Balance Sheet Issues
Early in minutes, there is reference to a person I did not know about:
The Manager of the System Open Market Account (SOMA) reported on developments in domestic and foreign financial markets during the period since the Committee met on April 27-28, 2010.The Manager of the SOMA holds a position at the New York Fed, and is appointed by the FOMC. He/she attends FOMC meetings, and on this occasion was called on for an extensive discussion of Fed balance sheet issues. Currently, the composition of the Fed's assets is very unusual. The average maturity of Treasuries held by the Fed is much longer than would have been normal in the past, and the Fed is holding a very large quantity of mortgage-backed securities (MBS) and agency securities, most of which are long maturity assets. Normal practice for long-maturity treasury securities held by the Fed in the past was to roll these over as they matured according to a fixed rule, as described in the minutes. The SOMA manager described some alternative scenarios for altering the fixed rule, these ideas were batted around, and the FOMC opted to stick to the fixed rule.
What's going on here? If we focus solely on Treasury securities, one aspect of the Fed's recent policy has been to move much more heavily into long-maturity Treasuries. Why? The Fed appears to believe that it can manipulate the term structure of interest rates. Short rates cannot go much lower, so it has attempted to force long rates down by buying long Treasuries. Could this be successful? Traditional central banking lore says no. Central bankers appear to operate on the belief that central bank actions have their effects in terms of returns on short-maturity assets, with little or no effect at the long end. Under the current circumstances, if the private sector can arbitrage across maturities, a swap of reserves for long Treasuries (or short Treasuries for long Treasuries) should not matter. Moving long rates down would have to depend on some inability to arbitrage, and I'm not sure that there is any evidence that such a friction exists.
Now suppose that a movement towards long Treasuries by the Fed is irrelevant. Does that mean it's innocuous? The Fed is now intermediating across maturities - the liabilities (currency and reserves) are all short maturity, and the assets go up to 30-year maturities. As is well-known, during the financial crisis, some financial institutions got into trouble due to a mismatch between the maturity of assets and liabilities, for example Gary Gorton is fond of a story about "repo runs." But the Fed is obviously not subject to runs. Currency is not redeemable in anything, and reserves can be withdrawn as currency, which is not redeemable. What is the maturity risk for the Fed? As the economy recovers, returns on alternative assets to reserves will start to look more attractive for banks. In order to control inflation, the Fed will have to raise the interest rate on reserves to make reserves more competitive relative to other assets. Now, while the Fed is currently making record profits (see here), they would not be if short-term interest rates had to rise significantly. What difference does this make? Profits made on Fed intermediation activities are just returned to the Treasury. Why would it matter if these profits are lower? Less revenue for the Treasury means they have to make it up somehow, and there is nothing that suggests that more taxation is in the wind. Thus, this means the Treasury has to issue more claims to pay US dollars in the future. If we think that what matters for long-run inflation is the growth rate in total (consolidated) government nominal debt, then this has to come back to bite the Fed in some fashion.
The maturity issue also matters in terms of the Fed's large holdings of MBS and agency securities. While there are clearly concerns on the FOMC about this, the minutes make clear that any decisions about addressing the maturity mismatch issue, or selling MBS, will be left for another day.
In the minutes, we have this:
Over the medium term, participants saw both upside and downside risks to inflation. Several participants noted that a continuation of lower-than-expected inflation and high unemployment could eventually lead to a downward movement in inflation expectations that would reinforce disinflationary pressures. By contrast, a few participants noted the possibility that a potentially unsustainable fiscal position and the size of the Federal Reserve's balance sheet could boost inflation expectations and actual inflation over time.I'm assuming that the concerns about deflation were coming in part from Eric Rosengren. His recent interview with the WSJ sounds a lot like Krugman. In the background is a "deflationary trap" model. The notion seems to be that we can get sucked into a black hole of deflation in which we can be lost for a decade or so, just like Japan in the 1990s. This makes absolutely no sense to me, but I'll have to investigate further - I'll let you know what I find out.
Another section in the minutes gives us this:
However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably.As I've commented before, the "instruments" in question here, the term deposit facility and reverse repos, accomplish nothing in terms of "exit." Further, as I discussed here, the Fed really has no room to move. It could buy more MBS, which if it has any effect, serves only to reallocate credit toward housing from more productive alternatives, and buying more Treasuries does essentially nothing under the current regime.