Among the many questions surrounding the Federal Reserve’s programme of quantitative easing (QE) is what will happen to the vast stockpile of bonds it has accumulated in its efforts to lower interest rates.
Officials at the bank have never been comfortable with their gargantuan balance-sheet. Since 2011 they have maintained that once QE has achieved its aims, the Fed would shrink back to its former size.
As its bonds mature, the story goes, they will disappear from its balance-sheet, along with the money the Fed created to pay for them. A new paper by two former advisers to the central bank, however, suggests a potential plot twist.
The problem with the Fed’s pile of assets is that it has a corollary in the form of a hoard of cash kept at the Fed by banks. Banks have long been required to deposit reserves at the central bank to ensure they can meet their daily obligations. But since the Fed began buying bonds from them, usually by crediting the accounts in which their reserves are held, this stash has swollen dramatically. It now stands at around $US2.6 trillion (see chart on next page).
Of the inflation that was supposed to erupt when the banks began lending this money there is little sign. Instead, the Fed has the opposite problem. There are so many dollars sitting idle that they risk interfering with the Fed’s conventional method for setting short-term interest rates. Before QE came along, the Fed would raise what is known as the Federal-funds rate by selling assets and thus draining the supply of reserves, forcing banks who need more to borrow from others. But it is hard to drive rates up like this if banks have so much cash they need never borrow.
Happily, in 2008 the Fed received the authority to push up interest rates in another way, by paying banks interest on their reserves. That discourages them from lending reserves to each other for next to nothing. The Fed can also offer banks term deposits and since September has experimented with “reverse repurchase agreements”, in which it in effect borrows from money-market funds using some of its bonds as collateral. Both instruments lock up reserves for longer periods.
In their paper Brian Sack and Joseph Gagnon argue that the Fed should embrace its supersized balance-sheet and the tools that come with it. It could stop worrying about the Federal-funds rate, and instead use these new methods to control short-term interest rates. This would have several advantages. First, the banks could keep their mountainous reserves. They would then worry less about running short of cash, giving them less incentive to hoard, which should help avert spikes in rates. Indeed, Fed research suggests the current abundance of cash encourages banks to pay each other more promptly, making the payment system safer. Second, if panic selling were affecting a certain financial instrument, the Fed could intervene by buying it without worrying whether the reserves it creates in the process send interest rates down sharply.
To some, that may be a reason to oppose the idea: during the crisis the Fed waded into unfamiliar markets as a last resort, and has in theory been trying to extract itself ever since. The new proposal looks a lot like institutionalising what is supposed to be an aberration.
Still, it is hardly a radical plan. New Zealand has a similar system, and the crisis forced the European Central Bank and the Bank of England to follow its lead. For the time being, at least, the Fed will have to continue using such measures, since it will probably need to raise interest rates long before its balance-sheet has returned to normal. If it likes what it sees, supersized may be the new normal.
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