Financial Regulation and the Fed Monetary Stimulus Exit Strategy
Carlos M Pelaez

The calculation of the government stimulus by Mark Pittman and Bob Ivry at Bloomberg declined from $12.8 trillion committed and $4.2 trillion used by March 2009 to $11.6 trillion committed and $3.0 trillion used by September 2009 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahys015DzWXc# see Pelaez and Pelaez, Regulation of Banks and Finance 224-7, Financial Regulation after the Global Recession, 157-70). The Federal Reserve total commitment by September 2009 was $5.9 trillion, or 50.8 percent of the total, and the use was $1.6 trillion, or 53 percent of the total. The deficits in the current budget proposal are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public is now moving toward an estimated 77.2 percent of GDP in 2020 (http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf ). Long-term projections are subject to significant error and actions could occur before the debt touches 100 percent of GDP. There is significant threat of rising interest rates because of the unwinding of the stimulus by the Fed and the financing of record deficits and refinancing of maturing debt. Rapidly rising interest rates and taxes could flatten the expansion path of GDP, preventing full employment.
The Fed is facing one of the most difficult challenges of its existence. Financial regulation restructuring the Fed is inopportune when the institution deals with the critical unwinding of the monetary stimulus. Proposals to audit the monetary policy of the Fed could jeopardize the capacity of the institution to design and implement policy because of the specter that an audit could reverse ongoing policy before intended effects are realized. The traditional independence of policy and choice of highly qualified board members and staff could be eroded by public audits. The choice of regional Federal Reserve Bank presidents by central government could further politicize monetary policy. The Fed has relied on the information obtained in its supervisory functions to design and implement policy in a form of economies of scope (Ben Bernanke cited in Regulation of Banks and Finance, 100). Relocation of Fed supervision may weaken overall supervision, restricting the Fed from obtaining vital information for its policy decisions. Regulatory shocks on the Fed could actually translate into adverse effects on financial markets when financing is required for rapid economic growth that can create jobs. There should be a moratorium on financial regulation until the Fed has the time and independence to exit the monetary stimulus.
The Fed is increasingly providing information on the exit strategy from the monetary stimulus (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). There are three areas of exit policies, interest rate adjustment, credit facilities and quantitative easing, which are discussed below in turn.
First, interest rate adjustment. The major instrument of Fed policy consists of targets of the fed funds rate. Fed funds consist of interbank loans of deposits of reserves by member banks at the Federal Reserve Bank in their region. The rate on fed funds is the cost of an additional dollar of funding that banks can use to lend. Increasing the fed funds rate increases the cost of borrowing money to lend by banks, likely causing an increase in the rate charged by banks on loans (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116, Financial Regulation after the Global Recession, 69-90, Globalization and the State Vol. I, 30-43, Government Intervention in Globalization, 38-9). The increase in interest rates deteriorates the balance sheets of households because increasing interest payments lower the market value of assets that can be used as collateral in borrowing such as by home equity loans. The deterioration in the assets of households and business has adverse effects on the balance sheets of creditor banks that may reduce credit to their clients. There is resulting decline in nominal income or aggregate demand that lowers general prices (see credit channel and financial accelerator models by Ben Bernanke and Mark Gertler cited in Pelaez and Pelaez, Regulation of Banks and Finance, 103-8, The Global Recession Risk, 221-3). The converse process occurs after a shock that lowers interest rates. There are lags in the effect of monetary policy on prices, nominal income and economic activity. The Fed has to anticipate economic conditions in the future to set targets on fed funds rates.
The Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years (http://www.federalreserve.gov/fomc/fundsrate.htm ). These policy impulses resemble traders who successfully shorted stocks reversing by going long in the same trading session to benefit from the undershooting during the 22 percent decline of the market on Black Monday, October 19, 1987. The central bank may not be as successful as the few traders who had that flexibility. The policy counterfactual posits that the credit crisis originated in four excessive types of stimuli in 2001-2004 (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): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining that rate indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings.
The exit strategy of the Fed includes the use of the interest rate on reserves deposited by member banks at the Fed as the policy rate instead of the rate on fed funds possibly supplemented with quantitative limits on reserves (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). The fed funds market has diminished in volume and interest rates on reserve deposits may be more adequate as temporary policy rate. The interest rate on reserves can be construed as the cost of an extra dollar of money to lend and its increase could have the desired effect of increasing interest rates to avoid the undesirable effects of excessively low interest rates. Higher interest rates would also discourage the oscillation of financial variables caused by the carry trade of taking short positions on the dollars and simultaneous long positions in commodities and emerging market stocks.
Second, liquidity facilities. The Fed used about 11 facilities of monetary policy during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). Lowering the fed funds rate was not as important in restoring normalcy in financial markets. Initial doubts on the potential default of mortgages bundled in structured products that were financed in sale and repurchase agreements (SRP) significantly increased perceptions of counterparty credit risk. Declines in prices of mortgage-backed and asset-backed securities in general and haircuts in SRPs reduced funding capital of traders, causing common liquidity effects and flight to quality in multiple market segments as analyzed by Markus Brunnermeier and Lasse Pedersen (cited in Pelaez and Pelaez, Regulation of Banks and Finance,223). The initial policy of the Fed was reducing the discount rate by 50 basis points on August 17, 2007 (http://www.federalreserve.gov/newsevents/press/monetary/20070817a.htm ). This was the first measure of providing financing for segments of financial markets of which the Term Auction Facility (TAF) providing short-term credit to depository institutions and the Term Asset-Backed Securities Loan Facility (TALF) were most important. TAF avoided the suspicion of credit problems by borrowing through the discount window while TALF alleviated counterparty credit risk problems in markets for asset-backed securities that provide financing for loans for autos, credit cards, small business and students. The Fed will phase out TAF on March 8 and TALF on March 31 with the exception of commercial mortgage-backed securities while most of the other facilities have been phased out. Commercial real estate loans continue to set pressure on bank balance sheets.
Third, quantitative easing. When policy interest rates are near zero, the central bank can manage its balance sheet by purchasing long-term securities. This quantitative easing can rebalance investment portfolios, causing increases in prices of long-term securities. The resulting decline in long-term interest rates could increase investment and stimulate economic recovery as analyzed by Ben Bernanke and Vincent Reinhart (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 103-7). The Fed balance sheet in the week ending on February 10, 2010, shows holdings of long-term securities of $1844 billion, with individual holdings of $708 billion of treasuries notes and bonds, $971 billion of agency-guaranteed mortgage-backed securities and $165 billion of Federal agency debt securities; the major item of liabilities is $1154 billion of deposits at the Fed by depository institutions or banks (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The Fed financed the balance sheet initially with deposits of banks remunerated with interest payments and Supplementary Financing or loan by Treasury that has virtually disappeared, being replaced with issue of notes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). The Fed is considering three tools to reduce large reserves of banks. (1) The Fed has been testing reverse repos in which securities in the balance sheet of the Fed can be sold with an agreement to repurchase them at contracted price, interest and date. The payment by the buyer withdraws reserves from the financial system. (2) The Fed is evaluating the issue of certificates of deposit similar to those offered by depository institutions to their clients that also withdraw funds. (3) The Fed can sell its portfolio of securities and allow securities to mature without new purchases (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). The choice, doses and sequence of policy actions will depend on strengthening of the recovery.
There are no doubts about increases in taxes and interest rates. Dismantling the stimulus is a tough task full of pitfalls in an environment of little hard knowledge about current and future economic and financial conditions. Congress can continue its usual oversight of the Fed. The public, market participants, the media and academics can engage in constructive debate on Fed policy. Economic recovery and job creation depend on successful adjustment of the monetary stimulus. Regulatory shocks of the Fed and financial markets may disrupt the process with unknown adverse effects. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)