By Dave Altig
It is not difficult to find people who espouse the following belief:
"One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its 'quantitative easing' policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?"
I dare say that I hear that criticism, in one form or another, nearly every day. So the claim above might only merit notice here because it comes from a Wall Street Journal op-ed penned by Professor Allan Meltzer, the eminent monetary macroeconomist and chronicler of Federal Reserve history. But what really distinguishes the critique is that it comes with a fairly novel and creative way of resolving the perceived problem:
"One idea is for the Fed to create its own version of a 'bad bank.' The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank’s assets. (The $1 trillion in Fed-created 'excess' bank reserves as a result of quantitative easing would become the liabilities of the bad bank.)
"The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline. The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away. Letting the market know precisely when the mortgage-backed securities would be sold makes the adjustment to the future elimination of excess reserves manageable."
Generally speaking, the Meltzer strategy offers what I perceive to be two critical criteria for a viable exit plan. One is that the winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible. The second is, of course, that the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.
It should not go unmentioned that these criteria are also features of exit plans that have been sketched by Federal Reserve officials—by Chairman Bernanke last year and by Philadelphia Fed President Charles Plosser more recently, for example. What distinguishes the Meltzer plan is less in approach and more in timing.
In fact, the Meltzer approach is similar in spirit to the Fed's Term Deposit Facility that became operational last summer. The simplified description of this facility is that it involves the Federal Reserve temporarily taking onto its own accounts the excess reserves of banks. If you want to call that account a "bad bank," you're getting close to the Meltzer plan.
Expanding just a bit, in a term deposit facility the private banking system deposits its excess reserves—an asset of private banks—with the Fed. In exchange, banks receive an asset in the form of interest-bearing "accounts," the analog of a time deposit that you might purchase from your bank. Just as you cannot spend the funds you put into a time deposit you own, banks cannot use funds deposited in the Term Deposit Facility to support credit expansion (at least not until the term of the deposit expires).
Which brings me to a point that I don't quite follow about the Meltzer plan: If reserve assets are removed from the banking system, what are the corresponding offsets on the balance sheets of private banks? My guess is you end up with something like term deposits or their economic equivalent—nonnegotiable sterilization bonds, for instance. And if you match the maturities of those deposits with the maturities of the MBS and long-term security portfolio, it becomes pretty clear that the debate is really less about tactics and more about some pretty familiar, but difficult, issues: When is it time to stand pat on policy, and when is it time to reverse course?
On this conversation, I will, as I often do, give the last word to Dennis Lockhart, our Bank's president, who spoke earlier today in Knoxville, Tenn.:
"My view of the future permits a degree of patience as regards monetary policy. There is still a halting and fragile quality to the economy. I think the process of restoration of full economic strength with higher employment continues to require support. That said, planning for an eventual change of course is completely appropriate as long as public discussion about planning deliberations and the plan itself don't create premature expectations of tightening.