The Structural Foundations of Monetary Policy

Michael D. Bordo, John H. Cochrane, Amit Seru, Michael D. Bordo, John H. Cochrane, Amit Seru

• Publisher: Hoover Institution Press
• Year: 2018
• Print ISBN: 9780817921347
• eBook ISBN: 9780817921361
• Edition: 1
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

In The Structural Foundations of Monetary Policy, Michael D. Bordo, John H. Cochrane, and Amit Seru bring together discussions and presentations from the Hoover Institution's annual monetary policy conference. The conference participants discuss long-run monetary issues facing the world economy, with an emphasis on deep, unresolved structural questions. They explore vital issues affecting the Federal Reserve, the United States' central bank. They voice concern over the Fed's independence, governance, and ability to withstand future shocks and analyze the effects of its monetary policies and growing balance sheet in the wake of the 2008 financial crisis. The authors ask a range of questions that get to the heart of twenty-first-century monetary policy. Finally they propose reforms to ensure that the Fed will remain independent, stable, strong, and resilient in an unpredictable world.

Chapter One

The Balance Sheet

Section One

The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy

Charles I. Plosser

Last fall I was invited to give a talk at the Swiss National Bank in honor of Karl Brunner on the occasion of the hundredth anniversary of his birth. Karl, of course, was a famous Swiss economist, often associated with coining the term “monetarism.” I first met Karl at the Hoover Institution, where he and Robert Barro were visiting in 1978. They recruited me to the University of Rochester. Between 1978 and his death in 1989, I was fortunate to be a colleague of Karl’s at Rochester and learned a great deal from him over those years—not only about economics but many other things, including his views of the professional responsibilities associated with being a journal editor. Having founded the Journal of Money, Credit, and Banking and the Journal of Monetary Economics, he felt strongly about the important role played by high-quality refereed academic journals. Karl’s interests also spanned political science, sociology, and the philosophy of science. He was truly a committed scholar and had an amazing intellect.

You might ask what all this has to do with the Fed’s balance sheet. Karl had a deep interest in policy, and he tried to encourage academics to take an interest in policy-related research. He founded the Carnegie-Rochester Conference Series on Public Policy with Allan Meltzer, his student and longtime collaborator. The two of them also created the Shadow Open Market Committee in 1971 to bring policy insights out of the academic environment and make them accessible to the press and broader public. One theme Karl stressed in his discussions of policy was that institutions matter. He thought it important to recognize that policy makers are not the romantic “Ramsey planners” that we economists often assume in our models but actors responding to incentives and subject to institutional constraints, both of which shape policy choices and outcomes. Karl felt we needed to understand that environment to provide useful policy advice. Little did I know during those years at Rochester that I would end up in a policy-making role at the Fed during one of the most challenging times for our central bank.

This preface is relevant because I found Karl’s message, which I heard so many years ago, to be more germane than I imagined. And consequently, it has helped shape my thinking about policy and the current debates over monetary reform, including alternative operating regimes for implementing monetary policy.

I have often spoken about important institutional aspects of our central bank.1 In particular, I have stressed the importance of Fed independence and how institutional arrangements influence it. I have stressed that in a democracy, independence must come with limitations on the breadth and use of authorities. These constraints must be chosen carefully to preserve independence and the ability to achieve objectives while limiting actions that go beyond acceptable boundaries. For example, I have suggested limiting the Fed’s mandate to price stability and restricting the composition of the asset side of its balance sheet to Treasuries. Such limitations would constrain discretion and largely prevent the Fed from engaging in credit allocation policies that, in a democracy, should be in the hands of the marketplace or elected officials.

My focus today is on the Fed’s balance sheet and how institutions, and the incentives they create, matter for how it is managed. Since 2006, the balance sheet of our central bank has grown about fivefold, primarily because of the Fed’s unconventional policies during the financial crisis and subsequent recession. Once the Fed had reduced the targeted fed funds rate to near zero in December 2008, it embarked on a program of large-scale asset purchases. Initially, those purchases were motivated by a desire to provide liquidity and maintain financial market stability. Those goals were largely achieved by mid-2009, yet quantitative easing (QE) continued and expanded. It was justified not on the grounds of financial market dysfunction but as a means to provide more monetary accommodation to speed up the recovery.

structure of the fed’s balance sheet

Currently, the Fed’s balance sheet is roughly $4.5 trillion, compared to about $850 billion prior to the financial crisis. The composition of the balance sheet is also quite different today than it was prior to the crisis. In 2006, the asset side of the balance sheet was predominately US Treasury securities. Today, approximately 40 percent of the balance sheet is composed of mortgage-backed securities (MBS), while Treasuries account for most of the rest. In addition, at various points during the crisis the Fed held hundreds of billions of dollars of other private-sector securities or loans, although most of these private-sector securities have rolled off the balance sheet, leaving primarily Treasuries and MBS.

The liability side of the balance sheet also reflects the impact of QE. In 2006, currency accounted for more than 90 percent, or $785 billion, of the $850 billion, and bank reserves just about 2 percent, or $18 billion, almost all of which were required reserves. Today, currency represents about $1.5 trillion, or just 33 percent of the balance sheet, while reserves have risen to about $2.6 trillion, or about 60 percent of the balance sheet, of which only $180 billion are required.2 So there is about $2.4 trillion in excess reserves today compared to zero in 2006.

Thus, currency has doubled (growing about 6 percent a year) over the last ten years, yet reserves have grown by a factor of about ten (growing about 26 percent per year).

As for the Fed’s assets, holding predominately Treasuries was historically viewed as neutral in the sense that no sector of the economy was favored over another, and the maturity structure was chosen so that the yield curve was not affected.3 The purchase of MBS during QE, however, was a deliberate effort to improve the housing sector, while acquiring other private-sector securities as part of the rescues of Bear Stearns and AIG was intended to aid the creditors of those institutions. In the rescues, the Fed sold off Treasuries to purchase private-sector securities and make loans. These were highly unusual actions in support of specific parties even though the broader goal was to stabilize the financial system. Regardless of the rationale, the actions amounted to debt-financed fiscal policy and a form of credit allocation. Thus, such changes in the mix of assets held by the Fed are frequently referred to as credit policy.

operating regimes and the role of the balance sheet

How big should the Fed’s balance sheet be? In part, this depends on the Fed’s goals and objectives and on the operating regime for monetary policy. Prior to the crisis, the Fed operated with a relatively small balance sheet. Its size was determined by the demand for currency and the demand for required reserves. The Fed supplied currency elastically and supplied reserves in a way that achieved the target for the fed funds rate (the interbank lending rate). That is, it expanded or shrank reserves in the banking system to achieve its funds rate target. This operating procedure required the Fed to increase or decrease its balance sheet accordingly. The size of the balance sheet was integral to setting the instrument of monetary policy—the fed funds rate.

The Fed has not provided much in the way of guidance regarding the role it sees for the balance sheet going forward. In its exit principles, the Fed has stated that “the size of the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.”4 This is not helpful without knowing how the Federal Open Market Committee (FOMC) will ultimately choose to implement monetary policy. Will it return to the prior framework of targeting the fed funds rate or will it adopt some other target or instrument? What will determine the size of the balance sheet? Different approaches will have different implications for the balance sheet.

As to the preferred instrument of monetary policy going forward, the FOMC seems to have suggested that it would like to restore the federal funds as its primary instrument but has not committed to this strategy. How will the FOMC then achieve its target? With the current large balance sheet flooding the market with reserves, trading in the fed funds market is quite thin compared to the precrisis period.

Several economists (including former Fed chair Ben Bernanke, now at the Brookings Institution, and John Cochrane at the Hoover Institution) have argued that since the Fed now has the ability to pay interest on bank reserves, it is possible, desirable, and perhaps more efficient to maintain a large balance sheet and use the interest rate paid on reserves (IOR) as the instrument of monetary policy rather than the fed funds rate. The basic idea is that by setting the interest rate it pays on bank reserves, the Fed establishes a floor for short-term risk-free rates. In such a regime, as long as the balance sheet is of sufficient size to satiate the demand for reserves, it can be arbitrarily large (that is, operate with significant amounts of excess reserves) without affecting the conduct of monetary policy. This operating regime is often referred to as a “floor system.” Under this type of system, the fed funds market as we know it would likely disappear. Indeed, as I noted, due to QE and the current large balance sheet, the funds market is mostly moribund today.

The precrisis system of targeting a fed funds rate could also be implemented in a world where interest is paid on reserves. In such a regime, the fed funds target could be set slightly above the interest rate paid on reserves (say twenty-five to fifty basis points). However, to achieve a funds rate higher than the floor, or IOR, the balance sheet (more precisely, reserves) would have to shrink. This method of setting the interest rate target is often referred to as a “corridor” or “channel system.” This is because the instrument (the fed funds rate) is in a corridor above the IOR but less than the discount or primary credit rate, which is the rate at which the Fed is willing to lend reserves to depository institutions.

How big might the balance sheet be today under such a corridor system? As a reference point, one can think of a balance sheet today composed of currency plus required reserves as about $1.7 trillion. Adding $100 billion or so for the Treasury’s general account suggests that we might expect a Fed balance sheet of $1.8–$1.9 trillion as the size necessary to return to the precrisis operating regime. The arguments for a large balance sheet, composed of significant quantities of excess reserves, untethered to monetary policy, generally focus on financial stability factors. One argument is that large amounts of riskless reserves ensure ample safe assets in the system, which presumably provides liquidity and reduces systemic risk (whatever that may mean). It is argued that a scarcity of safe assets contributed to financial fragility in the crisis.5 Moreover, paying interest on reserves mitigates the distortionary effects of the tax on deposits caused by reserve requirements.

risks of a large balance sheet

The theoretical arguments for a floor system and a large balance sheet are straightforward, and while I disagree with some elements of the economic arguments, my major concerns arise from the institutional arrangements and incentives engendered by such a system at the Fed and in other parts of the government. Who will determine the amount of excess reserves created and how will they do it, since the monetary policy instrument will be the IOR? Unfortunately, there is little discussion or analysis of how to determine the appropriate amount of excess reserves that should be created. Is it $10 billion, $100 billion, or $1,000 billion?

Making the Fed’s balance sheet unrelated to monetary policy opens the door for the Fed to use its balance sheet for other purposes. For example, the Fed would be free to engage in credit policy through the management of its assets while not impinging on monetary policy. Indeed, the Fed’s balance sheet could serve as a huge intermediary and supplier of taxpayer subsidies to selected parties through credit allocation. It also opens the door for Congress (or the Fed) to use the balance sheet for its own purposes. Let me elaborate by articulating several concerns raised by pursuing an operating regime that tolerates a large and unconstrained balance sheet. Some of these concerns could be mitigated through legislation, while others are not so easily addressed.

First and foremost, an operating regime where the Fed’s balance sheet is unconstrained as to its size or holdings is ripe for misuse, if not abuse. A Fed balance sheet unconstrained by monetary policy becomes a new policy tool, a free parameter if you will. Congress would be free to lobby the Fed through political pressure or legislation to manage the portfolio for political ends. Imagine Congress proposing a new infrastructure bill where the Fed was expected, or even required, to buy designated development bonds to support and fund the initiative so taxes could be deferred. This would be very tempting for Congress. Indeed, in testimony before Congress I was asked why the Fed shouldn’t contribute “its fair share” to an infrastructure initiative. Image the lobbying for the Fed to purchase “build America bonds” issued by the Treasury to fund infrastructure initiatives.

More generally, the temptation would be to turn the Fed’s balance sheet into a huge hedge fund, investing in projects demanded by Congress and funded by forcing banks to hold vast quantities of excess reserves on which the central bank pays the risk-free rate. Of course, this just represents off-budget fiscal policy.

Consider the European Central Bank’s holdings of sovereign debt. This policy seems to have been designed to prop up the financial positions of countries in fiscal distress. Imagine if Illinois or California were on the verge of default. Would Congress decide that Fed purchases of state and local bonds constituted an acceptable tactic to delay and defer undesirable turmoil? Imagine the moral hazard and perverse incentives such a policy might induce.

Another recent example of these pressures can be found in Switzerland. The Swiss National Bank (SNB) has grown its balance sheet, which is composed mostly of foreign exchange reserves. Political pressure is being applied to “use” the reserves to invest in various initiatives, such as Swiss companies or other politically attractive activities. The arguments are often couched in the language of “risk management” or “appropriate diversification” of the SNB’s balance sheet.

Congress will undoubtedly find many “appropriate” uses for the Fed’s balance sheet and could do so and claim it doesn’t interfere with the independence of monetary policy. Recall that in 2015 Congress raided the Fed’s balance sheet to help fund a transportation bill. In 2010, the resources for the Consumer Financial Protection Bureau were found in Fed revenues. These were all efforts to exploit the central bank for fiscal policy purposes.

Imagine the political debates over appointments to the Board of Governors. Hearings might focus on the nominees’ views on the investment policy for the balance sheet rather than monetary policy. Political press...

Table of contents

• Contents
• Preface
• 1. The Balance Sheet
• 2. The Natural Rate
• 3. Lessons from the Quiet Zero Lower Bound
• 4. Monetary Policy and Payments
• 5. Monetary Policy Making When Views Are Disparate
• 6. Monetary Rules and Committees
• 7. The Euro Crisis
• 8. Monetary Policy Reform
• 9. Policy Panel
• Contributors and Discussants
• About the Hoover Institution’s Working Group on Economic Policy
• Index