The Final Solution

The only thing standing in the way of President Trump using the Federal Reserve to bankroll his real estate empire or a Democratic congress using the Fed to provide massive infrastructure and universal health care without raising taxes is…Nothing and Nobody!

How this is going to happen is explained in a paper by Charles Plosser at the Hoover institute at their 2018 Monetary Policy Conference. The entire book covering the conference, “The Structural Foundations of Monetary Policy . Hoover Institution Press. Kindle Edition” can be purchased at Amazon for $2. I have copied and pasted excerpts from Plosser’s presentation below.  The bold highlights are the parts that support my outrageous opening remarks.

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The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy                                                                                    Charles I. Plosser

My focus today is on the Fed’s balance sheet and how institutions, and the incentives they create, matter for how it is managed. Since 2006, the balance sheet of our central bank has grown about fivefold, primarily because of the Fed’s unconventional policies during the financial crisis and subsequent recession.

Regardless of the rationale, the actions amounted to debt-financed fiscal policy and a form of credit allocation. Thus, such changes in the mix of assets held by the Fed are frequently referred to as credit policy. Prior to the crisis, the Fed operated with a relatively small balance sheet. Its size was determined by the demand for currency and the demand for required reserves. That is, it expanded or shrank reserves in the banking system

to achieve its funds rate target. This operating procedure required the Fed to increase or decrease its balance sheet accordingly. The size of the balance sheet was integral to setting the instrument of monetary policy—the fed funds rate.

Several economists (including former Fed My focus today is on the Fed’s balance sheet and how institutions, and the incentives they create, matter for how it is managed. Since 2006, the balance sheet of our central bank has grown about fivefold, primarily because of the Fed’s unconventional policies during the financial crisis and subsequent recession. Once the Fed had reduced the targeted fed funds rate to near zero in December 2008, it embarked on a program of large-scale asset purchases. Initially, those purchases were motivated by a desire to provide liquidity and maintain financial market stability. Those goals were largely achieved by mid-2009, yet quantitative easing (QE) continued and expanded. It was justified not on the grounds of financial market dysfunction but as a means to provide more monetary accommodation to speed up the recovery.

Currently, the Fed’s balance sheet is roughly $4.5 trillion, compared to about $850 billion prior to the financial crisis. The composition of the balance sheet is also quite different today than it was prior to the crisis. In 2006, the asset side of the balance sheet was predominately US Treasury securities. Today, approximately 40 percent of the balance sheet is composed of mortgage-backed securities (MBS), while Treasuries account for most of the rest. In addition, at various points during the crisis the Fed held hundreds of billions of dollars of other private-sector securities or loans, although most of these private-sector securities have rolled off the balance sheet, leaving primarily Treasuries and MBS. The liability side of the balance sheet also reflects the impact of QE. In 2006, currency accounted for more than 90 percent, or $785 billion, of the $850 billion, and bank reserves just about 2 percent, or $18 billion, almost all of which were required reserves. Today, currency represents about $1.5 trillion, or just 33 percent of the balance sheet, while reserves have risen to about $2.6 trillion, or about 60 percent of the balance sheet, of which only $180 billion are required.2 So there is about $2.4 trillion in excess reserves today compared to zero in 2006.

chair Ben Bernanke, now at the Brookings Institution, and John Cochrane at the Hoover Institution) have argued that since the Fed now has the ability to pay interest on bank reserves, it is possible, desirable, and perhaps more efficient to maintain a large balance sheet and use the interest rate paid on reserves (IOR) as the instrument of monetary policy rather than the fed funds rate. The basic idea is that by setting the interest rate it pays on bank reserves, the Fed establishes a floor for short-term risk-free rates.

Who will determine the amount of excess reserves created and how will they do it, since the monetary policy instrument will be the IOR? Unfortunately, there is little discussion or analysis of how to determine the appropriate amount of excess reserves that should be created. Is it $10 billion, $100 billion, or $1,000 billion? First and foremost, an operating regime where the Fed’s balance sheet is unconstrained as to its size or holdings is ripe for misuse, if not abuse. A Fed balance sheet unconstrained by monetary policy becomes a new policy tool, a free parameter if you will. Congress would be free to lobby the Fed through political pressure or legislation to manage the portfolio for political ends. Imagine Congress proposing a new infrastructure bill where the Fed was expected, or even required, to buy designated development bonds to support and fund the initiative so taxes could be deferred. This would be very tempting for Congress. More generally, the temptation would be to turn the Fed’s balance sheet into a huge hedge fund, investing in projects demanded by Congress and funded by forcing banks to hold vast quantities of excess reserves on which the central bank pays the risk-free rate.

Recall that in 2015 Congress raided the Fed’s balance sheet to help fund a transportation bill. In 2010, the resources for the Consumer Financial Protection Bureau were found in Fed revenues. These were all efforts to exploit the central bank for fiscal policy purposes. Imagine the political debates over appointments to the Board of Governors. Hearings might focus on the nominees’ views on the investment policy for the balance sheet rather than monetary policy. Political pressure to purchase various forms of securities to support favored projects or initiatives could be enormous and fraught with controversy.

I have other concerns surrounding the implementation of monetary policy under a big-balance-sheet regime. The evidence accrued to date suggests that the IOR does not provide a firm floor for the funds rate or other short-term rates. One way the Fed has sought to address these problems is by increasing its interventions into the short-term money markets. This program is the reverse repo program, or RRP. This program allows non-depository institutions to borrow Treasury securities from the Fed overnight (which soaks up reserves) with an agreement that the Fed will repurchase the securities the next day.

Thus, we have some evidence that the floor system currently in place does not provide a firm floor and must be supported by the RRP program, which effectively drains reserves from the banking system on an ongoing basis.

The Fed has become a larger and more deeply embedded participant in the short-term financial markets than ever before. This is a worrisome development, as RRPs give large financial firms a safe and reliable place to flee in times of volatility—and making it easy to do so may increase systemic risk rather than reduce it. The instrument of monetary policy in a floor system is the interest paid on reserves. Unlike the funds rate, the IOR is an administered rate rather than a market rate. Under current law, the IOR is set by the Board of Governors, not the FOMC. In other words, it is the Board of Governors rather than the FOMC that technically determines monetary policy. Under a pure floor system, the FOMC would become irrelevant. Gutting the FOMC’s role in monetary policy would undermine independence and result in monetary policy becoming far more political.

A large Fed balance sheet that is untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed and use its balance sheet to conduct off-budget fiscal policy and credit allocation. Such actions would undermine Fed independence and politicize the Fed to a far greater degree than it currently is. Without changes in the Federal Reserve Act, it would shift the conduct of monetary policy to a more politicized Board of Governors and away from the FOMC. Finally, it seems to require that the Fed play a much larger, directive role in the functioning of short-term money markets, potentially reducing the traditional role of market forces. For these reasons, I think the economy would be better served if the Fed returned to an operating regime based on a smaller footprint, where the balance sheet is more directly linked to the conduct of monetary policy. (It ain’t going to happen but Trump will stack the board with incompetents who will do his bidding and Democrats will create bigger entitlement programs and neither will want to pay for it by increasing taxes. But don’t worry, the stock market will probably go up…until it doesn’t)

Source of quotes

The Structural Foundations of Monetary Policy (pp. 15-16). Hoover Institution Press. Kindle Edition.

 

About Frank Sortino

Frank Sortino is finance professor emeritus from San Francisco State University and Director of the Pension Research Institute which he founded in 1981. For 10 years he wrote a quarterly analysis of mutual funds for Pensions and Investments Magazine and he has written two books on the subject of Post Modern Portfolio Theory. He has been a featured speaker at many conferences in the U.S., Europe, South Africa, and the Pacific Basin. Dr. Sortino received his Ph.D in Finance from the University of Oregon and has carried out research projects with many institutions like Shell Oil, Netherlands and The City and County of San Francisco Retirement System.
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