Brian P Sack: Preparing for a smooth (eventual) exit
Remarks by Mr Brian P Sack, Executive Vice President of Markets Group of the Federal
Reserve Bank of New York, at the National Association for Business Economics Policy
Conference, Arlington, Virginia, 8 March 2010.
* * *
Thank you for inviting me to speak today. In my remarks, I will provide an update on the
progress that the Federal Reserve is making toward preparing for a smooth exit from the
extraordinary policy actions that were taken in response to the financial crisis.1 I should note
up front that I will not be providing any information about the likely timing of policy tightening;
those decisions will be made and communicated by the Federal Open Market Committee
(FOMC). Instead, I will focus my comments on the policy tools and strategy that are likely to
be used whenever that exit becomes appropriate. I will also discuss the preparedness of
financial markets for the Fed's exit, in order to assess how financial conditions may evolve as
the exit approaches and gets under way.
When the time comes to tighten monetary policy, the Federal Reserve will be embarking on a
tightening cycle like no other in its history. First, this tightening cycle will have two policy
dimensions, in that the FOMC will have to decide on the path of its asset holdings in addition
to the path of the short-term interest rate. Second, we will be using tools to drain reserves
that are new and that will have to be implemented on a scale that the Fed has never before
tried. And third, we will be operating in a framework of interest on reserves that has not been
fully tested in U.S. markets.
All of that may sound risky. However, I believe the Federal Reserve is positioned to minimize
any risks involved. Most important, we have worked hard to ensure that we have all of the
tools needed to exit, and FOMC members have begun to describe a strategy for using them
that is cautious along several dimensions. In addition, if we communicate effectively, the
markets should be clearly informed and well prepared ahead of the exit. These are the points
that I will emphasize in more detail.
Liquidity facilities: a success story
When discussing the Federal Reserve's exit strategy, it is important to separate liquidity
facilities from the stance of monetary policy. While the exit from the accommodative
monetary policy stance has yet to begin, the exit from liquidity facilities is nearly complete.
Let me begin with some comments on recent developments regarding the liquidity facilities,
and then I will move on to monetary policy.
As is well known, the Federal Reserve launched a number of liquidity facilities to provide
short-term funding to the financial markets during the crisis, in order to meet the
extraordinary demand for liquidity at that time. Here I am referring to those facilities that
provided funding at maturities of up to three months to particular sets of firms, such as the
primary dealers, money market mutual funds, commercial paper issuers, and depository
institutions.2 Just today, we conducted the last operation associated with those facilities,
meaning that all of the short-term liquidity facilities that were introduced during the crisis have
now effectively been retired. The only special liquidity program that remains active is the
Term Asset-Backed Securities Loan Facility, which I consider to differ from the short-term
liquidity programs because it provides funding for up to five years.
With the wind-down of these short-term liquidity facilities, it is a good time to look back and
assess their performance. The bottom line here is simple: these programs were an
unquestionable success. We have witnessed a remarkable improvement in the functioning of
short-term credit markets and an impressive recovery in the stability of large financial firms.
While a whole range of government actions contributed to this recovery, giving financial
institutions greater confidence about their access to funding, and that of their counterparties,
was most likely a crucial step toward achieving stability.
Moreover, the exit from these facilities has been quite smooth. At their peak, these facilities
provided more than $1.5 trillion of credit to the economy. Today, the remaining balance
across them is around $20 billion. It is impressive that the Fed was able to remove itself from
such a large amount of credit extension without creating any significant problems for financial
markets or institutions. That success largely reflects the effective design of those programs,
as most were structured to provide credit under terms that would be less and less appealing
as markets renormalized. This design worked incredibly well, as activity in most of the
facilities gradually declined to near zero, allowing the Fed to simply turn them off with no
market disruption.
The success of these facilities should be judged by the outcomes they produced for financial
market functioning, and not by the financial returns they generated on the Federal Reserve's
books. However, there are several reasons why the Fed might be expected to profit from this
type of lending under most circumstances. First, the Fed is providing funds in response to an
extreme move in the price of liquidity - that is, it is in effect buying a cheap asset. Second,
the programs themselves, if successful at returning market functioning, would help the
performance of the Fed's loans to be sound. And third, the lending under these facilities has
to be adequately secured.
Asset holdings: a policy lever
While the exit from the liquidity facilities has been successful, the exit from the
accommodative stance of monetary policy involves a different set of challenges. Many of
these challenges arise from the Federal Reserve's outright holdings of Treasury debt,
agency debt and agency mortgage-backed securities (MBS), which together represent the
overwhelming share of the Fed's balance sheet today. Indeed, as a result of our large-scale
asset purchase programs, these asset holdings now account for $2.0 trillion of the Fed's
$2.3 trillion balance sheet.
The Federal Reserve is approaching the scheduled end of its large-scale asset purchases.
We have bought $169 billion of agency debt to date, nearly fulfilling our plan to purchase
"about $175 billion". For MBS, we have only about $30 billion of purchases remaining to
reach our $1.25 trillion target. In addition, we completed $300 billion of purchases of
Treasury securities late last year. Looking across these programs, we have now purchased
$1.69 trillion of assets, bringing us 98 percent of the way through our scheduled purchases.
To get to this point, the Trading Desk at the New York Fed has so far conducted 126 discrete
operations to purchase Treasury and agency debt, and has managed 292 trading days on
which either it or its investment managers have acquired MBS.
My view is that the purchase programs have helped to hold down longer-term interest rates,
thereby supporting economic activity. With the conclusion of the programs approaching, the
Desk has been tapering the pace of its purchases of agency debt and MBS. However, even
as the pace of our purchases has slowed, longer-term interest rates have remained low, and
MBS spreads over Treasury yields have remained tight. This pattern suggests that the
effects of the purchases have been primarily associated with the stock of the Fed's holdings
rather than with the flow of its purchases. In that case, the market effects of the purchase
program will only slowly unwind as the balance sheet shrinks gradually over time.3
In my previous speech back in December, I discussed in detail the channels through which
these market effects may arise. By removing large amounts of duration and prepayment risk
from the market, the Fed's asset purchases reduced the volume of risk that the market had
to hold, which lowered the risk premia on those assets. Put differently, the purchases bid up
the prices of those assets and hence lowered their yields. The lower levels of yields would be
expected to boost other asset prices as investors substitute into alternative asset classes.
These patterns describe what researchers often refer to as portfolio balance effects.
Such effects are important to consider, because they have implications for monetary policy. If
the Fed's holdings of assets have produced lower long-term interest rates, the FOMC has to
carefully take into consideration how it will manage the size of its balance sheet going
forward. In particular, a rapid and substantial reduction in our holdings of assets would likely
push up long-term interest rates that is, it would put upward pressure on those rates by
unwinding the portfolio balance effect. That increase in long rates would, in turn, weigh on
other asset prices, reversing the positive effects that had been associated with the expansion
of the Fed's balance sheet.
Under this view, the size of the Fed's asset holdings becomes a relevant policy lever.
Accordingly, this will be the first tightening cycle for which there are two broad policy
decisions in play, as the FOMC will have to set out not only the path of the short-term interest
rate, but also the path of its asset holdings. The decisions on these two variables will have to
be made in conjunction with one another to produce the desired outcome for economic
activity and inflation.
These considerations leave open a range of outcomes for how the two instruments will be
used. In his February 10 testimony, Chairman Bernanke described a possible approach for
managing the size of the balance sheet. In particular, he indicated that he does not currently
anticipate that the Fed will sell any of its asset holdings until the economic recovery is more
firmly established and policy tightening has gotten underway. Until that time, the portfolio
would shrink only through asset redemptions. Chairman Bernanke noted that the Fed's
holdings of agency debt and MBS are being allowed to roll off the balance sheet, without
reinvestment, as those securities mature or are prepaid, and that the FOMC may choose to
redeem some of its holdings of Treasury securities in the future, as well.
With this approach, the FOMC would be shrinking its balance sheet in a gradual and passive
manner. That, in my view, is a crucial message for the markets. It should limit any reversal of
the portfolio balance effects described earlier, effectively putting reductions in asset holdings
in the background for now as a policy instrument. As long as this approach is maintained, it
would leave the adjustment of short-term interest rates as the more active policy instrument -
the one that would carry the bulk of the work in tightening financial conditions when
appropriate.
This approach is cautious in several dimensions. First, a decision to shrink the balance sheet
more aggressively could be disruptive to market functioning. Second, a more aggressive
approach would risk an immediate and substantial rise in longer-term yields that, at this time,
would be counterproductive for achieving the FOMC's objectives. Third, the effects of swings
in the balance sheet on the economy are difficult to calibrate and subject to considerable
uncertainty, given our limited history with this policy tool. And fourth, policymakers do not
need to use this tool to tighten financial conditions. They can tighten financial conditions as
much as needed by raising short-term interest rates, offsetting any lingering portfolio balance
effects arising from the still-elevated portfolio.
Even under this cautious strategy of relying only on redemptions, the Federal Reserve could
achieve a considerable decline in the size of its balance sheet over time. From now to the
end of 2011, we project that more than $200 billion of the agency debt and MBS held by the
Federal Reserve will mature or be prepaid, though the actual total will depend on the path of
long-term interest rates and the prepayment behavior of mortgage holders. Thus, the Fed's
asset holdings would shrink meaningfully if the FOMC maintains its current strategy of not
reinvesting those proceeds. In addition, about $140 billion of Treasury securities mature
between now and the end of 2011, giving the FOMC scope to reduce its asset holdings even
further if it chooses to not replace some of those maturing securities.
While the passive strategy of relying on redemptions may be appropriate for now, it might not
be sufficient over the longer-term. One problem is that relying only on redemptions would still
leave some MBS holdings on our balance sheet for several decades. As indicated in the
minutes from the January meeting, the FOMC intends to return to a Treasuries-only portfolio
over time. This consideration could motivate the FOMC to sell its agency debt and
mortgagebacked securities at some point, once the economic recovery has progressed sufficiently.
Draining tools: control of short-term rates
Under the strategies just described, the Fed's asset holdings are likely to still be elevated at
the time that the FOMC wants to raise short-term interest rates. That creates a challenge for
controlling those rates, because of the large amounts of reserves that were created from the
Fed's purchases of those assets. It is therefore important for the Fed to determine the way in
which it will raise short-term interest rates in an environment with so much liquidity - a topic
that I will now cover.
The primary vehicle for making adjustments to short-term interest rates in that environment is
the ability to pay interest on reserves. We would expect changes in the interest rate on
reserves to have a significant influence on other short-term interest rates. However, in order
to ensure our ability to influence those other short-term interest rates, we have been
developing two tools that can be used to reduce the large amount of excess reserves in the
banking system - term deposits with banks and reverse repurchase agreements (reverse
repos) with a broader universe of financial institutions. Let me first provide an update on the
progress we have made in developing these tools.
On term deposits, the Federal Reserve has received public comments on the proposed
structure of the facility that was published in December, and we are working toward its final
form. As described in the recent Monetary Policy Report, the Federal Reserve expects to be
able to conduct test transactions in the spring and to have the facility fully ready, shortly
thereafter, to conduct transactions when needed.
On reverse repos, we have already successfully run small-scale operations using Treasury
and agency debt as collateral with primary dealers. However, that leaves two significant
steps still to take in preparing the tool. One is developing the capacity to use our MBS
holdings as collateral. Work in that area is nearly complete, and we will likely conduct some
small-scale operations with MBS collateral in a month or so to exercise that capability. The
other step is expanding the set of counterparties that we use for such operations. Earlier
today, we published criteria for money market mutual funds to become eligible to participate
in reverse repo operations, which was a first and important step in that direction. We are
currently working with other types of firms to assess their potential participation in the
program, as well. Our expectation is to have arrangements in place and to be ready to
transact with some non-dealer firms by the end of the second quarter. This expansion of
counterparties is important for boosting the capacity of the program.
The bottom line is that the preparation of both facilities is advancing very effectively. Looking
across the two programs, we will have established the capacity to drain a significant portion
of excess reserves by the second half of the year. Of course, achieving this capacity does
not say anything about how and when the FOMC will decide to actually drain reserves.
The actual timing and size of draining operations, and their relation to changes in the interest
rate paid on reserves, will depend on how market and economic conditions evolve. Chairman
Bernanke discussed one possible sequence in his February 10 testimony. He suggested that
operations to drain reserves could be run on a limited basis well ahead of policy tightening, in
order to give market participants time to become familiar with them, and then could be scaled
up to more significant volume as we approach the time for policy tightening.
Removing a portion of the excess reserves from the system ahead of increasing the rate paid
on reserves is a cautious approach, as it should improve the Fed's control of short-term
interest rates when it comes time to tighten monetary policy.4 To be sure, even at today's
reserve levels, we would expect the interest rate paid on excess reserves to exert
considerable pull on other short-term interest rates such as the federal funds rate or repo
rates. However, we are unsure of the exact relationship between these rates and believe that
it is likely to be tighter when the banking system is not as saturated with liquidity as it is
today. Thus, it may be prudent to remove some portion of excess reserves before raising the
interest rate on reserves.
Note that the policy tightening in this scenario will still likely be taking place in an
environment of large excess reserve balances, and the main workhorse of the tightening
cycle will still be the interest paid on reserves. However, the draining tools can be used to
best ensure the success of that framework.
Market conditions: at risk on exit?
Finally, let me turn to conditions in financial markets and discuss whether there may be
vulnerabilities related to the Fed's exit from the current monetary policy stance. I think there
are two potential areas of concern.
The first potential concern is that the exit strategy could simply cause confusion among
market participants, prompting volatility in asset prices. As noted earlier, this tightening cycle,
when it arrives, will be more complicated than past cycles, as there will be more decision
points facing policymakers. With more decision points come more opportunities for the
markets to be confused by our actions. The recent changes to the discount rate and the
Treasury's Supplementary Financing Program balances highlight this concern, as the
amount of attention that those actions received was outsized relative to their significance for
the economy or for the path of short-term interest rates.
The burden is on the Fed to mitigate this risk by communicating clearly about its policy
intentions and the purpose of any operational moves it might take. In this regard, the
forwardlooking policy language that the FOMC is currently using in its statement is important. I would
argue that this language contains much more direct and valuable information about the likely
path of the short-term interest rate target than does any decision about draining reserves.
Indeed, it will be difficult for market participants to make precise inferences about the timing
of increases in the target interest rate from the patterns of reserve draining alone, in part
because the FOMC has not specified the path of reserves it intends to achieve before raising
interest rates.
The second potential concern that some may have is whether the markets have adequately
priced in the exit strategy. However, a few considerations should limit this concern. Most
important, the current configuration of yields and asset prices incorporates expectations that
short-term interest rates will begin to rise around the end of this year. Thus, the markets
seem prepared for the risks toward tighter policy. Moreover, looking out to longer maturities,
the shape of the Treasury yield curve appears to incorporate not only expectations of policy
tightening, but a decent-sized term premium on longer-term securities. Indeed, the term
premium is well above the levels observed over most of the past several years, even though
inflation is likely to be low and upside inflation risks are limited. This should help to diminish
the chances of a sizable upward shift in yields.
A related issue is whether the current levels of risky asset prices will prove robust in a rising
rate environment. This may be a particular concern among those who argue that the current
low policy rate environment has fueled an unsustainable rise in asset prices beyond their
fundamental values. However, this is not clearly the case on a broad basis. Obviously, risky
asset prices have undergone a historic rise from their trough in early 2009. But this rise
began from an extreme starting point, one in which asset prices were being depressed by the
baseline forecast of a deep recession, by the prospect of further downside risks to the
economy, and by very elevated risk premiums.
As the economy stabilized, asset prices benefitted from both the improving economic outlook
and a significant renormalization of risk premiums - a pattern that was a desired outcome
from the stance of monetary policy. Moreover, we do not see definitive signs that risk
premiums have broadly become too low at this point. To be sure, a number of significant
risks remain in the economic outlook, and those translate into financial market risks.
Eventually, though, we expect to reach a period of sustained, above-trend growth to absorb
the substantial slack in place, which is an environment that should be quite supportive of
risky asset prices. Policy tightening will presumably occur as that happens, limiting the
downside risk to markets associated with policy actions.
Conclusion
In conclusion, the exit from the various liquidity facilities that the Federal Reserve
implemented has been very successful, as the up-front design of those facilities reduced the
need to actively manage the end of those programs. However, the exit from the current
stance of monetary policy is quite different, in that it will have to be actively managed to
ensure a smooth exit.
I began the speech by noting that we face an extraordinary challenge with this exit, given the
historic steps that have been taken with the Fed's balance sheet. This challenge, which
involves operating in uncharted territory along several dimensions, will inherently involve
some uncertainties and risks. However, as I hope is clear from my remarks, the Federal
Reserve's efforts to date should minimize those risks. Indeed, I believe the Fed's efforts have
been prudent along a number of dimensions.
As a first step, we have been careful to make sure we have an adequate set of tools. To that
end, we have developed multiple tools that can be used for draining reserves, in order to
ensure our capability to do so. Moreover, we have been testing those tools and will continue
to take steps to ensure that we and the markets are prepared to use them in more significant
volumes when needed. Developing the tools is not enough, though. As a second step,
policymakers will need to formulate a strategy for using them in an appropriate manner to
avoid any undesired outcomes for financial markets and the economy.
The FOMC is actively engaged in determining that strategy, as indicated in the FOMC
minutes from the January meeting. The strategy to be employed has not been fully decided,
but recent speeches by FOMC members and the recent FOMC minutes have begun to
convey some of the possibilities. Many of the potential steps described seem to guard
against the risks involved. For example, reducing the size of the Fed's balance sheet through
redemptions for now will produce a gradual adjustment that will be easier for the markets to
digest. In addition, steps taken to drain reserves ahead of policy tightening may best ensure
the success of interest on reserves at influencing other short-term interest rates.
Overall, an approach along these lines should help to ensure a smooth exit from the current
accommodative stance of monetary policy. Moreover, if the Fed's intentions are well
communicated to the financial market participants, they too should be fully prepared and in
the best possible shape for navigating this exit.