Fed’s Exit Strategy

After the reappointment of Ben Bernanke, discussions about the exit strategy from the massive increase in liquidity intensified again. On Squawk Box of the CNBC Asia channel one guest expressed his doubt that the Fed will be able to withdraw the liquidity because they are holding a lot of illiquid assets.

The Fed has more levers to control money supply than just open market operations and I will discuss them below, but let’s focus first on the balance sheet.

The inflationary danger arises from the fact that banks (depository institutions) hold over 819bln in deposits at the Fed (the second line in the liabilities side). If these institutions withdraw their deposits at the Fed and start lending out, there will be inflation. In order to reduce inflationary pressures, the Fed should be able to withdraw money from circulation. In normal times, the operation is very simple – the Fed officials sell some of Fed’s assets on the open market. By doing this, the Fed gets back cash and thus money supply in the economy goes down. To be able to perform this operation, however, the Fed must have liquid assets.

If we look at the asset side, we will see that the Fed has over 600bln in mortgage backed securities. Clearly, these are not good candidates for an open market operation. But in addition, there are at least three items that can be quickly sold or cancelled – US Treasury securities ($736bln), Term Auction Credit (credit with short maturity of about $220bln), and Commercial Paper facility of about $50bln. The last two items are part of credit facilities that the Fed can cancel easily once commercial banks start lending. The total amount is above 1trillion. In short, the Fed has enough balance sheet instruments to counteract the potential conversion of bank deposits into money.

Consolidated Balance Sheet of All Federal Reserve Banks (August 20, 2009) (Billions of USD)

Assets		Liabilities and capital
Gold US Treasury Securities Mortgage-backed Securities Term Auction Credit Commercial paper Other portfolio holdings Liquidity swaps Other assets	11 736 609 221 53 61 69 304	Banknotes Deposits of deposit. institutions US Treasury Other Capital	871 819 240 83 51
Total	2064	Total	2064

But these balance sheet tools do not exhaust the ammunition of the Fed to counteract any raise in inflation. Let me enumerate here some of the possible actions:

1. Open market operations (as described above).

2. Closing down of lending facilities (as described above)

3. Change in reserve requirements. What matters for inflation is the increase in broad measures of money. The Fed can raise required reserves ratios and by doing this they can reduce dramatically the speed at which money enters the economy. Required reserve ratios are used rarely because they are a very powerful tool (too powerful, one might say) in the control of money supply.

4. Change in the interest rate paid on the deposits of commercial banks. The Fed currently pays interest to banks that deposit their money in the Fed. If they increase this rate, the process of conversion of deposits into currency will slow down.

5. Issuance of central bank bonds. Currently the Fed does not have the authority to issue bonds (why would they borrow money, if they can print money?). But for the purposes of controlling money supply, they may ask the Congress to authorize them to issue bonds if they run out of Treasury bonds (i.e. they use all of them in open market operations) and they still need to reduce money supply further. This is a less conventional tool, but it has been used in China since 2003. Indeed this is how the People’s Bank of China sterilizes the effect of capital inflows and trade surpluses on money supply.

Armed with all these instruments, it is clear that, technically at least, the Fed possesses the levers to control the supply of money, so that rate of inflation does not increase above their (implicit) target persistently.

If you want to monitor the balance sheet of the Fed, it is published weekly on the following site: http://www.federalreserve.gov/releases/h41/Current/ (scroll down to where you see “Consolidated Statement of Condition of All Federal Reserve Banks”.)

Below is my interview for CNBC Asia from August 26, 2009, about the reappointment of Ben Bernanke as the chairman of the Fed (I know that I am biased). I also discuss Fed’s exit strategy briefly.

Ilian Mihov

More stimulus?

The debate about the need for a new stimulus package in the US is becoming more prominent among economists (see what Krugman or De Long have to say about it) and news web sites (the WSJ or CNBC are just an example).

What I find interesting is that this debate is taking place when most of the first stimulus package has not been implemented. In a recent conference at the IMF, Doug Elmendorf director of the US Congressional Budget Office, presented a summary of the progress of the first stimulus package. I was surprised to hear that at that point (a month ago), only 6% of the allocated money had been spent. By the end of September, it is likely that this figure will only be 25%.

Some of this delay was expected but it raises questions about what a second stimulus package would do to these figures. Even if we reach the conclusion that the US economy is in a weaker state than what was forecasted when the first stimulus package was approved (and this is probably true), how long will it take to implement a second stimulus package? Will new projects simply be added to the list of the current ones and be implemented a couple of years from now? This is a very important issue that needs to be resolved before we can start thinking about how many more billions of dollars we need to add to the first stimulus package.

As a side note, I find this related article by Paul Krugman very interesting. When it comes to fiscal policy, the burden of proof to show that it is an effective tool is so much higher than when it comes to monetary policy. And I agree with his reading that this is probably because ideologically, more government spending is a much more difficult proposition than lower interest rates.

Antonio Fatás

Stimulus money and the Chateau of Fontainebleau

Here is an interesting article from the New York Times about how fast France is spending the approved "stimulus money" relative to the US. The reason is that in a country with a large and more centralized system of public investment, there are many more "shovel ready" projects. The project they refer to is the renovation of the Chateau of Fontainebleau (home of one of the two INSEAD campuses). France is hoping to spend 75% of the stimulus money this year, a figure that is much larger than what is currently forecasted for the US. Here is an interesting chart with the evolution of money spent in the American Recovery and Reinvestment Funds. Numbers remain very low from the overall size of the program. The fact that we might see faster implementation of stimulus packages in countries with large governments (such as France) means that these countries not only benefit from strong automatic stabilizers, but they might also be able to be more effective when it comes to the implementation of discretionary fiscal policy measures.

Antonio Fatás

Ups and downs of fiscal policy

The large increase in government debt that we are witnessing across many countries have raised questions about the adjustment that will be necessary to bring those levels back to normal.

As much as the projected increases in debt are large for many governments, we have seen these high levels in the past and in some cases adjustments towards lower levels of debt have been fairly smooth and have taken place over a relatively short period of time. One of these examples is Ireland in the 1996 to 2006 period. During those years government debt was reduced from over 100% of GDP to about 20%. Fiscal discipline during those years helped, but what was more important was to have a fast-growing economy that made the level of debt shrink in relation to GDP. None of the advanced economies (the US, the Euro area) will be able to replicate the growth rates of Ireland in those 10 years but the message is clear: without healthy growth, bringing down debt to GDP ratios will be impossible (and Japan is a good example of what to expect if growth does not return).

The Irish example is also a reminder of how important is to have a proper framework for long-term sustainability of public finances. While the reduction of the debt levels was very impressive, some of the contributing factors were of a cyclical nature but they were judged to be structural by the policy makers. Once the cycle changed and the surpluses turned into large deficits, debt levels increased and, in the case of Ireland, we are witnessing a return to the high levels of the early 90s.

As an example of how cyclical factors helped during those years, the chart below - from the Public Finances 2009 publication of the European Commission - shows how dependent the increase in taxes was on the boom in property taxes. At the peak in the real estate boom, property-related taxes accounted for close to 20% of all tax revenues. In 2008 they have gone down to 10%, a loss of about 3 percentage points of GDP. Ireland is not the only country that is suffering from this problem. Overoptimistic scenarios used during the expansion phase did not produce the necessary fiscal discipline that could have created the necessary space for the current fiscal expansion. Let's hope we get this right in the next expansion (whenever it starts).

Antonio Fatás

Update on the difficulty of building counterfactuals

An update to our previous post. Below is a chart from the blog Calculated Risk that makes clear how difficult is to judge the effectiveness of economic policies. The two blue lines show the projections made by the Obama administration on January 10th for the evolution of the unemployment rate with and without the implementation of the recover plan. The difference between the two was a measure of the expected positive effects of such a plan. The red line shows the actual behavior of unemployment, much worse than any of the two predictions. A failure of the recovery plan or the fact that things have gotten much worse than what we expected in January?

Antonio Fatás

The difficulty of building counterfactuals

What are the effects of the monetary policy actions that central banks around the world have taken since the start of the crisis? How many jobs will be "saved or created" by the stimulus packages put forward by governments? These are crucial questions for policy makers but they are also very difficult to answer. The only way to provide a proper answer to these questions is by building a counterfactual: "what if those actions had not happened?". Easy to say, very difficult to do (at least in a credible manner). This leads to very interesting debates and, in some cases, confusion.

For example, the Obama administration has switched from talking about "jobs created" (by the stimulus packages) to "jobs created or saved". The reason was that they realized that over the first months (years?) of their mandate, we would only see negative growth for employment - i.e. jobs will only be destructed - so it did not make much sense to talk about "jobs created". To claim success of their policies, they need to talk about the jobs that would be saved and claim that without the stimulus packages there would have been even more jobs destructed. Wiliam McGurn in a recent Wall Street Journal article does not like this. Quoting from the article:

"If the "saved or created" formula looks brilliant, it's only because Mr. Obama and his team are not being called on their claims. And don't expect much to change. So long as the news continues to repeat the administration's line that the stimulus has already "saved or created" 150,000 jobs over a time period when the U.S. economy suffered an overall job loss 10 times that number, the White House would be insane to give up a formula that allows them to spin job losses into jobs saved."

I agree that it is difficult to hold governments accountable when we do not have a clear baseline on what would have happened without their actions, but this issue does not just apply to the Obama administration or to the "saved and created" formula. Even if we were in a period of job growth, any claim on "jobs created" would also have to be judged in relation to what would have happened if policies had been different. So whether politicians talk about "jobs created" or "jobs saved", we always need to question the assumptions in their economic projections.

Much of the empirical research in economics is about designing tests that can allow us to build counterfactuals and measure the true effects of policy actions. But in most cases this requires the use of historical time series and bundling together many episodes. And then the difficulty is to extrapolate what we learn from those historical episodes and see whether their lessons apply to the current scenario. As an example, our research might tell us that fiscal expansions have had in the past positive effects on output and employment and we can quantify those effects. But circumstances are always changing and it could be that under the current economic conditions those effects will be smaller or larger. As much as we have historical data on similar episodes, each episode is different from the previous one and it is impossible to control for all relevant factors. Having said that, this is not an excuse that can justify any claim on the number of "jobs created or saved". Baseline scenarios and counterfactuals can be built even if they are uncertain, and they should always be used to judge the impact of economic policies - in bad times and in good times.

Antonio Fatás

When will the U.S. recession end? (Ilian on CNBC)