The Fed's Quasi-Fiscal Policies
The policies that the Fed embarked on in late 2007 are a sharp departure from the old way of performing monetary policy. In fact, it is difficult to state that the Fed is any longer in the business of traditional monetary policy — understood in the United States as aiming for low inflation and smoothed output volatility. A new breed of monetary policies better referred to as "quasi-fiscal" policies has become the norm.
The Fed's policies have a fiscal flair to them for two reasons.
First, no longer are output and inflation the primary concerns. The Fed has framed any reference to inflation over the past four years in the context of either:
- the low levels of price inflation erasing inflationary fears from pursuing unorthodox monetary policies, or
- the threat of deflation, thus creating the "need" for monetary expansion to ward off its ill effects.
Inflation has not been a direct concern in the sense that the Fed's role is to control it. Instead, it has been viewed as a constraint on Fed policies to pursue other ends.
Concerns about maintaining output have likewise taken a backseat. Monetary economists (Fed officials included) conventionally viewed monetary policy as a tool to minimize the output gap. During recessionary periods, just the right dose of monetary expansion should tempt employers to increase production and hire workers. The attention now, however, is on keeping banks capitalized through monetary expansion. By not allowing the bad debts on banks' balance sheets to bring them to insolvency, the Fed is hoping to stave off a contagious banking crisis. The Fed is seemingly less directly concerned with maintaining output, and more with keeping banks afloat (which, admittedly, officials think will translate into employment).
The second reason that the Fed has been taking on decidedly fiscal activities is that its policies are directly affecting its own finances. Traditional monetary policy left the Fed's balance sheet intact. Until this recession, the textbook explanation of how the Fed alters the money supply held true: it bought or sold Treasury bills, and the money supply correspondingly increased or decreased. By purchasing assets of lesser quality over the recession, the Fed has endangered its own balance sheet in the name of strengthening those of the preferred members of the banking system.
Philipp Bagus and I were among a small chorus of economists who noticed the fiscal aspect to these new monetary policies when they started. Several years ago we pointed to the dangers that such policies could breed. In particular, we focused on the compromised role of money as a store of value as the quality of the money-supply-backing assets (the Fed's assets) diminished. We viewed inflation, in other words, as a looming threat beyond the level normally targeted by the Fed. We gave two reasons.
First, as the Fed bought low-quality assets to strengthen the banking system's balance sheet, it has increased the base money supply by almost 2 trillion dollars (or 250 percent). The Fed was not immediately concerned, as inflationary pressures seemed subdued. Besides, in the future the position could be unwound — the Fed could just sell the assets it purchased (mortgage-backed securities and GSE debt) back to the banking sector, draining the cash from banks' reserves in the process. In theory, inflation would be a nonissue.
The problem that few considered was simple: what would happen if the Fed's new assets lost value before they were sold back to the banking system? A qualitative mismatch was made. The Fed bought assets of uncertain value and paid for them with assets fixed at par value by definition (reserves). Any loss of value in the Fed's new assets would translate into new money that the Fed could not purchase back from the banking system. In other words, inflationary pressures will appear if the Fed realizes a loss on its assets (which it has not had to do, as they remain largely unsold). Alternatively, to bring expectations into the picture, inflationary pressures can build today on the expectation that in the future the Fed will have to realize a loss on its assets.
The second inflationary threat comes in the form of an unusual question. What happens if the Fed goes bankrupt? While an institution granted monopoly rights over the issue of money is a strange candidate for insolvency, there is precedent, though mainly in cases with a currency mismatch between the central bank's assets and liabilities. Luckily for Ben Bernanke and the gang, no such mismatch plagues the Fed. Nor does the Fed have many inflation-indexed liabilities, another holding that could endanger its solvency. Just to be safe, the Fed changed its accounting rules about a year ago to ensure that the bookkeepers would not have to worry about troublesome insolvencies.
Still, is the Fed safe from declaring itself insolvent? Not as long as it holds weak assets on its books.
The Fed currently has about $800 billion worth of mortgage-backed securities included in its assets. Add to that $100 billion of federal-agency debt securities, not all of which are guaranteed by the federal government. Include roughly $35 billion worth of AIG assets still on the books, and the Fed has a sizable holding of inarguably low-quality assets. (With the downgrade of the federal government last year, some might say that the Treasuries are not much better.) If the value of these questionable assets decreases, there is no automatic adjustment for its liabilities to follow suit. Cash sells at par, everywhere and always. The Fed’s liabilities will hold their par value, while its assets have a great chance of declining.
The one adjustment that the Fed can make is a reduction in its capital. With a capital-ratio of 2.4 percent, a minor loss on its assets would make the Fed balance sheet insolvent. Note that this happens regardless of the way that you record the loss, and hence the changes to the Fed's accounting rules only superficially affect its solvency.
The Treasury is the only institution that can save the Fed when it needs to be recapitalized. We would be remiss to think that a Congress paying into the Fed instead of skimming earnings off it would remain a hands-off spectator in American monetary affairs. There is a clear incentive for Congress to start asking for favors from the Fed, which generally means — if other countries where such demands are placed on the central bank by the government are any guide — higher levels of money printing and inflation.
Luckily we are no longer the only ones discussing this problem. A new working paper by the IMF analyzes this same problem and concludes that
- yes, quasi-fiscal policies can be highly inflationary as central banks cannot unwind their positions, but
- the fiscal authority (i.e., the Treasury) can come to their aid to help them do so.
What the authors fail to address is what happens when the central bank becomes explicitly accountable to the Treasury and dependent on its funding to operate. If the Fed continues its policies of purchasing low-quality assets from the banking system to stabilize it, we might just find out. I for one would rather leave that question to the theory outlined above — and not put it into practice.