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The Fed's Exit Strategy
The Fed has financed its loans and securities purchases in the past year by creating new reserves for the banking system (in effect, printing money). Reserves have rocketed, to almost $900 billion now from an average of $11 billion in the year to September. Many analysts see these excess reserves as a pool of inflationary fuel just waiting for the match of credit demand.
The Fed considers this analysis flawed. It sees excess reserves as a problem only if they overwhelm its ability to raise the federal funds rate when need arises. That risk has shrunk since the Fed received authority in September to pay interest on reserves, as other major central banks have long been able to. That in theory should put a floor under the Fed funds rate. Banks should not lend excess reserves at, say, 1%, if they can earn 2% from the Fed.
That said, the Fed cannot be certain that paying interest will work as planned, so it would also like to be able to soak up some reserves. Some were created by the Fed’s myriad loans to banks, issuers of commercial paper and others to unfreeze the credit markets. Those liquidity facilities charge borrowers a penalty rate which makes them less attractive as private credit returns. That is now happening, and the liquidity facilities have begun to shrink (see chart). The Fed could hurry that process up by raising the penalties.
Managing its growing securities holdings will be tougher. The Fed could simply sell them but that would create waves. “The day you sell will be a big market event,” says Mr Dudley. “Historically, the Fed has been buy and hold.” Since the average maturity of the Fed’s bond holdings is five to ten years, the Fed will have to find a way to mop up, or “sterilise”, the related bank reserves for a long time. The usual approach is to conduct reverse-repurchase agreements, borrowing from one of its 16 primary dealers for short periods of time in order to finance the assets on its balance-sheet. But dealers may not have the necessary capacity for the task.
The Fed is currently absorbing reserves by having the Treasury issue more debt than it needs. When dealers purchase the debt, cash shifts from their reserves accounts to Treasury deposits at the Fed, where they remain, unspent. But the Treasury itself is constrained by the debt ceiling set by Congress, and an independent central bank should not rely on the fiscal authority for one of its tools.
A better solution would be for the Fed to issue its own bills, as other central banks do. It could rely on a wider variety of investors, not just primary dealers, to manage its balance-sheet. It would restrict the maturity of such bills to less than 30 days to avoid interfering with Treasury’s longer-dated issuance. The hitch is that Congress has to authorise it. It may come to that. “As long as people are worried about whether we have adequate tools, it makes sense for us to get more tools even if we don’t think we need them,” says Mr Dudley.
The Fed considers this analysis flawed. It sees excess reserves as a problem only if they overwhelm its ability to raise the federal funds rate when need arises. That risk has shrunk since the Fed received authority in September to pay interest on reserves, as other major central banks have long been able to. That in theory should put a floor under the Fed funds rate. Banks should not lend excess reserves at, say, 1%, if they can earn 2% from the Fed.
That said, the Fed cannot be certain that paying interest will work as planned, so it would also like to be able to soak up some reserves. Some were created by the Fed’s myriad loans to banks, issuers of commercial paper and others to unfreeze the credit markets. Those liquidity facilities charge borrowers a penalty rate which makes them less attractive as private credit returns. That is now happening, and the liquidity facilities have begun to shrink (see chart). The Fed could hurry that process up by raising the penalties.
Managing its growing securities holdings will be tougher. The Fed could simply sell them but that would create waves. “The day you sell will be a big market event,” says Mr Dudley. “Historically, the Fed has been buy and hold.” Since the average maturity of the Fed’s bond holdings is five to ten years, the Fed will have to find a way to mop up, or “sterilise”, the related bank reserves for a long time. The usual approach is to conduct reverse-repurchase agreements, borrowing from one of its 16 primary dealers for short periods of time in order to finance the assets on its balance-sheet. But dealers may not have the necessary capacity for the task.
The Fed is currently absorbing reserves by having the Treasury issue more debt than it needs. When dealers purchase the debt, cash shifts from their reserves accounts to Treasury deposits at the Fed, where they remain, unspent. But the Treasury itself is constrained by the debt ceiling set by Congress, and an independent central bank should not rely on the fiscal authority for one of its tools.
A better solution would be for the Fed to issue its own bills, as other central banks do. It could rely on a wider variety of investors, not just primary dealers, to manage its balance-sheet. It would restrict the maturity of such bills to less than 30 days to avoid interfering with Treasury’s longer-dated issuance. The hitch is that Congress has to authorise it. It may come to that. “As long as people are worried about whether we have adequate tools, it makes sense for us to get more tools even if we don’t think we need them,” says Mr Dudley.
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