By Steven K. Beckner
(MNI) – Philadelphia Federal Reserve Bank President Charles Plosser
warned Monday that the Fed would go down “a dangerous road” if it were
to indefinitely maintain a large balance sheet and use it as an
alternative or parallel monetary policy tool.
In a speech prepared for delivery to a Bank of France conference
in Paris, Plosser said the Fed should shrink its roughly $3 trillion
balance sheet, which it built up in the course of buying assets to push
down long-term interest rates after it exhausted its ability to cut the
federal funds rate, and return entirely to pegging the funds rate as its
primary means of operating monetary policy as soon as possible.
In its June 2011 minutes, the Fed’s policymaking Federal Open
Market Committee indicated it plans to take a sequence of “exit” steps
that would accomplish just that — eventually.
But Fed Chair Ben Bernanke said in January the whole exit process,
including reductions in bank reserves, would not commence until at least
“late 2014″ — consistent with the FOMC’s expected period of keeping the
federal funds rate between zero and 25 basis points.
One of those exit steps would be to stop reinvesting proceeds of
maturing securities so as to start letting the Fed securities portfolio
shrink “naturally,” but gradually.
Outright asset sales, which would shrink the balance sheet more
actively and quickly, are expected to happen only later in the process
— all contingent on economic conditions.
Actual, meaningful shrinkage of the balance sheet may not occur
until well after the FOMC starts raising the funds rate and the rate of
interest it pays on excess reserves.
And, as Plosser noted with chagrin, some think the Fed should
purposefully keep a large balance sheet — and a large amount of excess
reserves — even after the economy and the financial system fully
recover to give itself an additional policy lever.
Plosser said such an approach would exacerbate a problem that
already exists — the “blurring” of the boundary between monetary and
fiscal policy.
Framing the issue in prepared remarks, Plosser asked, “Do central
bankers anticipate that their balance sheets will shrink to more normal
levels as they move away from the zero lower bound? Is it desirable to
do so? Or should monetary policy now be seen as having another tool,
even in normal times?”
Plosser noted that “some have suggested that central banks adopt a
regime in which the monetary policy rate is the interest rate on
reserves rather than a market interest rate, such as the federal funds
rate. This would then permit the central bank to manage its balance
sheet separately from its monetary instrument, freeing it to respond to
liquidity demands of the financial system without altering the stance of
monetary policy.”
“In principle, this would take pressure off central banks to shrink
their balance sheets from the current high levels and simply rely on
raising the interest rate on reserves to tighten monetary policy,” he
said.
Plosser did not say who he was referring to. Bernanke and other Fed
officials have often said the Fed’s ability to pay interest on reserves
enables it to raise the funds rate even while maintaining a large
balance sheet, but they have not explicitly advocated perpetuating a
dual track monetary policy indefinitely, as have some private
economists.
Plosser said “the alternative is to return to a more traditional
operating regime in which the central bank sets a target for a market
interest rate, such as the federal funds rate in the U.S., above the
interest rate on reserves.”
“Implementing this regime would require a smaller balance
sheet,” he said, making clear that this is his preference.
“I am very skeptical of an operating regime that gives central
banks a new tool without boundaries or constraints,” he said. “Without
an understanding, or even a theory, as to how the balance sheet should
or can be manipulated, we open the door to giving vast new discretionary
abilities to our central banks.”
Plosser said “this violates the principle of drawing clear
boundaries between monetary policy and fiscal policy.”
“When markets or governments come to believe that a central bank
can freely expand its balance sheet without directly impacting the
stance of monetary policy, I believe that various political and private
interests will come forward with a long list of good causes, or rescues,
for which such funds could or should be used,” he warned.
As it is, he said, the Fed already stepped over the line into
fiscal policy when it engaged in “credit allocation” favoring the
housing industry by purchasing hundreds of billions of dollars worth of
mortgage-backed securities.
He said its support of the commercial paper market and money market
funds in wake of the Lehman Brothers bankruptcy in late 2008 was also an
example of the Fed breaching the wall between monetary and fiscal
policy.
Plosser said “economic theory and practice teach us that monetary
policy works best when it is clear about its objectives and systematic
in its approach to achieving those objectives. Granting vast amounts of
discretion to our central banks in the expectation that they can cure
our economic ills or substitute for our lack of fiscal discipline is a
dangerous road to follow.”
Plosser said the sequence of probable exit steps, or “principles,”
announced by the FOMC last June “represented an important first step in
the FOMC’s attempt to restore the boundaries between monetary and fiscal
policies.”
“In particular, the FOMC clearly stated its desire to return to an
operating environment in which the federal funds rate is the primary
instrument of monetary policy,” he said. “To achieve that objective, the
Fed will have to shrink its balance sheet to a more normal level.”
“I interpret this as saying that our balance sheet should not be
viewed as a new independent instrument of monetary policy in normal
times,” he said.
Plosser also approvingly noted that “the exit principles also
indicated the Committee’s desire to return the Fed’s balance sheet to an
all-Treasuries portfolio. This re-establishes the idea that the Fed
should not use its balance sheet to actively engage in credit
allocations.”
Plosser’s broader point — one which he has made many times before
— is that the Fed and other central banks must guard their independence
and not allow themselves to be drawn into helping their governments
finance the huge budget deficits accumulated during the financial crisis
and recession.
Deficits can only be financed through taxation, debt or printing
money, he observed, and “the temptation of governments to exploit the
printing press to avoid fiscal discipline is often just too great.”
“Thus, it is simply good governance and wise economic policy to
maintain a healthy separation between those responsible for tax and
spending policy and those responsible for money creation,” he said.
The central bank’s main task should be maintain the purchasing
power of the nation’s currency, he said.
“Yet, that task can be undermined, or completely subverted, if
fiscal authorities set their budgets in a manner that ultimately
requires the central bank to finance government expenditures with
significant amounts of seigniorage in lieu of current or future tax
revenue.”
** MNI Washington Bureau 202-371-211 **
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