Safe Assets And The Coordination Of Fiscal And Monetary Policy

by: Tim Duy

Kansas City Federal Reserve Bank President Esther George considers the long-run consequences of Federal Reserve policy:

But, while I agree with keeping rates low to support the economic recovery, I also know that keeping interest rates near zero has its own set of consequences. Specifically, a prolonged period of zero interest rates may substantially increase the risks of future financial imbalances and hamper attainment of the FOMC's 2 percent inflation goal in the future.

A long period of unusually low interest rates is changing investors' behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system...The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels. Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

Brad DeLong wonders:

The Fed's current Quantitative Easing ∞ program involves its buying risky bonds--thus diminishing the pool of risky assets that the private sector can hold. Esther George objects because… it does not make complete sense to me...Because there is less in the way of risky assets for the private sector to hold--and because that pushes prices of risky assets up and returns on risky assets down--QE ∞ actually makes private-sector portfolios riskier? Is that the argument?

I think DeLong is looking at a continuum of assets from safe to risky, where cash anchors the safe end of the continuum. Right next to cash is the somewhat riskier Treasury security. Thus by exchanging cash for Treasury securities, you by definition must be removing risk from the continuum, and thus the public's portfolio is now less riskier.

But, as he notes, this is obviously not how George views the situation. And, note that George claims that the intention of Fed policy is in fact to push people into riskier portfolios, which implies that the Fed believes that they are in fact making the public's portfolio more, not less, risky. This implies that DeLong's view is not just in opposition to George's, but to that of the majority of policymakers as well.

I think a way you can explain George's position if you consider Treasuries as less risky than cash. At first, this sounds crazy, but if you assume there is no default risk (which I don't think there should be if you can print currency of the same denomination as the bond), then the Treasury bond may be perceived as a safer because it provides some return. Assuming no default risk, for any given inflation rate, the Treasury bond will thus be a safer store of value. If you viewed the world from this perspective, then the Fed is increasing riskiness of the public's portfolio.

This, however, is not how I think the Fed considers the situation. I think the Fed tends to view the public's desired cash holdings as roughly constant (although the rise in deposits would call this into question). If by QE the Fed swaps out some of the safe Treasury securities for cash, the public, not wanting to hold anymore cash, takes the cash and, by default, purchases riskier assets, and thus is left with holding a portfolio of riskier assets. George believes this disrupts the natural order of things by creating financial market distortions.

In any event, I tend to take this in a different direction from here. George appears to be saying that the Fed is eliminating (more accurately, removing) the safe assets that the public wants to hold. Suppose that this is true. Does this mean that the Fed should reverse policy to increase the proportion of safe assets in the public's hands? Or does it mean that another agency - perhaps a fiscal authority, hint, hint - should take action to increase the proportion of safe assets in the public's hands?

Once again, we come back to the issue of coordinating monetary and fiscal policy. If the public has a strong demand for noncash safe assets, monetary policy has something of a secondary role by providing an accommodative environment by which the fiscal authority can issue those assets. If the proportion of safe to risky assets is not "correct", the the fiscal authority should have a role in correcting that imbalance. In this world, then, it is not really the actions of the monetary authority that is creating the financial sector imbalances that concern George. It is the lack of action by the fiscal authority that creates those imbalances. George should be criticizing the fiscal authorities, not the monetary authority.

In other words, if a recession is the result of the public shifting to safe assets, the Fed is trying to respond by taking away the option of safe assets, leaving only risky assets. Instead, the Fed should view their role creating an environment (making clear that default is not an option) that allows the fiscal authority to issue more safe assets.

All of this, however, suggests that fiscal policy has a much greater role in stabilizing economy activity than conventional wisdom would hold. I suspect, however, that thinking along these lines is anathema to Federal Reserve officials who maintain that stabilization policy is the domain of monetary policy only. But if in fact there needs to be greater cooperation, and instead we continue to rely solely on monetary policy, then we will continue to experience less-than-satisfactory economic outcomes which will eventually endanger the cherished independence of central banks.

In short, I don't think you can have a discussion about the influence of monetary policy on the riskiness of the public's portfolio without including some discussion about the role of the issuer of those safe assets, the fiscal authority.