Central banking in the credit turmoil: An assessment of Federal Reserve practice

“Monetary policy refers to open market operations that expand or contract high-powered money (bank reserves and currency) by buying or selling Treasury securities. Credit policy shifts the composition of central bank assets, holding their total fixed. Interest on reserves policy involves adjusting interest paid on bank reserves” (Introduction, p. 2). The author notes that “the three-fold classification did not matter much for the Fed in the past,” since credit policy was historically minor, the Fed could not pay interest on reserves until October 2008, and monetary policy alone was used to target the federal funds rate – but the classification “is essential to understand the extraordinary central banking initiatives in the current context” once all three were deployed simultaneously and at unprecedented scale (p. 2).

Because the central bank returns to the Treasury, after expenses, all the interest it earns on the Treasury securities it holds, so “expansionary monetary policy provides the fiscal authorities with a flow of additional revenue,” and “all the revenue from monetary policy is transferred via the acquisition of Treasuries to the fiscal authorities to allocate as they see fit” (Introduction, p. 3; Section 3, p. 4). The paper illustrates this with a concrete example: in 2006, with the Fed’s portfolio nearly all Treasuries, no interest paid on reserves, and the federal funds rate averaging around 6 percent, the Fed transferred roughly $30 billion to the Treasury (Section 3, p. 4). Monetary policy also has a second fiscal dimension the paper stresses: it governs “the tax rate on reserves,” the wedge between the federal funds rate and interest paid on reserves, by varying the scarcity of reserves in the banking system (Section 3, p. 4).

Because when the central bank sells Treasuries to fund loans or acquire non-Treasury securities, “the result is just as if the Treasury financed the loans or purchases by borrowing from the public” – credit policy “involves the fiscal allocation of public funds in a way that monetary policy does not” (Section 3, p. 4). The paper stresses that even fully collateralized central-bank lending exposes taxpayers to risk: emergency lending that finances the exit of uninsured claimants from a subsequently failed institution “strips that institution of collateral that would be available otherwise to cover the cost of insured deposits or other government guarantees” (Section 3, p. 4). Because monetary policy’s goals (price stability, full employment) are clear and “Treasuries only” leaves fiscal allocation entirely to the fiscal authorities, monetary policy can be conducted independently; because credit policy’s objectives “have not been clear” and it inherently allocates public funds, the paper argues it cannot claim the same independence (Introduction, p. 3).

Paying interest on reserves “frees monetary policy to fund credit policy independently of interest rate policy” – it was for this reason that the Fed asked Congress in May 2008 to expedite its statutory authority to pay interest on reserves, which had originally been scheduled to take effect only in 2011 (Section 3, p. 5; Section 4.4, p. 7). Mechanically, setting interest on reserves at the intended policy-rate target while creating an abundance of reserves (“satiation”) lets the Fed hit its interest-rate target without needing to keep reserves scarce – in effect implementing “Milton Friedman’s ‘optimum quantity of money’ with respect to bank reserves” – so the Fed could fund a massive expansion of credit-policy lending with newly created reserves without losing control of the federal funds rate (Section 3, p. 5).

The TAF was “established as a pure credit policy in as much as the Fed financed TAF loans with funds acquired by selling Treasury securities from its portfolio, with no effect on aggregate bank reserves” (Section 4.1, p. 6). Because it had little effect on total reserves or the federal funds market, the paper argues the TAF should not have been expected to move marginal interbank borrowing rates much; instead, it provided “infra-marginal relief” to banks caught with persistent funding shortfalls, by letting them substitute cheaper TAF credit for more expensive term interbank borrowing – but even though TAF loans were fully collateralized and profitable to the Fed on net, “it cannot be said that the TAF provided interest savings to banks at little risk to the taxpayer,” since fully collateralized lending can still strip a failed borrower of collateral otherwise available to cover insured deposits (Section 4.1, p. 6).

In financing JPMorgan Chase’s acquisition of Bear Stearns through a $29 billion loan to the limited liability company Maiden Lane I, the Fed departed from its usual practice in three ways at once: it lent to a limited liability company rather than a depository, it lent against assets of questionable value, and “its loan amounted to a purchase” – with JPMC absorbing only the first $1 billion of losses, the Fed bearing nearly all further downside, and the Fed capturing any upside, “the Fed had all of the upside of the asset valuations and all but a small fraction of the downside,” which the author reads as an effective purchase of a pool of risky assets financed by selling Treasuries – “pure credit policy, which amounted to a debt-financed fiscal policy purchase” (Section 4.2, pp. 5-6). The paper quotes Paul Volcker’s April 2008 remark that the Fed had acted “to the very edge of its lawful and implied powers,” and argues in retrospect this exposed the Fed to being used as an “‘off budget’ arm of fiscal policy” without Congress having been asked in advance to appropriate resources for financial-system stabilization (Section 4.2, pp. 6-7).

Facing AIG’s rapid deterioration in September 2008, the Fed announced an $85 billion loan with Treasury support, a decision immediately criticized by members of Congress as a “questionable commitment of taxpayer funds” – and Chairman Bernanke concluded the Fed had been “stretched to its limits” and could not do more, prompting the push for TARP (Section 4.3, pp. 7-8). The author’s conclusion is unambiguous: “the Fed faced a no-win situation in deciding whether or not to support AIG,” since either decision “would have lacked sufficient political legitimacy and undermined its independence for further fiscal action,” and more generally, “an independent central bank cannot be responsible for delivering or deciding upon the delivery of fiscal support for the financial system” (Section 4.3, p. 8) – this episode is the paper’s central piece of evidence for the need for a pre-negotiated boundary between Fed and Treasury responsibilities.

Because government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks are legally ineligible to receive interest on balances they hold at the Fed, their lending in the federal funds market could push the effective federal funds rate below the interest-on-reserves rate, weakening interest on reserves’ ability to serve as a floor when the Fed later tries to raise rates without first shrinking its balance sheet (Section 4.4, p. 8). The paper notes that arbitrage by eligible depositories (borrowing from GSEs to redeposit at the Fed) can partly offset this, “but such arbitrage cannot be counted upon absolutely to stabilize the federal funds rate close to interest on reserves, especially in periods of financial distress,” and proposes as a direct fix either modifying federal-funds-market regulations to exclude ineligible lenders or extending interest-on-reserves eligibility to them (Section 4.4, p. 8).

“Principle 1: As a long run matter, a significant, sustained departure from a ‘Treasuries only’ asset acquisition policy is incompatible with Fed independence. Principle 2: The Fed should adhere to ‘Treasuries only’ except for occasional, temporary, well-collateralized ordinary last-resort lending to solvent, supervised depository institutions. Principle 3: Fed credit initiatives beyond ordinary last-resort lending should be undertaken only with prior agreement of the fiscal authorities, and only as bridge loans accompanied by take-outs arranged and guaranteed in advance by the fiscal authorities” (Section 5.1, p. 10). The stated aim is to preserve “the Fed’s independence to react flexibly and decisively to stabilize economic and financial conditions” for the functions that genuinely require independence, while confining fiscally consequential credit-allocation decisions to a pre-agreed process with the Treasury and Congress rather than improvised case-by-case interventions (Section 5.1, p. 10).

Because “to grant or deny taxpayer support for the financial system is fiscal policy,” and “to force a central bank to make fiscal policy, especially such contentious fiscal policy decisions, would politicize the central bank and destroy its independence” (Section 5.2, p. 11). The paper endorses the Dodd-Frank Act’s choice to place that “one stop shop” systemic-regulator role, including authority to grant or deny fiscal support to distressed firms or sectors, in a Treasury-chaired Financial Stability Oversight Council rather than the Fed, arguing that outcome was “correct” given the analysis of the AIG and Bear Stearns episodes earlier in the paper (Section 5.2, p. 11).

The 1951 Accord ended a wartime arrangement in which the Fed had kept interest rates low to help finance the war and, later, to hold down the cost of accumulated federal debt; Fed officials argued that continuing to do so “would require inflationary money growth that would destabilize the economy and ultimately fail,” and the Accord “famously reasserted the principle of Fed independence so that monetary policy might serve exclusively to stabilize inflation and macroeconomic activity” (Section 5, p. 9). The paper treats this as the precedent for why Fed independence over interest-rate policy is now well established and productive, and argues by direct analogy that credit policy – which the 1951 Accord did not address, because Fed credit policy was historically modest – now needs its own accord for the same underlying reason: to protect the parts of central banking that genuinely benefit from independence while subjecting the fiscally consequential parts to agreed limits (Section 5, pp. 9-10).

The paper proposes enlarging the Fed’s surplus capital account – either through a direct transfer of new Treasury securities from the fiscal authorities or by letting the Fed retain interest earnings over time – so the Fed can self-insure its ability to pay interest on reserves under any future scenario, without needing to shrink a balance sheet that may hold substantial long-term securities acquired to fight deflation (Section 6.2, p. 12). The concern is a potential cash-flow mismatch: if the Fed buys long-term securities at high prices (low yields) to fight deflation and then must raise interest on reserves to fight inflation before it can shrink its balance sheet, interest earnings on its long-term portfolio could fall short of what is needed to pay the higher interest on reserves. The author argues the proposed capital enlargement “would have no fiscal cost as long as the Fed did not draw on the interest or the principal of its surplus capital,” since the Fed would simply return the interest on the enlarged account’s Treasury holdings to the Treasury as usual, while substantially improving the Fed’s power to act decisively against both inflation and deflation (Section 6.2, p. 12).