WORD ON THE STREET: The last five years have been an extraordinary time for the global economy and monetary policymakers. The financial crisis and the severe global recession that followed have tested our resolve, our patience and our economic theories. To restore the health of ailing financial markets and economies, central banks have driven short-term interest rates to essentially zero, expanded their balance sheets to unprecedented levels, and engaged in market interventions that have blurred the lines between monetary policy and fiscal policy.
These extraordinary efforts were well intentioned. Although it will be some time before we fully understand the effectiveness of various actions, some have credited them with preserving financial markets and saving the global economy from an even deeper recession. Yet, these actions also carry long-term risks for our economies and for central banks.
During the height of the crisis, the Federal Reserve instituted various liquidity facilities for particular segments of the financial system that were under stress. These programs supported primary dealers, the commercial paper market and money market fund investors. The Fed also gave support to specific individual institutions, including Bear Stearns and American International Group, to avert what could have been disorderly failures.
After reducing its policy rate, the fed funds rate, to essentially zero, the Fed instituted several large-scale asset-purchase programs. The first of these programs of quantitative easing, commonly referred to as QE1, ultimately involved purchasing $175 billion of housing agency debt and $1.25 trillion of agency mortgage-backed securities, or MBS; the Fed also purchased $300 billion in longer-term Treasuries in 2009. The unprecedented purchases of significant quantities of MBS were intended to support housing – the specific sector of the economy in which the financial crisis was centered.
As market functioning returned to normal, large-scale asset purchases continued. But the purpose shifted to providing monetary stimulus or defending against the potential for deflation while our policy instrument was constrained by the zero lower bound rather than supporting market functioning or lender-of-last-resort activities. As the economy struggled to recover and deflation became a concern, the Fed implemented QE2, a program to purchase $600 billion in longer-term Treasury securities. Most recently, the Fed instituted QE3, an open-ended program to purchase agency MBS at a pace of $40 billion per month.
In addition to the asset-purchase programs, the Fed has been engaged in a maturity extension program, popularly referred to as Operation Twist – an intervention that was last attempted, with little success, in the 1960s. The objective of this program is to flatten the yield curve by removing duration from the market.
Finally, the Fed has attempted to alter public expectations of the future path of monetary policy and the economy by issuing forward guidance about how long it expects to keep the fed funds rate exceptionally low. As of September, that expected date was at least through mid-2015.
As a result of these policy initiatives, the Fed has now held its policy rate near zero for almost four years, its balance sheet is more than three times larger than before the crisis, and the composition of its balance sheet has shifted toward mainly longer-term housing-related and Treasury securities compared with mostly short-term Treasury securities held before the crisis. Indeed, by the end of this year, the Fed will hold almost no short-term Treasuries.
Despite these extraordinary efforts by the Fed, our economy remains lackluster – unemployment remains uncomfortably high and is declining only slowly, economic growth is mediocre, and confidence in the future remains subpar.
Risky business
I join many economists who are skeptical that further asset purchases will have much effect on longer-term interest rates. Even if they do, the declines in long rates are likely to have fairly negligible effects on employment or growth at best. On the other hand, I believe the extraordinary policies the Fed has pursued pose substantive longer-term risks: These include moral hazard, future inflation and loss of institutional credibility.
Let's first discuss moral hazard. In taking unconventional and unusual steps in recent years, policymakers run the risk of altering the public's expectations of how policy will be conducted in the future. This is most frequently discussed in the context of the too-big-to-fail (TBTF) problem. In trying to stabilize the financial system, policies led creditors of large financial institutions to expect that the government will protect them from losses.
This creates moral hazard and undermines the market discipline that creditors exert on a firm's risk-taking. Without a clear set of rules or guidelines that tell market participants how such lender-of-last-resort policies will be conducted in the future, the actions run the risk of sowing the seeds of a future credit crisis. Moreover, it is unlikely that regulatory reform as embodied in Dodd-Frank has substantially addressed the TBTF problem. Indeed, some have argued that it has expanded the government safety net, thereby aggravating moral hazard.
Yet, moral hazard risks are not confined to the TBTF problem. By engaging in targeted purchases of housing-related securities, the Fed has affected expectations about what monetary policy will do in the future should the housing market take a sharp downturn.
Will market participants price housing-related assets with the expectation that the Fed will protect the market from significant losses? Will investors in other markets expect similar treatment and therefore be encouraged to take excessive risk? Similarly, will holding rates at essentially zero for a long time also spur increased and undesirable risk-taking in the search for higher yields? Certainly, the Fed does not intend to create such moral hazard. Yet, the lack of clear guidelines about future monetary policy can introduce its own form of instability and uncertainty.
Another potential risk is future inflation. So far, the asset-purchase programs have expanded the Fed's balance-sheet assets from about $900 billion before the crisis to nearly $3 trillion. Banks are holding $1.5 trillion in excess reserves in their accounts at the Fed. These reserves are not inflationary in the current environment. Indeed, inflation and inflation expectations remain near our goal, despite high unemployment rates or large measures of output gaps.
Yet, history tells us that central banks tend to find it easier to lower interest rates than to raise them. Moreover, it is difficult to identify the appropriate moment to begin tightening policy, even in the best of times. The tremendous expansion in the size of the Fed's balance sheet complicates the challenges the Fed will face when it comes time to begin exiting from this period of extraordinary accommodation.
Once the recovery strengthens – and it surely will – long rates will begin to rise, and banks will begin lending out their excess reserves. Loan growth could be quite rapid, and there is a real possibility that the Fed will have to withdraw accommodation very aggressively in order to restrain money growth and inflation.
While economic conditions might evolve very gradually, financial markets are not always patient. As soon as the markets perceive that the Fed might begin to remove accommodation, we could see long-term rates move up quite rapidly. In such an environment, policymakers might need to tighten policy quickly to contain inflationary pressures. Will this tightening require rapid sales of housing-related assets that could potentially disrupt a recovering housing market?
The bigger our balance sheet, the more difficult it will be to exit in a way that meets our inflation objective without creating instability in the real economy, thereby undermining our credibility and reputation.
The Fed's recent policy choices also impose other institutional risks. The purchase of large quantities of housing-related securities is viewed by some commentators and policymakers as a type of credit allocation to one sector of the economy in preference to other sectors. I, and others, believe such credit allocations should be in the province of the fiscal authorities, not the central bank. Blurring the boundaries between monetary and fiscal policies can pose institutional risks for the central bank and its independence.
As I mentioned, the Fed's balance sheet is not only quite large, but it now contains mostly long-term securities. As interest rates rise, if the Fed finds it must sell assets at a rapid pace to restrain inflation, it would very likely incur substantial losses. If so, the Fed may not be able to make any remittances to the Treasury for some years.
While this is of little macroeconomic significance, it will not go unnoticed, particularly in an era when the government will be struggling to reduce deficits. This could place considerable short-term pressure on the Fed to prevent those losses by tightening policy more slowly than might otherwise be appropriate.
If, instead of asset sales, the Fed tries to restrain credit growth by increasing the interest rate paid on excess reserves, this would reduce our remittances to the Treasury as more of the Fed's income would be paid out to the banks holding the reserves. Again, this is of little significance to the macroeconomy, but it is a risk to perceptions about the institution, which eventually may put the Fed's independence at risk.
It is very hard to quantify the risks associated with our unconventional policies. But they are real. With our recent extraordinary policies, we have sailed into uncharted territory; we need to acknowledge that, proceed with caution, and continually assess the potential costs and benefits of our policy actions.
Charles I. Plosser is president and CEO of the Federal Reserve Bank of Philadelphia. This article is adapted and edited from a speech delivered at the Cato Institute's recent 30th Annual Monetary Conference. The original text of Plosser's speech is available online.
