Fed Exit, Discount Window, Policy Constraints and Orderly Adjustment
Carlos M Pelaez

The two most important interrelated issues of economic policy are (1) the orderly unwinding of the Fed stimulus in the form of fed funds rate target of 0 – ¼ percent while downsizing the Fed’s balance sheet, which as of Feb 17, 2010, shows $1200 billion of reserve balances of members banks deposits at Federal Reserve Banks and $1899 billion of holdings of securities of which $709 billion in Treasury notes and bonds, $1024 billion in mortgage-backed securities and $166 billion in federal agency securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ); and (2) reducing the budget deficit to reverse the perilous path of the debt/GDP ratio. The issue of world imbalances or current account and fiscal deficits of the United States and current account surplus of Asia is analyzed in technical literature as the threat of disorderly adjustment (Pelaez and Pelaez, The Global Recession Risk, 11, 19-55, 188-229). According to this view that was popular before the global recession, continuing US fiscal and current account deficits would find a tipping point at which risk premiums on US debt would cause crashing bond and stock markets, depreciation of the dollar and income contraction or global recession without which there would not be full adjustment of unsustainable internal and external deficits. The credit crisis was actually provoked by the Fed’s target of the fed funds rate at 1 percent between Jun 2003 and Jun 2004, the interruption of the auction of 30-year Treasury bonds between 2001 and 2005 to lower mortgage rates, the yearly housing subsidy of $221 billion and the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). These policies created an incentive to highly leveraged, excessively risky exposures with low liquidity and imprudent credit assessment. The threat of disorderly adjustment currently is posed by high interest rates resulting from the unwinding of the Fed stimulus and financing the trillion-dollar budget deficits and refinancing maturing debt. Increasing interest rates and taxation could flatten the growth path of the economy, prolonging the jobless recovery. US debt could become unsustainable at some point in the future forcing adjustment by tax increases and expenditure reductions.
The objective of this post is to analyze the policies of the Fed in unwinding the stimulus, the constraints of monetary policy, effects of the unwinding and the orderly adjustment of fiscal deficits and debt. The following sections discuss Fed policies, constraints and the orderly adjustment.
First, exit policies. On Feb 18 the Fed announced “modifications” of its discount window programs effective Feb 19 (http://www.federalreserve.gov/newsevents/press/monetary/20100218a.htm ). The changes are intended as part of continuing normalization of financial markets and not as a change in the accommodative policy stand, in particular, the 0 to ¼ percent target for fed funds. The main modification is the increase in the primary rate or discount window rate from ½ percent to ¾ percent. Primary credit loans are provided by the Federal Reserve Banks to depository institutions that are solvent but require funding. This is part of the Bagehot 1873 principle in his Lombard Street by which central banks lend to solvent but temporarily illiquid institutions with the guarantee of highest-rated securities at a punitive rate to discourage moral hazard, which consist of engaging in careless bank management because of the safety net of central bank loans (cited in Pelaez and Pelaez, International Financial Architecture, 175-8, 194). The Fed also modified the maximum maturity of primary credit loans to overnight, which had been extended during financial markets stress to longer terms. Because of the stigma of borrowing through the discount window, signaling difficulties in individual banks, the fed created the Term Auction Facility (TAF) among 11 emergency facilities (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1, Regulation of Banks and Finance, 224-6). The TAF rate was increased from ¼ percent to ½ percent and the Fed confirmed the final auction of TAF funds for Mar 8. As a result of the new measures the spread relative to the fed funds target of 0 to ¼ percent of the discount window rate changed to 0.5-0.75 and the spread of the TAF rate changed to 0.50-0.75 percent. The initial nervousness in financial markets was provoked by the remembrance that the first easing measure in the credit crisis was on Aug 17, 2007, when the Fed reduced the discount window rate from 1 percent to 0.75 percent also agreed in a telephone meeting with the members of the FOMC (http://www.federalreserve.gov/newsevents/press/monetary/monetary20071016a1.pdf ) and then lowered the fed funds rate from 5.25 percent to 4.75 percent in the following meeting of the FOMC on Sep 18, 2007 (http://www.federalreserve.gov/fomc/fundsrate.htm ). The Fed maintained during a prolonged period a spread of one percentage point between the discount window and fed funds rate, which is consistent with the Bagehot rule of punitive discount window lending rates by central banks. The doubt persists in spite of reassurances to the contrary by the Fed that the increase in the discount window is not only because of more normal credit market conditions but also to allow ample spread relative to the fed funds rate that would facilitate a tightening posture.
Information on the view of the Fed is available in the testimony to Congress on the exit strategy (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ) and in the minutes of the Federal Open Market Committee (FOMC) meeting on Jan 26-7 (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100127.pdf ). The documents are consistent with the announcement of the modifications of primary credit rates and terms on Feb 18 but the view is changing toward increases in interest rates and withdrawal of the stimulus at an unknown time in the future. There are three sets of information in the documents. (1) The view of the current economy by the staff of the Fed and the members of the FOMC coincides with that of many market participants. The economy of the US is expanding with the engine changing from a lower rate of inventory liquidation to growth of demand, industrial production and investment. The housing market remains sluggish while the employment situation is improving but not as desirable. Consumer price inflation is subdued. There are not restraints from financial markets on economic growth. The indicator of financial risk provided by the spread of LIBOR to the overnight indexed swap (OIS) or LIBOR/OIS spread remains low. Economic growth with significant resource slack still suggests accommodative monetary policy. The Fed has responsibilities in four areas: monetary policy, supervision and regulation, systemic risk and provision of financial services. There are three objectives of monetary policy: stable prices, maximum employment and moderate long-term interest rates, which have conflicted in the past (Pelaez and Pelaez, Financial Regulation after the Global Recession, 74). Balancing these objectives is a delicate art. (2) The exit strategy consists of the isolated use or combination of six tools: (i) increases in the interest on excess reserve balances (IOER); (ii) term reverse sales and repurchase agreements (RSRP) with primary dealers; (iii) RSRPs with market participants other than primary dealers; (iv) absorbing excess reserves with a term deposit facility (TDF); (v) redeeming without reinvesting of maturing and prepaid securities held by the Fed; and (vi) sale before maturity of securities held by the Fed. With the exception of increases in the IOER, all tools would reduce the excess reserves held by depository institutions at the Federal Reserve Banks. The Fed has expertise in managing all these tools. It is quite difficult to anticipate market reactions to the various alternatives of increasing interest rates and reducing excess reserves. (3) The central tendency of the forecast of the FOMC is for GDP growth in 2010 of 2.8 to 3.5 percent, accelerating to 3.4 to 4.5 percent in 2011 with long-term trend of 2.5 to 2.8 percent. The unemployment rate would remain at 9.5 to 9.7 percent in 2010 declining to 8.2 to 8.5 percent in 2011 and to 6.6 to 7.5 percent in 2012. PCE inflation would remain in the 1 to 2 percent range. There is significant uncertainty in forecasts of economists especially turning points. The critical question is whether maintaining low interest rates with growth of the economy accelerating toward 4 percent is consistent with targets of fed funds rates of 0 to ¼ percent. Zero interest rates induce the carry trade of short positions in dollars and long positions in commodities and emerging market stocks that cause wide oscillations in financial variables (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). Zero interest rates also create incentives for high risk, excessive leverage exposures with low liquidity and careless credit risk assessment. The tradeoff for the Fed is whether increasing rates to reduce these distortions could cause an overshooting of interest rates and exchange rates, disrupting financial markets. Replacing or affecting the FOMC with a risk council of politically appointed members instead of the technical tradition of the Fed as in proposed financial regulation would deteriorate instead of improving the conduct of macroeconomic policy at an inopportune time.
Second, constraints of monetary policy. The golden period of central banking is called “the great moderation,” consisting of significant reduction in inflation with adequate growth rates of output and subdued volatility in both inflation and output but continuing oscillation of financial variables in the two decades preceding the current crisis (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195). In the search for a new paradigm of macroeconomic policy, the IMF finds that using the interest rate to anchor inflation expectations suggests that monetary policy by central banks amortized shocks on the economy. The prevailing view before the crisis was that enhanced macroeconomic policy could attain sustained growth with price stability (http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf ). Inflation targeting was considered the optimal process for central banking (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). The credit crisis and global recession demonstrated the insufficient hard knowledge on the conduct of monetary policy and overall macroeconomic policy.
There are at least seven constraints in designing and implementing monetary policy. (1) There are major technical limitations in measuring and forecasting lags in effects of monetary policy on income and prices. The channels of effects of monetary policy on output are difficult to specify and verify. Macroeconomic policies may be improperly simulated and anticipations of policy could reverse intended effects (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116). (2) Analyzing conditions of the current economy and financial markets is quite difficult. There is significant uncertainty in economic forecasting. The Fed bases its policy on the uncertain forecast of economic and financial conditions six months ahead of the current decision. (3) The increase in interest rates, or tighter monetary policy, is being processed in an environment of loose fiscal policy with rapidly growing expenditures, deficits and debt/GDP ratios. The intended increase of interest rates by monetary policy may be magnified by loose fiscal policy. It may be difficult for the Fed to find the desirable level of interest rates and the slope of the yield curve. (4) Tightening monetary policy departs from the current target of 0 to ¼ percent for fed funds rates. Low inflation may facilitate the task of the Fed in finding a positive real rate of interest that eliminates the distortions of zero policy interest rates. (5) Current economic conditions are characterized by moderate growth of the economy but continuing high unemployment rates. In this tough employment market, the Fed may be restricted by its objective of considering full employment, resulting in conflicts with other objectives. These conflicts exist in the objectives themselves. (6) Unwinding quantitative easing by sale of securities could raise long-term interest rates, steepening the yield curve. Term deposits at the Fed and reverse repos will find rising interest rates at maturity or refinancing. The weight of the huge balance sheet of the Fed exerts pressure on feasible monetary policy; and (7) the regulatory shock in the form of ambitious proposals in Congress could weaken the Fed at an inopportune time when its technical expertise and independence are most required. Increases in interest rates may deteriorate bank balance sheets to the extent that banks are borrowing short-dated funds and lending long-dated instruments and cause oscillations in exchange rates affecting currency mismatches (Pelaez and Pelaez, The Global Recession Risk, 174-87, provides an analysis of balance sheet effects and a practical stress case in reality). The Dow Jones US Bank Index has ranged between 82.61 and 241.0 in the past 52 weeks, declining 0.87 percent in the past three months (http://online.wsj.com/public/npage/industry_focus.html?bcind_sid=171501&bcind_ind=8300&symbol=8300 ). This is hardly the time to induce declines of bank stock prices by national regulation when proposals of global regulation by the Basel Committee on Banking Supervision call for increases in Tier 1 or common stock capital as percent of risk-weighted assets.
Third, disorderly adjustment. Research at the Fed and IMF has failed to find cases of extreme risks of disorderly adjustment in current account deficits (Pelaez and Pelaez, Globalization and the State, Vol. II, 185-90). The research over many centuries of experience by Carmen Reinhart and Kenneth Rogoff alerts about debt crises following credit crises (http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691142165/ref=ntt_at_ep_dpi_1 ). An important adjustment barrier currently is the joint incidence of a zero central bank policy interest rate, trillion dollar deficits and rapidly growing debt/GDP ratio. The immediate risk is flattening the expansion curve of the economy, resulting in weak employment conditions.
The policy mix is a major restraint of effective macroeconomic policy. Tight monetary policy with loose fiscal policy remind past episodes of debt crises and stop-and-go volatile growth. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)