Friday, May 7, 2010

Fed Independence

The Fed has of course attracted a lot more attention than usual since 2008. Plenty of people, including Eliot Spitzer, are asking for the Fed's head on a plate. Here is the core of his reasoning:
In monetary policy—controlling the supply of money—the Fed is constrained by reasonably well-understood policy levers that have a macro impact, and its decisions are rather evident in short order. Now, in contrast, the Fed is engaging in fiscal policy—spending money—and in fact has become the single largest fiscal actor in the U.S. economy, dispensing hundreds of billions of dollars to private parties. In doing so, the Fed is picking winners and losers. Why Goldman but not Lehman? Why guarantee the debt of some companies but not others?
It looks like the Fed will escape relatively unscathed though. Legislation wending its way through Congress (see here) appears to have been toned down, to the point where the Fed will see some auditing only of its market activities during the financial crisis.

Now, the Spitzer quote above is quite confused, but in an interesting way. First, by definition, the Fed is not engaged in fiscal policy. All of the Fed's recent activities are permitted under the Federal Reserve Act, which prescribes what monetary policy is (though we could debate whether the Act gives the Fed too much power). Second, the Fed is not "dispensing money," it is acquiring assets, and so far making a profit in doing so. Most importantly, Spitzer seems to think that the Fed is typically not up to much - it moves the money supply around, announces fed funds rate targets, publishes its statements and minutes, and everything is fine. Well, not really. Central bankers are practiced at laying low, keeping secrets, and saying as little as possible in public. First, the Fed typically moves its fed funds rate target up or down by 1/4% at any FOMC meeting, and they do that for a reason. This is part of laying low. Monetary policy could be having very big effects - changing the level of GDP, reallocating credit across sectors, etc. But the average Congressperson, Joe Schmoe, or Jane Doe, is not going to notice this much in real time. Second, we all know how central bankers (Alan Greenspan being the classic example) can drone on for hours, sound authoritative and confident, say absolutely nothing of importance, and get away with it. Third, while the Fed publishes the minutes of FOMC meetings (see here), it does this with a lag, and in a very vague manner. We don't know the actual words, and who said what until five years later. By then, this information has only historical interest, and it is hard to hold anyone accountable. Having this information on a timely basis (i.e. immediately) is of course key to understanding exactly what the Fed is up to.

Now, in intervening in such a massive way, the Fed is being called to account, and rightly so. The Fed is enormously powerful, and able to reallocate resources in important ways, even in normal times. If and when the Fed gets its balance sheet back to "normal," maybe we should be thinking seriously about more transparency in central banking as well as in private banking.


  1. Only if the Fed generate losses on its MBS holding (if it did not take sufficient hair cut) could its intervention be considered "fiscal policy". Otherwise, its MBS transactions is just an asset swap.

    It is true that if the Fed ends up loosing significant amount of money on its MBS holdings then this creates obviously an issue since this would mean non elected officials engaging in fiscal policy and picking "winners" and "losers". I doubt however that the Fed will end up loosing anything on its MBS transactions (overall).


  2. Yes, I did not say I agreed with anything in the Spitzer quote. If the Fed purchases MBS at the same prices that the private sector would otherwise take them, then this is irrelevant. If they take them at higher prices (which is possible, if they dominate the market), then this is not irrelevant, and the Fed can lose money on the deal, but so far it is doing well - Fed profits are up. Whether you call it fiscal policy is just semantics. How the Fed can ultimately lose money on MBS transactions would be as a result of mismatched maturities on the Fed's balance sheet. The MBS are long-maturity, and the Fed is also holding a lot of long-maturity Treasuries. If the Fed does not unload its MBS (and unloading will be essentially irrelevant, given no change in the interest rate on reserves), and is forced to increase short-term interest rates to control inflation, then the long-maturity assets on its portfolio fall in value. If the Fed then unloads the MBS, it takes a loss.

  3. No need for the Fed to unload them. Even if it takes 40 years for all its holdings of MBS to mature, who cares?

    I am wrong... but I take it that you did not drop your line about excess reserves creating impending inflation. I hope you are not holding your breath over this.... Haven't you noticed that during this week mini financial panic, the currency that appreciated the most is the one that belongs to the most heavily indebted country: Japan. And Japan have had excess reserves on its Central bank balance sheet for a long long time.


  4. Maybe I'm not making myself clear. What do you mean "drop your line about excess reserves creating impending inflation?" That's not my position at all. Read this piece:

    The large quantity of excess reserves is not in itself a problem for inflation control. However, there are two problems with the Fed holding a large quantity of MBS financed with reserves: (i) maturity mismatch on the Fed's balance sheet; (ii) subsidization of the housing market. Given the nature of both problems, the Fed should sell all of its MBS holdings within a year or two.