William C Dudley: The economic outlook and the Fed's balance sheet -
the issue of "how" versus "when"
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Association for a Better New York Breakfast Meeting, New
York, 29 July 2009.
* * *
It is a pleasure to have the opportunity to speak here at the Association for a Better New
York. This group has obviously been very successful. New York today is a far different and
vastly superior place from what I found when I first arrived as a freshman at Columbia
University in 1970.
Today, I'd like to accomplish two tasks. First, I'll comment briefly on the economy and the
economic outlook - where we have been and where we may be going. I'm going to suggest
that the balance of risks is still tilted toward weakness in growth and employment and not
toward higher inflation. I will also argue that it is premature to talk about "when" we are going
to exit from this period of unusual policy accommodation.
Second, I will talk about the impact of the Federal Reserve's lending facilities and purchase
programs on the size of the Fed's balance sheet. I'll explain why an expanded balance sheet
does not constrain our ability to exit from the current degree of policy accommodation. In
other words, contrary to what is sometimes argued, it is not the case that our expanded
balance sheet will inevitably prove inflationary. It is important that this critical issue be well
understood. The public must be absolutely confident that the Fed can meet its monetary
policy objectives of low and stable inflation and sustainable economic growth. Before I begin
to get into these issues in earnest, let me note that, as always, the views I put forward today
are my own and do not necessarily reflect the position of the Federal Open Market
Committee (FOMC) or the Federal Reserve System.
Turning first to the outlook, the economic contraction appears to be waning and it seems
likely that we will see moderate growth in the second half of the year. The economy should
be boosted by three factors: 1) a modest recovery in housing activity and motor vehicle
sales; 2) the impact of the fiscal stimulus on domestic demand; and 3) a sharp swing in the
pace of inventory investment. In fact, if the inventory swing were concentrated in a particular
quarter, we could see fairly rapid growth for a brief period.
Regardless of the precise timing, there are a number of factors which suggest that the pace
of recovery will be considerably slower than usual. In particular, I expect that consumption -
which accounts for about 70 percent of gross domestic product - is likely to grow slowly for
three reasons. First, real income growth will probably be weak by historical standards. There
were a number of special factors that boosted real income in the first half of the year, helping
to offset a sharp drop in hours worked and very sluggish hourly wage gains. These factors
included the sharp drop in gasoline and natural gas prices; the large cost-of-living-allowance
increase for Social Security recipients reflecting last year's high headline inflation; a sharp
drop in final tax settlements; a reduction in withholding tax rates; and a one-time payment to
Social Security recipients. These factors provided a transitory boost to real incomes, which
will be absent during the second half of the year. As a result, real disposable income is likely
to decline modestly over this period.
Second, households are still adjusting to the sharp drop in net worth caused by the persistent
decline in home prices and last year's fall in equity prices. This suggests that the desired
saving rate will not decline sharply. That means consumer spending is unlikely to rise much
faster than income. In other words, weak income growth will be an effective constraint on the
pace of consumer spending.
Moreover, some sectors such as business fixed investment in structures are likely to
continue to weaken as existing projects are completed. In an environment in which vacancy
rates are high and climbing, prices are falling, and credit for new projects is virtually
nonexistent, this sector is likely to be a significant drag on the economy over the next year.
Perhaps most important, the normal cyclical dynamic in which housing, consumer durable
goods purchases and investment spending rebound in response to monetary easing is
unlikely to be as powerful in this episode as during a typical economic recovery. The financial
system is still in the middle of a prolonged adjustment process. Banks and other financial
institutions are working their way through large credit losses and the securitization markets
are recovering only slowly. This means that credit availability will be constrained for some
time to come and this will serve to limit the pace of recovery.
If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to
remain elevated and capacity utilization rates unusually low for some time to come. This
suggests that inflation will be quiescent. For all these reasons, concern about "when" the Fed
will exit from its current accommodative monetary policy stance is, in my view, very
premature.
In contrast, I think it is important to address today the issue of "how" the Fed can exit from
the current stance of policy when the time comes, even if its numerous special facilities and
purchase programs continue to keep the size of its balance sheet at an expanded level.
Why do I believe it is so important to explain the issue of "how" having just argued that
"when" is not yet a pressing issue? The reason is that if people believe - correctly or
incorrectly - that the Federal Reserve could have a problem managing a smooth exit from its
accommodative policy stance, this belief alone could have the adverse effect of causing
inflation expectations to become less well anchored and risk premia on long-dated debt
securities and loans to rise. These effects could conceivably make it more difficult to
generate a sustainable economic recovery.
This risk seems significant. For example, just last week a major bank published a survey of a
broad array of 1800 investors. Of those surveyed, 20 percent thought that inflation might
average more than 2.5 percentage points per year above their assessment of the Federal
Reserve's target. This outcome presumably reflects two factors - the balance-sheet
expansion of the Fed and the large fiscal deficit.
With this in mind, let me spend the remainder of my time discussing the sources of growth in
the Federal Reserve's balance sheet over the past year and a half or so, and explain why I
am confident that the exit from our accommodative policy stance, as well as from our various
lending facilities and purchase programs, can be handled smoothly.
As you are aware, the Federal Reserve has been engaged in a wide array of unprecedented
activities over the past two years in response to the financial crisis. These include:
•
Liquidity facilities designed to improve market function. These include facilities
oriented to banks and dealers such as the Term Auction Facility (TAF), Primary
Dealer Credit Facility (PDCF) and the foreign exchange swap programs; and facilities
designed to improve market function in impaired parts of the money and capital
markets such as the Commercial Paper Funding Facility (CPFF) and the Term
AssetBacked Securities Loan Facility (TALF).
•
Purchase programs oriented to easing financial conditions. These include the agency
debt, agency mortgage-backed securities (MBS) and Treasury purchase programs.
•
Several firm-specific interventions in which the Federal Reserve has taken on illiquid
asset portfolios from Bear Stearns and AIG, with the goal of managing and liquidating
these asset portfolios over time in a manner that is in the best interests of the federal
government and the U.S. taxpayer.
These programs have led to significant changes in both the composition and size of the
Federal Reserve's balance sheet. For example, in August 2007, prior to the onset of the
crisis, the Federal Reserve's balance sheet was about $870 billion. Currently, the size of the
balance sheet is about $2 trillion. To gain a better understanding of how we got to where we
are now, I think it is useful to divide the past two years into three distinct phases.
The first stage I'll define as the period running roughly from the start of the crisis in August
2007 to September 2008. During this stage, the Fed's monetary policy implementation
regime worked in such a way that control over the size of its balance sheet, and more
specifically over the level of excess reserves, was essential to ensure that the Open Market
Desk could control the fed funds rate in a manner consistent with the FOMC's monetary
policy objectives. Had the Fed's special liquidity facilities grown sufficiently large during that
period, raising the level of the excess reserves in the banking system, the fed funds rate
would likely have fallen far below the FOMC's target rate. To keep the fed funds rate around
the target, the only sure-fire option was to avoid a significant expansion in the balance sheet
by funding the expansion of nontraditional assets, such as TAF loans, FX swaps, and PDCF
loans with similarly sized liquidations of the Federal Reserve's portfolio of Treasury
securities. Thus, over the period from August 2007 up through the time of the Lehman
Brothers failure in September 2008, the total size of the Fed's balance sheet and the level of
excess reserves in the banking system changed very little.
The second stage began in October 2008 when the Federal Reserve gained the authority to
pay interest on reserves, including excess reserves. The addition of interest on reserves to
the Fed's toolkit effectively broke the link between the size of the Fed's balance sheet and
the stance of monetary policy. Policymakers now had the capacity to expand the size of the
Fed's liquidity facilities and other programs without the threat of compromising the control of
monetary policy. This new tool immediately proved enormously helpful. The Fed was able to
respond to the deterioration of conditions in the fall of 2008 by sharply increasing the size of
its Term Auction Facility program and removing the limits on the size of many of the foreign
exchange swap programs. These programs, along with the increased use of the Fed's
standing liquidity facilities and the start-up of the Commercial Paper Funding Facility in late
October, led to a sharp growth in the Federal Reserve's balance sheet beginning in late
September.
The third phase is marked by the launch of the Fed's purchase programs, starting with the
agency debt program that began in December 2008 and extends through to the present.
During this phase, the Fed's overall balance sheet has actually declined slightly. The
demand for the Fed's special liquidity programs has diminished more quickly than the
purchase programs have been ramped up. Although this shrinkage was not anticipated or
targeted, it is a welcome indication that there has been improvement in the functioning of the
short-term funding markets.1 As market function has improved and credit spreads have
narrowed, many of the Fed's liquidity facilities have become less attractive and there has
been a corresponding decline in usage. For example, outstanding foreign exchange swaps
have declined from a peak of $586 billion last December to about $110 billion currently, and
outstanding commercial paper held by the CPFF has fallen from a peak of about $350 billion
last fall to around $110 billion currently.
Despite the recent dip in the size of the balance sheet, the size of the purchase programs
underway makes it likely that balance-sheet growth will resume as assets acquired in
conjunction with these programs overwhelm any further declines in the funds advanced via
the shorter-term liquidity facilities. The size of the Federal Reserve's balance sheet seems
likely to grow to roughly $2.5 trillion, somewhat above the peak reached last December.
It is no coincidence that the growth of the Federal Reserve's balance sheet since last fall has
been accompanied by a sharp rise in the amount of excess reserves. When the Federal
Reserve extends a loan or purchases a security, this automatically adds reserves to the
banking system unless the Fed undertakes an offsetting reserve draining operation. Although
some of the excess reserves that have been generated by the balance-sheet expansion
were initially sopped up by the Treasury's Supplemental Financing Program, total excess
reserves have climbed to more than $700 billion from nearly zero at the beginning of the
crisis.
The sharp rise in excess reserves has caused the monetary base, which is simply the sum of
currency plus total reserves, to expand significantly. The increases in excess reserves and in
the monetary base generated by the Fed's balance-sheet growth have led some observers to
worry that this expansion will ultimately prove inflationary. Proponents of this view say that
the monetary base, the broad monetary aggregates, total credit outstanding and inflation
have historically tended to move together, at least over longer time periods. Thus, if the
monetary base is growing rapidly, as it has been over the past year, the view is that this
growth will ultimately lead to inflation.
Is this concern well founded? The answer is that in a world where banks could not be paid
interest on excess reserves, these persistent high reserve balances would indeed have the
potential to prove inflationary.2 In that world, the excess reserves are likely to lead ultimately
to an overly accommodative monetary policy. The story goes like this: If banks are earning
no interest on their excess reserve holdings, they will be willing to lend those reserves out to
any creditworthy borrowers as long as the interest rate is positive after adjusting for risk. The
borrowers would then spend these monies, thereby boosting economic activity. The funds
would not disappear, but instead would flow back into the banking system as they were
deposited by those who had received the income generated by the increase in spending,
thus replenishing the reserves that had been lent out in the first round of lending. This would
result in a new stock of excess reserves that would then lead to a second round of credit
creation and a further increase in economic activity. This cycling of excess reserves into
credit creation, and the corresponding increase in economic activity, would continue until the
excess reserves were fully absorbed by an increase in currency outstanding and/or an
increase in required reserves associated with the rise in the amount of banking deposits.
Inflation would rise as the excessive credit creation generated by the excess reserves led to
an overheated economy and a rise in inflation expectations.
But that is not the world in which we now live. Because the Federal Reserve now has the
ability to pay interest on excess reserves (IOER), it also now has the ability to prevent excess
reserves from leading to excessive credit creation. Because the Federal Reserve is the
safest of counterparties, the IOER rate effectively becomes the risk-free rate.3 By raising that
rate, the Federal Reserve raises the cost of credit more generally because banks will not
lend at rates below the IOER rate when they can instead hold their excess reserves on
deposit with the Fed. Because banks no longer seek to lend out their excess reserves, there
is no increase in the amount of credit outstanding, no redeposit of the excess reserves, no
increase in economic activity and no risk that excessive credit creation will fuel an inflationary
spiral.
For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent
with the amount of required reserves, money supply and credit outstanding consistent with its
dual mandate of full employment and price stability. If demand for credit exceeds what is
appropriate, the Federal Reserve raises the IOER rate to reduce demand. If the demand for
credit is insufficient to push the economy to full employment, then the Federal Reserve
reduces the IOER rate, recognizing that the IOER rate cannot fall below zero. This does not
differ much from how the Federal Reserve has behaved historically - set the fed funds rate
at a level consistent with the desired level of economic activity and inflation over time.
So how does the IOER rate relate to the fed funds rate? The two rates are likely to track
each other closely in most circumstances.4 First, banks generally do not have any incentive
to sell fed funds at rates below the IOER rate. Only nondepository institutions - such as the
government sponsored enterprises (GSEs) - that can buy and sell fed funds but are not able
to hold excess reserves with the Fed, might have an incentive to sell fed funds at rates below
the IOER rate. But even in this case, the fed funds rate would not likely fall far below the
IOER rate. After all, if the fed funds rate were to fall significantly below the IOER rate, banks
could purchase the fed funds and hold them as reserves with the Fed, earning the difference.
The ability of banks to engage in arbitrage should limit the size of the deviations between the
IOER rate and the fed funds rate. Thus, through the IOER rate, the Federal Reserve can
effectively retain control of monetary policy.
In addition to paying interest on excess reserves, the Federal Reserve also has the ability to
drain the excess reserves from the banking system. This can be done in a variety of ways:
reverse repo transactions with dealers and other counterparties, securities sales from the
Fed's portfolio or bill issuance by the Treasury, with the funds deposited at the Federal
Reserve. Although our ability to pay interest on excess reserves is sufficient to retain control
of monetary policy, it is not bad policy to have both a "belt and suspenders" in place. As a
result, we are working out ways to drain reserves to provide reassurance that we will not -
under any circumstance - lose control of monetary policy.
A related concern is the question of whether the Federal Reserve will be able to act quickly
enough once it determines that it is time to raise rates. This concern reflects the view that the
excess reserves sitting on banks' balance sheets are essentially "dry tinder" that could
quickly fuel excessive credit creation and put the Fed behind the curve in tightening
monetary policy.
In terms of imagery, this concern seems compelling - the banks sitting on piles of money that
could be used to extend credit on a moment's notice. However, this reasoning ignores a very
important point. Based on how monetary policy has been conducted for several decades,
banks have always had the ability to expand credit whenever they like. They don't need a
pile of "dry tinder" in the form of excess reserves to do so. That is because the Federal
Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its
target. If banks want to expand credit and that drives up the demand for reserves, the Fed
automatically meets that demand in its conduct of monetary policy. In terms of the ability to
expand credit rapidly, it makes no difference whether the banks have lots of excess reserves
or not.
Another source of concern among some market participants has been the Federal Reserve's
purchase of Treasury securities. The worry here is that the Federal Reserve's purchases are
"monetizing the debt" and that therefore these purchases will ultimately prove inflationary.
Regarding the Fed's Treasury purchase program, I want to make two points. First, with the
fed funds rate constrained at zero lower bound, policymakers needed to find other ways to
stimulate economic activity. The agency debt and agency MBS purchase programs proved
effective in narrowing credit spreads in the debt and MBS market, but the Federal Reserve
would have encountered diminishing returns in terms of impaired market function if it had
raised the sizes of these two programs further. This suggested that the best course to hold
down mortgage rates and other private borrowing rates would be to engage in a Treasury
purchase program that would put downward pressure on Treasury rates. In this regard, the
Fed's purchases have not been motivated by accommodating an expansive fiscal policy and
the large fiscal deficits that are its consequence. I can assure you that the Federal Reserve
will never engage in a program to accommodate or facilitate an unsustainable fiscal policy
program. Instead, these programs were designed to help ease financial conditions at a time
that the Federal Reserve could not push the fed funds rate below zero.
Second, the program is small. So even if one were to take a darker view of what the Federal
Reserve has done, it is important to put the purchase program in context. Even after
completion of a purchase program of up to $300 billion of Treasuries, the Federal Reserve's
holdings of Treasuries will be smaller than they had been in August 2007 on the eve of the
crisis. Moreover, as a share of Treasuries outstanding, the Fed's share will be the lowest
since the early 1990s.
Overall, the Federal Reserve's balance-sheet expansion has had notable benefits. The asset
purchase programs have helped to keep longer-term private interest rates relatively low, and
the expansion of liquidity facilities has helped to restore more normal market function.
However, this does not mean that the Federal Reserve balance-sheet expansion and
Treasury purchase program are cost free, only that the benefits of these programs,
individually and collectively, are seen as exceeding the potential costs.
Nevertheless, there are three issues on the cost side that deserve note. First, policymakers
need to take seriously any concerns that the Fed's actions might conceivably lead to an
inflation problem. After all, inflation is driven mainly by two variables - inflation expectations
and the degree of pressure on resources. It would be potentially very damaging if any of the
Fed's programs were to unhinge inflation expectations. One risk with embarking on the
Treasury purchase program was that it had the potential to create the misperception that the
Fed was providing the fiscal authorities with the means to fund a more stimulative fiscal
policy than they would otherwise have been able to finance. This misperception around the
intent and purpose of the program could have undermined the Fed's credibility and triggered
a damaging rise in inflation expectations. Indeed, one of my primary goals for this speech is
to make it clear that we have not compromised our ability or our commitment to keep inflation
in check. Keeping inflation and inflation expectations well anchored around a low level is
essential.
Second, the Federal Reserve's balance-sheet expansion does have a consequence for the
balance sheet of the banking system. The increase in the amount of excess reserves has to
be held by banks. Excess reserves are a risk-free asset that they may not wish to hold. More
important, to the extent that the banks worry about their overall leverage ratios, it is possible
that a large increase in excess reserves could conceivably diminish the willingness of banks
to lend. At present, these balance-sheet issues do not appear to be having a meaningful
effect on bank behavior. In fact, the excess reserves serve as a liquidity buffer that many
banks find attractive in the current environment. But that does not mean we can ignore this
issue. We need to keep this issue in mind as we contemplate how much balance-sheet
expansion might be appropriate.
Third, the Federal Reserve is taking on some interest-rate risk in terms of its balance sheet.
The excess reserves have an overnight maturity. These liabilities are being used to purchase
longer-term assets. In principle, if short-term interest rates were to move up very sharply, the
cost of funding could eventually exceed the return on the Fed's assets. The bigger our
balance sheet, the greater the amount of interest-rate risk we are assuming.
We have examined this issue in detail. Suffice it to say, it is conceivable that the Federal
Reserve's net-interest margin could be pinched in certain environments - say if the economic
recovery turned out to be very robust. But our analysis shows that it is extremely unlikely that
the Fed's net-interest margin will turn negative. In part, that is due to the fact that the
balance-sheet risk associated with the interest-rate mismatch is offset to a large degree by
the fact that the cost of much of the Fed's liabilities - the amount of currency outstanding - is
zero. So when short-term rates rise, the cost of a significant portion of the Fed's liabilities is
unaffected.
Making policy during a crisis involves making tough choices. Perfect solutions are not always
achievable or even legally feasible. I can assure you that our decisions have been made
carefully, always with an eye toward finding the right balance between the risks and rewards
of alternative options. Most critical is our commitment never to take actions that might
compromise our ability to retain our control of monetary policy and that might undermine our
ability to achieve our dual mandate of full employment and price stability.
Thank you for your kind attention. I would be very happy to take a few questions.