintSMSEmailMoreReddit IattendedtheFed’srecentgatheringinbeautifulJacksonHole,Wyoming—thefirsttimeIhadbeensincetheendofmytermasFedchairman.Ienjoyedtheopportunitytocatchupwithmanyfriendsandformercolleagues. Asusual,themediaweremostfocusedondiviningthenextpolicymoveoftheFederalOpenMarketCommittee(FOMC),butIfoundthemoreinteresting(andultimatelymoreconsequential)discussionswereabouttheFed’slonger-termpolicyframework,thethemeoftheconference.InthispostI’llreportononeimportantdebate:thequestionoftheoptimallong-runsizeoftheFed’sbalancesheet.Itseemedtomethatthestrongestargumentsmadeattheconferencesupportedastrategyofkeepingthebalancesheetlarge(thoughcomparabletoothermajorcentralbanks),ratherthanshrinkingittoitspre-crisislevelastheFOMCcurrentlyplanstodo.  BenS.Bernanke DistinguishedSeniorFellow-EconomicStudies-TheBrookingsInstitution Twitter BenBernanke TheFed’sbalancesheethasroughlyquintupledsincethefinancialcrisis,fromabout$900billionin2007toabout$4.5trilliontoday.(SeehereforausefuloverviewofthemainelementsoftheFed’spre-crisisandcurrentbalancesheets.)TheincreasemostlyreflectstheFed’slarge-scaleassetpurchases(quantitativeeasing),whichtheFOMCemployedtoreducelonger-terminterestratestohelptheeconomyrecoverfromtheGreatRecession.AlthoughtheFedstoppedaddingtoitsstockoffinancialassetsinOctober2014,itstillholdsabout$2.5trillionofU.S.Treasurysecuritiesand$1.7trillionofgovernment-guaranteedmortgage-backedsecurities. CorrespondingtotheincreaseinFedassets,therehavealsobeensubstantialchangestotheliabilitysideofthebalancesheet.Beforethecrisis,theFed’sliabilitiesweremostlyFederalReservenotes(currency).Today,FederalReservenotesarestillalargeitem(about$1.4trillion),butthelargestcategoryofFedliabilitiesisbankreserves(depositsthatcommercialbanksholdattheFed).Bankreservesnowtotalabout$2.4trillion,upfromlessthan$20billionin2007.Ultimately,thesourceoftheincreaseinreserveswastheFed’sassetpurchases:TheFedfinanceditspurchasesofsecuritiesfromtheprivatesectoreffectivelybywritingchecksonitself.Sellersofsecuritiesdepositedthosechecksinthebankingsystem,andbanksinturnaddedthosefundstotheirreserves. Importantly,thelargeincreaseinthesizeofthebalancesheet,andinthequantityofbankreservesinparticular,changedfundamentallyhowtheFedaffectsitsshort-termpolicyinterestrate,thefederalfundsrate,whichistherateatwhichbanksborrowandlendreservestoeachother.Priorto2008,beforethebalancesheetexpanded,theFedmanagedtheratebychangingthequantityofreservesinthesystem.Byreducingtheavailablesupplyofreserves,forexample,theFedcouldpushuptheirprice,thefederalfundsrate. Withtheenormousquantityofreservesnowavailable,however,smallchangesinthesupplyofreservesnolongersufficetocontrolthefundsrate.Today,theFedinfluencesitandothershort-termratesprimarilybyvaryingtheinterestrateitpaysbanksontheirreserves(knownasIOER,orinterestonexcessreserves).ThisapproachreliesonthepresumptionthatbanksareunlikelytowanttoborroworlendinprivatemarketsataninterestratemuchdifferentfromwhattheycanearnonthereservestheyholdattheFed.Tofurtherimproveitscontrolofinterestrates,theFednowalsoallowsotherprivate-sectorinstitutionallenders,suchasmoneymarketfunds,toearnafixedrateofinterestoncashheldforshortperiodswiththeFed,throughaprogramknownastheovernightreverserepurchase(RRP)program.CurrentlytheIOERissetatone-halfpercentagepointandtheinterestrateontheRRPprogramissetatone-fourthpercentagepoint.TheuseofthetworateshasprovenquitesuccessfulsofarinkeepingthefederalfundsrateintheFOMC’stargetrangeofone-fourthtoone-halfpercent. RelatedBooks BrookingsPapersonEconomicActivity:Spring2017 EditedbyJaniceC.EberlyandJamesH.Stock 2017 BrookingsPapersonEconomicActivity:Fall2016 EditedbyJaniceC.EberlyandJamesH.Stock 2017 W WorldEmploymentandSocialOutlook2016 ByInternationalLaborOffice 2016 It’sworthnotingthattheFed’scurrentapproachtosettinginterestratesisquitesimilartothatofothermajorcentralbanks;theFed’spre-2008system,incontrast,wasidiosyncratic.ConformitywithinternationalpracticeisnotnecessarilyareasontoprefertheFed’scurrenttoolset.Butitisofsomecomforttoknowthat,ratherthanbeingnewanduntried,thesemethodshavebeeningeneraluseforawhileandtheirimplicationsformonetarycontrolarewellunderstood. BecausethesizeoftheFed’sbalancesheetiscloselytiedtoitsmethodsforinfluencingshort-terminterestrates,thedebateatJacksonHolewasaboutwhich“package”makesmoresense:(1)thepre-2008systemthatincludesarelativelysmallbalancesheetandthemanagementofthefundsratethroughoperationsthatvarythesupplyofbankreserves;or(2)thecurrentsystemthatincludesalargebalancesheetandthesettingoftheIOERandtheinterestrateonRRPstoestablishthefedfundsrate.TheFOMC’spubliclyannouncedstrategy,reiteratedbyJanetYelleninheropeningspeech,istoreturnovertimetothepre-2008system.Theplanistodothis,attheappropriatetime,byendingthereinvestmentofmaturingsecurities,therebyallowingthebalancesheettoshrink“naturally,”andbyphasingouttheRRPprogram,sothatnon-bankswillnotbeabletomakedepositsattheFed. Doesthisplanmakesense?Theanswerisnotclearcut,butbasedonthediscussionsattheconference,I’llofferthreeargumentsforchangingcourseandkeepingthebalancesheetclosetoitscurrentsizeinthelongrun,whilemanaginginterestratesthroughthepaymentofinterestonbankreservesandacontinuedRRPprogram.[1] First,inapaperpresentedattheconference,RobinGreenwood,SamuelHanson,and(formerFedBoardmember)JeremySteinpointedoutthatalargeFedbalancesheetcouldbeatoolforenhancingfinancialstability.Astheauthorsdocumented,thereisastrongdemandfromtheprivatesectorforsafe,liquid,short-termsecurities,asindicatedbythefactthatinvestorsappearwillingtoacceptmuchloweryieldsforveryshort-termgovernmentsecurities(e.g.,one-weekT-bills)thanforgovernmentsecuritiesatlongerterms,evensaysixmonths.[2]Avarietyofregulatorychangesaffectingbanks,money-marketfunds,andotherfirmsarelikelytoincreasethedemandforsafe,liquidassetsevenfurther.Howcanthisdemandbemet?Onepossibilityistoleaveitentirelytotheprivatemarkettosupplysuchassets.Wehavelearnedthehardway,though,thatthisstrategycanleadtotrouble,iftheexceptionallylowcostofveryshort-termborrowingincentivizesriskybehavior.Forexample,beforethefinancialcrisissomefirmsfinancedlong-termriskyassetsbyissuingshort-termcommercialpaper(so-calledasset-backedcommercialpaper).Whendoubtsaroseaboutthequalityoftheunderlyingassets,however,thisformoffinancingquicklydisappeared,forcingthefirmstosellofftheirassetsindestabilizing“firesales.”Thisdynamicwasamajorsourceofthecrisis. Toreducetheincentivesforsuchbehavior,Greenwoodetal.explained,theFedcouldprovidesafeshort-termassets(unliketheprivate-sectoranalogues,theywouldbetrulysafe!),intheformofbankreservesandespeciallythroughanexpandedRRPprogramthatwouldbeopentoawiderangeofcounterparties.PresumablytheavailabilityofsuchassetsattheFedwouldcrowdoutatleastsomeriskyprivatebehaviorbyreducingtheliquiditypremiumonveryshort-termfinancing.[3]Todothatinaquantitativelymeaningfulway,however,theFedwouldhavetokeepitsbalancesheetnearitscurrentsizeandcontinue(orexpand)itsRRPprogram.[4]Importantly,byusingitsbalancesheetastheprimarytoolforenhancingfinancialstability,theFedwouldgainmorescopetofocusonitsinflationandemploymentobjectiveswhensettinginterestrates. Second,assuggestedbyDarrellDuffieandArvindKrishnamurthyinanotherpaperattheconference,alargerbalancesheetthatincorporatesarobustRRPprogramcouldimprovethetransmissionofmonetarypolicy.AlthoughtheFedisabletocontrolthefederalfundsratereasonablyaccurately,monetarypolicycanonlyhaveitsdesiredeconomiceffectstotheextentthatchangesinthefederalfundsratearereflectedinbroaderfinancialconditions.However,forvariousreasons,banksmaynotfullypassonchangesinthefundsratetodepositorsandborrowers.Thelinksbetweenbankborrowingandlendingratesandkeyratesinsecuritiesmarketscanalsobeimperfect,duetomarketfragmentationandinadequateliquidity.Recentregulatorychangesthreatentofurtherimpedemonetarypolicytransmission.[5]DuffieandKrishnamurthyarguethattheFedcouldbetterensurethatitsinterestratedecisionsaretransmittedtomoneymarketsandfinancialmarketsgenerallybymaintainingasizableRRPprogram,throughwhichnonbankinstitutionscandepositdirectlywiththeFedandearntheRRPinterestrate.[6]WiththeRRPprogramprovidingadirectlinkbetweentheshort-termpolicyrateandthesecuritiesmarkets,theFedcouldrelylessontheindirecttransmissionofmonetarypolicythroughthebankingsystem. AthirdpossiblemotivationfortheFedtokeepalargebalancesheetinthelongrunrelatestoitsroleasalenderoflastresortduringfinancialcrises.Duringapanic,depositorsandotherprovidersofshort-termfundingrunonfinancialinstitutions,whichcanleadliquidity-shortinstitutionstodumpassetsatanyprice(the“firesales”problemmentionedabove).Byservingasalenderoflastresort(i.e.,bystandingreadytolendcashagainstgoodassets),centralbankscanreplacemissingliquidity,avoidthefiresaledynamic,andcalmthepanic.However,foracentralbanktosuccessfullyinjectliquidityintothesystem,financialinstitutionshavetobewillingtoborrow,whichtheymaybereluctanttodoiftheyfearthiswillidentifythemasparticularlyweakfinancially;thisinhibitiontoborrowingisknownas“stigma.”TheFedhadtoworkhardtoovercomestigmaduringthefinancialcrisisof2007-2009,andlegislativechangessincethecrisishaveprobablymaketheFed’sstigmaproblemworse. Itisstrikingthatthestigmaprobleminseveralotherjurisdictions,notablytheeurozone,waslesssevere.Generally,EuropeanfinancialinstitutionsdidnotavoidborrowingfromtheEuropeanCentralBank(ECB).Apossiblereasonisthat,beforethecrisis,EuropeanfinancialfirmshadbothsubstantialdepositsattheECB(reserves)aswellaslargeborrowings.[7](Incontrast,intheU.S.beforethecrisis,neitherbankreservesnorborrowingsfromthecentralbankweresignificant.)BecauseEuropeanfirmsroutinelyengagedwiththecentralbankinnormaltimes,duringthecrisistheyappearedabletousetheirreservesoradjusttheirlevelofcentralbankborrowingswithoutsignalingsharpchangesintheirfinancialconditions,thusmitigatingstigma.Inthisrespect,theECB’slargerbalancesheetcomingintothecrisisimproveditsabilitytoserveitscriticalfunctionaslenderoflastresort. Idon’twanttooverstatethisargument.Asalways,therearetradeoffs:Forexample,inprovidingmorebackstopliquiditytothefinancialsystem,centralbanksmayreducetheprivatesector’sincentivestomanageitsownliquidityeffectively(themoralhazardproblem).[8]ThelegalenvironmentintheU.S.isalsomorerestrictivethaninEurope,inthattheECBcanlendroutinelytononbankfinancialinstitutionsbuttheFedcannot.Still,there’sagoodcasetobemadethatmaintainingsignificantbaselinelevelsofbankreservesandbankborrowingsfromtheFedwouldreducestigmaandthusenhancetheFed’sabilitytorespondeffectivelytoapanic.[9] I’vemadethreeargumentsfortheFed’skeepingalargebalancesheetinthefuture,whichwouldalsoimplycontrollingthefundsratebysettingtheIOERandtherateonRRPs,orthroughsimilarmethods.Whatarethecounterarguments?WhydoestheFOMCevidentlywanttoreturntothesmaller,simplerbalancesheetofthepre-crisisperiod? Related Coronavirus(COVID-19)Economics WhatdidtheFeddoinresponsetotheCOVID-19crisis? EricMilsteinandDavidWessel Friday,December17,2021 UpFront Whatistherepomarket,andwhydoesitmatter? JeffreyChengandDavidWessel Tuesday,January28,2020 BenBernanke ShrinkingtheFed’sbalancesheet BenS.Bernanke Thursday,January26,2017 OnereasonappearstobeconcernsthattheRRPprogramcoulditselfbedestabilizinginafinancialpanic.Inthisview,inaperiodoffinancialstress,investorswouldbetemptedtodumpprivateshort-termassetsinfavoroflendingtotheFed.PhasingouttheRRPprogramwouldavoidthispossibility,itisargued. Whilethisissuedeservesfurtherconsideration,somegoodresponsescameoutoftheconference.Forexample,asJeremySteinandotherspointedout,theRRPprogramcouldbecapped,limitingtheamountoffundsthatcouldflowinduringastressedperiod.KeepingtheRRPinterestratelowevenasprivateratesriseduringapanicwouldalsoreducetheincentiveforinvestorstoflocktotheFed.TotheextentthatalargerbalancesheetenhancesfinancialstabilityandimprovestheFed’sabilitytoserveasalenderoflastresort,asI’vediscussedinthispost,theseriskswouldalsobereduced. AdifferentargumentagainstalargeFedbalancesheetwasmadebymyformerPrincetoncolleagueChrisSimsinalunchtimetalkontheinteractionofmonetaryandfiscalpolicies.Chrispointedoutthat,withlargeassetholdings,centralbanksmayfaceincreasedriskoffinanciallosses,losseswhichultimatelycanaffectthegovernment’soverallfiscalposition.Fiscallossesinturncouldtriggeralegislativeresponse,threateningthecentralbank’spolicyindependence.Chrisadvocateda“lean”balancesheet,minimizingthefiscalriskstakenbythecentralbank.[10] Certainlythispointisimportant,anditseemedtoresonatewiththecentralbankingaudience.However,JeremySteininhissessionagainmadewhatIthoughtwasaneffectivecounterargument,whichwasthatthecentralbank’sfinancialriskdependsmoreonthemixofassetsheldthanontheoverallquantity.Heandhiscoauthordemonstratedintheirpaperthat,iftheFedweretoholdprimarilyassetsthataresafeandoflimitedduration(suchasgovernmentdebtof2-3years’maturity),apermanentlylargebalancesheetneednotimplyexcessivefiscalrisks. Overall,IthinktheFOMC’splantoreturntoapre-2008balancesheetandtheassociatedoperatingframeworkneedsmorethought.TheappropriatesizeandcompositionoftheFed’sbalancesheetinevitablydependsonarangeofcomplexdecisionsaboutthemanagementofmonetarypolicyandtheroleofthecentralbankinpreventingandrespondingtofinancialcrises.We’velearnedalotaboutbothareassincethecrisis,andsomeimportantargumentshaveemergedforkeepingthebalancesheetlargerthaninthepast.Maybethisisoneofthosecaseswhereyoucan’tgohomeagain. [1]InatalkattheIMFinspring2015,Iraised(inapreliminaryway)thepoints(#1and#2below)thatalargebalancesheetwouldallowtheFedtoprovidemarketswithasafe,short-termassetandthatitcouldimprovemonetarycontrol. [2]Theauthorsreportthat,from1983-2009,theyieldonone-weekT-billsaveraged0.72percentagepointslessthantheyieldsonsix-monthbills.Sincetheriskstobothassetsarenegligible,almostallthisdifferencepresumablyreflectsthe“moneyness”oftheshortest-termassets. [3]Inotherwords,theFedwouldbeusingitsbalancesheettoflattentheshortendoftheyieldcurve,therebyreducingtheprivatesector’sincentivetoengageinmaturitytransformation. [4]AnalternativepublicoptionwouldbefortheTreasurytoissuemoreshort-termbills.However,thatwouldinvolvefrequentauctionsofnewbills,which(theauthorsargue)theTreasuryseesascostly.TheadvantageofFed-suppliedassetsisthattheydonotinvolvecontinuousauctions;instead,theFedsetsaninterestrateandallowsthedemandforRRPstovarywithmarketconditions. [5]Forexample,tougherlimitsonleveragemakeitlessattractiveforbankstoparticipateinrepomarkets,reducingtheliquidityofthosemarketsandlooseningthelinksbetweenthereporate,acriticalshort-termfundingrate,andthefundsrate. [6]AdditionalargumentsforwhyalargebalancesheetcouldmakemonetarypolicytransmissionmoreeffectivewereprovidedattheconferencebyRicardoReis.Reis’spaperfocusedontheliabilitysideoftheFed’sbalancesheetandargued(amongotherpoints)thattheabilitytovarytheinterestratepaidonreservesaccordingtothematurityofreserveholdingspotentiallyprovidestheFedwithanewpolicytool. [7]FordataontheECB’sbalancesheet,seehere. [8]Foradiscussionoftradeoffsassociatedwithliquidityprovision,seethispaperatJacksonHolebyUlrichBindseil. [9]Toinducebankstoborrowfromthediscountwindowduringnormaltimes,theFedcouldconsiderauctioningdiscountwindowcredit,asitdidduringthecrisis. [10]Onsimilarprinciples,thereisagoodargumentthatcentralbanksshouldminimizeinterventionsincreditmarkets.IthinkitmakessensefortheFedultimatelytoeliminateitsholdingsofmortgage-backedsecurities,forexample.Attheconference,Bindseil(seefootnote8)alsorecommendeda“lean”balancesheetconsistentwiththe“core”functionsofthecentralbank,althoughhepresentedargumentsonbothsidesoftheissue. Commentsare nowclosedforthispost.  BenBernanke BenS.BernankeisaDistinguishedFellowinResidencewiththeEconomicStudiesProgramattheBrookingsInstitution.FromFebruary2006throughJanuary2014,hewasChairmanoftheBoardofGovernorsoftheFederalReserveSystem.Dr.BernankealsoservedasChairmanoftheFederalOpenMarketCommittee,theSystem'sprincipalmonetarypolicymakingbody. TheHutchinsCenteronFiscalandMonetaryPolicyprovidesindependent,non-partisananalysisoffiscalandmonetarypolicyissuesinordertoimprovethequalityandeffectivenessofthosepoliciesandpublicunderstandingofthem. 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