This guest commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics
At her February 15, 2017, semiannual report to Congress, here, Fed Chair Janet Yellen said:
“The Committee has continued its policy of reinvesting proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, has helped maintain accommodative financial conditions.”
This decision means that the money supply will continue to expand recklessly. This might be an acceptable risk if a large balance sheet provided some important benefits. But it does not. I analyze the arguments for maintaining a large balance sheet and show why none provides benefits worth the risk.
The Fed is playing with fire because as I have noted here and here, the Fed’s bloated balance sheet has produced a massive increase in the money supply and has encouraged banks to take on more risky loans. The M1 money measure has increased by an astounding $2 trillion since August 2008.
This happened because banks have been financing their lending out of reserves supplied by the Fed’s large balance sheet. Furthermore, the money supply will continue to expand as long as the Fed’s balance sheet remains large.
As I noted here, the link between M1 and inflation has been essentially nonexistent since the early 1980s and inflation has been subdued in spite of the massive increase in the money supply. Consequently, one might argue that the continuation of massive increases in M1 provide little risk. This would be a good argument for maintaining a large balance sheet if the benefits from it were large. But as my analysis of these arguments shows, there isn’t.
Bernanke (2016), here, endorsed several reasons suggested by economists for maintaining a large balance sheet indefinitely. The first is by Greenwood, et al. (2016) here. They argue that a large balance sheet could be a tool for enhancing financial stability. The idea is that the Fed’s balance sheet supplies banks with a large quantity of “safe short-term assets” in the form of excess reserves.
As Bernanke describes it, this combined with “an expanded RRP program (the Fed sells securities today and agrees to repurchase them at a specific future date at an agreed on price) that would be open to a wide range of counterparties… the Fed would crowd out at least some risky private behavior by reducing the liquidity premium on very short-term financing.” Bernanke goes onto suggest that “by using its balance sheet as the primary tool for enhancing financial stability, the Fed would gain more scope to focus on its inflation and employment objectives when setting interest rates.”
The second is a model by Duffie and Krishnamurthy (2016), here. These authors suggest that a large balance sheet and the use of RRPs could improve the “transmission of monetary policy.” As Bernanke describes it, various market imperfections and recent regulatory changes are such that “banks may not fully pass on changes in the funds rate to depositors and borrowers.”
Hence, a large balance sheet combined with “a sizable RRP program” would provide “a direct link between the short-term policy rate and the securities markets” so the“Fed could rely less on the indirect transmission of monetary policy through the banking system.”
So what exactly is the problem Bernanke is trying to fix?
Do financial markets really need more safe assets to function efficiently? $20 trillion in default-risk-free government debt isn’t enough? What’s the evidence that markets aren’t working or that the changes in the funds rate didn’t get transmitted to other short-term rates prior to the large balance sheet, the Fed’s use of IOER, and the Fed’s RRP program?
The figure here shows thefederal funds rate and the 3-month Treasury bill rate daily from January 1, 1999, to July 31, 2007. The two rates move closely together; during much of the period, they were nearly identical. While not shown, the 1-month term repurchase rate also tracked the 3-month T-bill rate closely.
I see no reason to believe that the relationship would be tighter. Even if it was, I see no reason to believe Bernanke’s assertion that by maintaining a large balance sheet “the Fed would gain more scope to focus on its inflation and employment objectives when setting interest rates.” However, I am certain that a large balance sheet will cause the money supply to expand dramatically. Moreover, the problem for the effectiveness of the FOMC’s interest rate policy is the link between changes in federal funds rate to changes in long-term rates, not the link between changes in the federal funds rate and short-term rates. None of these arguments suggest that this linkage would be strengthened.
It is important to realize that these suggestions, as well as John Cochrane’s (2014) model, here—which appears to be a panacea for the economy—rest on the belief that the only effect of the Fed’s large balance sheet is that it makes excess reserves essentially perfect substitutes for default-risk-free government debt.
As John Cochrane puts it, “Reserves and short-term treasuries are and will remain essentially perfect substitutes at the margin. Reserve demand becomes indeterminate – banks are indifferent to holding another dollar of reserves and another dollar less short-term treasuries.”
But banks are not indifferent between holding another dollar of reserves that pay the IOER and making another dollar of loans at much higher interest rates. Bernanke and the others fail to recognize a basic economic fact: banks have an incentive to make loans as long as the risk adjusted interest on loans is higher than the IOER.
Furthermore, increasing the IOER won’t prevent the money supply from expanding because lending rates increase with increases in the IOER. The bank prime loan rate was 3.25 percent when the IOER was 25 basis points and has increased with each of the three 25-basis point increases in the IOER to 4 percent.
Other lending rates also have risen. Bernanke’s third reason for maintaining a large balance sheet is perplexing. Specifically, he suggests that maintaining a large balance sheet will enhance the Fed’s ability to be a “lender of last resort.” Bernanke points out that in times of crises the Fed needs to provide funds to banks, but banks have been reluctant to borrow from the Fed for fear of being identified as “weak financially.”
This is true. But the Fed has fixed this problem. InDecember 2007, the Fed introduced the Term Auction Facility (TAF). Banks were not reluctance to borrow from the Fed through the TAF. It’s puzzling that Bernanke would suggest that a massive balance sheet is needed to fix a problem that the Fed has already fixed.
Federal Reserve Bank of St. Louis economist, David Andolfatto, recently made what he characterized as “A public finance case for keeping the Fed’s balance sheet large,” here. Andofatto argues that because of the Fed’s large balance sheet the “Fed has been returning about $80-90 billion per year to the U.S. Treasury.” Cumulatively, the Fed has returned over $600 billion to the Treasury since 2008. This means the national debt, currently about $ 20 trillion, would have been over $600 billion larger had the Fed not had a large balance sheet. Hence, Andolfatto suggests,
Reducing the Fed’s balance sheet at this point in time seems like a needless loss for the U.S. taxpayer. Given that the Treasury is marketing a bond, who do you want to hold it? If the debt isheld outside the Fed, the government needs some way to pay the 2% carry cost of the debt. The government will in this case have to reduce program spending, increase taxes, or increase the rate of growth of debt-issuance. Alternatively, if the Fed holds the debt, the carry cost is generally much lower. This cost-saving constitutes a net gain for the government. So why not take advantage of it?
Apparently, Andolfatto forgot that the Fed needs to be independent of the government so it can conduct monetary policy in the public’s interest. The 1953 “Accord” between the Federal Reserve and the Treasury came about out of concern that the Fed was “monetizing the debt.” Indeed, central bank independence has been a concern of central bankers and monetary economists for a long time.
Elsewhere (Thornton, 1984, 2010), I pointed out the Fed is monetizing the debt if the Fed is purchasing securities for the purpose of helping theTreasury finance the debt. This is what Andolfatto is suggesting because the large balance sheet is financing a massive increase in the money supply. Of course, he spins it as a “needless loss for the U.S. taxpayer.” He ignores completely the loss in social welfare if the Fed is unable to pursue an independent monetary policy, as well as the possible adverse consequences of a massive increase in the money supply.
So why does the FOMC say it’s maintaining a large balance sheet? Well, not much beyond the statement that a large balance sheet helps “maintain accommodative financial conditions.” But what exactly does this mean? The FOMC has never said what financial conditions means or how it measures it. This is no doubt due to the fact that financial conditions is a vague concept. Consequently, it is hardly surprising to find that it has been measured in a variety of ways.
All are essentially statistical measures with vague theoretical foundations. For example, the Federal Reserve Bank of Chicago’s National Financial Conditions Index, here, is a weighted average of a 105 financial variables, each expressed relative to its sample average and scaled by its sample standard deviation.
Why relative to their means? Answer: so the index will have a mean of zero. Why relative to each variable’s standard deviation? Answer: so the index won’t give more weight to a measure simply because it is more variable. These are good statistical reasons. However, they do nothing to alter the fact that the index is nothing more than a weighted average of a bunch of financial variables that may or may not provide useful information about the condition of financial markets or the economy.
Indeed, there is no evidence that such indices are useful. Yellen simply asserted this. I don’t believe the FOMC has any evidence to support this assertion. Indeed, a 2013 Federal Reserve staff study, here, evaluated 12 financial conditions indices. The study found that their predictive power for macroeconomic variables for horizons one to three month is weak unless the financial crisis is included in the sample period. The study’s authors suggest this fact could be indicative of data mining, i.e., constructing the index so that it works well during the financial crisis. This is hardly compelling evidence for maintaining a large balance sheet.
So why is the Yellen Fed so reluctant to shrink the balance sheet? In her March 15, 2017, press conference, here, she said this in response to a question about the balance sheet,
We’ve emphasized, for quite some time, that the Committee wishes to use variations in the Fed Funds Rate target, our short-term interest rate target as our key active tool of policy. We think it’s much easier in using that tool to communicate the stance of policy. We have much more experience with it, and have a better idea of its impact on the economy.
So, while the balance sheet asset purchases are a tool that wecould conceivably resort to if we found ourselves in a serious downturn where we were, again, up against the zero bound, and faced with substantial weakness in the economy. It’s not a tool that we would want to use as a routine tool of policy.
You asked what well under way means. I can’t give you a specific answer to that. And I think the right, the right way to look at it is in qualitative, and not quantitative, terms. It doesn’t mean some particular cutoff level for the federal funds rate that, when we’ve reached that level,we would consider ourselves well under way. I think what we want to have is confidence in the economy’s trajectory.
A sense that the economy will make progress, that we’re not overly worried about downside risks, and adverse shocks that could hit the economy, that could quickly after setting it off on the path to shrinking the balance sheet gradually over time cause us to want to begin to add monetary policy accommodation. So I think it has to do with the balance of risks and confidence in the economic outlook, and not simply the level of the federal funds rate.
So the FOMC is not maintaining the balance sheet out of concern for downside risk or adverse shocks. The problem appears to be that a 4.7 percent unemployment rate and nearly eight years of economic expansion are insufficient for feeling confident about the economy’s trajectory.
But according to Yellen, the FOMC is not maintaining a large balance sheet for monetary policy: The stance of policy is measured by the federal funds rate, not the size of the balance sheet. So long as the FOMC continues to implement policy with the funds rate, there is no reason to believe that the market would interpret shrinking the balance sheet as a change in monetary policy, that is, higher interest rates.
If the FOMC is concerned about an adverse market reaction to reducing the size of the balance sheet, as I believe it is, the likelihood of an adverse reaction could be mitigated if Yellen and other FOMC participants said a large balance is no longer necessary because financial markets are now functioning well and the funds rate is well controlled.
Such a statement would allay concern that reducing the size of the balance sheet would cause interest rates to rise. The FOMC could reinforce this outcome by saying that returning the balance sheet to normal would allow the FOMC to target a specific level of the funds rate rather than a range. Having a specific target would tighten the relationship between the funds rate and other short-term rates, that is, allow the FOMC to conduct monetary policy as it did before December 2008.
Bernanke and others who have suggested the Fed can operate indefinitely with a large balance sheet fail to recognize that the money supply will continue to expand as long as risk-adjusted lending rates are higher than the IOER. The only way the Fed can stop this from happening is by reducing the size of the Fed’s balance sheet to the point where excess reserves return to the pre-September 2008 level, about $ 1 to $2 billion.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
