By Randall Kroszner
Published: August 11 2009 22:20
(Click to enlarge)
Leaving a financial crisis is like leaving an awkward social gathering: a good exit is essential. In 1936-37, the Federal Reserve made a colossal mistake in its “exit strategy”. This time round it is crucial that central banks get their timing right.
Seventy-three years ago, fearing the large accumulation of reserves held by the banks at the Fed could result in an “uncontrollable expansion of credit in the future” if the banks decided to lend out those reserves, the Fed raised reserve requirements to absorb them. This sharp tightening of monetary policy stopped the robust recovery that had been in train since 1933, precipitating a “double-dip” contraction in 1937-38, which according to Milton Friedman and Anna Schwartz in their 1963 book A Monetary History of the United States, 1867–1960 “was one of the sharpest on record”.
Today, there is much concern about the inflation potential of the roughly $700bn (€494bn, £425bn) accumulation of excess reserves on the Fed’s balance sheet as well as excess reserves on many other central banks’ balance sheets. Central banks must not repeat the premature “exit” mistake of 1936-37.
The big challenge is for central banks to avoid deflation and provide the monetary accommodation to restore economic growth without igniting high inflation down the line. In the US, market-based measures of inflation compensation do not suggest market participants expect inflation to move to high levels in the next decade (see chart 2). However, late last year and early this year, markets worried that deflation could grip the US economy. The proliferation of new credit facilities, expanded swaps with other central banks, and reduction of the Federal funds rate target to nearly zero for an “extended period” helped mitigate the deflation fear. The Fed’s balance sheet grew more than two-and-a-half fold during 2008 to end the year above $2,300bn as many market participants borrowed through these facilities and central banks drew on their swap lines with the Fed (chart 3).
As credit markets subsequently began to thaw, risk spreads that had exploded to unprecedented levels across a wide variety of asset classes and maturities began to come down, leading to a dramatic decline in the demand for borrowing from short-term lending facilities and for swaps. These facilities were structured so that there would be a natural “exit strategy” by which market participants would turn to the central bank only when the spreads were at extraordinary levels. Thus, these facilities would wind down as markets normalised without any need for specific action by the Fed, and indeed they have, falling by more than $1,000bn from their peak at the end of 2008. Partially offsetting this natural run-off are the Fed purchase programmes for longer-term securities (Treasuries, agencies, and mortgage-backed securities) so, on net, the Fed’s balance sheet now stands at just over $2,000bn.
The mitigation of the deflation fear and the reduction in risk spreads has had an important consequence for the effect of traditional monetary policy. Since inflation expectations have turned from negative to positive, the “real” Federal funds rate is now lower. That is, adjusting for expected inflation, borrowing costs are now lower. In addition, the reduction in the risk spreads also means the effective cost for many types of borrowers has been reduced. For these reasons, even though the target Federal funds rate has not changed since the end of last year, traditional monetary policy has become more accommodative, exactly as the non-traditional actions, consisting of the short-term facilities and swaps, continue to shrink.
As economies stabilise and recover, central banks will face the same challenge the Fed faced in the mid-1930s: when and how to reduce monetary accommodation and prevent the large accumulation of bank reserves on its balance sheet from being lent out, causing an inflationary expansion of money and credit. A fundamental misjudgment by the Fed was to assume that, as the economy revived, banks would manage liquidity exactly as they had prior to the banking crises earlier in the decade and hold only the legally required minimum. When the Fed sharply increased reserve requirements in 1936 and 1937 (see chart 1), banks responded by calling in loans to build a liquidity cushion above legal requirements, thereby sharply contracting money, credit and economic activity.
Just last autumn, Congress gave the Fed a new tool that will play a crucial role as it exits from its unusually accommodative monetary policy: the ability to pay interest on reserves. Previously, a recovery would mean more opportunities for banks to lend and so they would draw down non-interest-bearing reserves and expand credit and hence the money supply. Interest on reserves, however, can cut that logic short by providing incentives for banks to hold reserve balances rather than lend them out, as the Federal funds rate target rises. The Fed now has a greater control over the reserve choices of banks because it can raise the return on reserves relative to banks’ lending opportunities, and thereby better manage credit and money growth in a recovery. In addition, of course, the central bank can drain reserves directly from the system through reverse purchase agreements and the sale of long-term securities from its portfolio, among other means. The ability to pay interest on reserves also allows the Fed to offer term deposits to the banks, thereby committing the depositing bank to keep its reserves with the Fed for a specified period of time.
Complicating central banks’ exit strategy, both in the 1930s and today, is fiscal policy. (Monetary policy was not alone to blame.) Ahead of the 1936 US election, a temporary, targeted “bonus” totalling more than 1.5 per cent of gross domestic product was paid out to first world war veterans, providing a fiscal stimulus to an already rapidly recovering economy. The Fed’s concern about the potential for monetary policy to add to this stimulus was not unjustified, for the economy grew extremely rapidly in 1936 (see chart 1), although the Fed’s response was far too strong.
Turning back to today, countries have committed to massive increases in fiscal expenditure (see chart 4), much of which is not going to be spent until 2010 or 2011. As economies begin to stabilise and grow, central banks will face a dilemma – is growth part of a sustainable recovery or due to a short-term impact of fiscal stimulus? If the former, then it is sensible to implement exit strategies from unusual accommodation; if not, then it might be appropriate to wait to see whether growth has taken root, which entails greater risks of inflation. Separating the impact of fiscal stimulus from sustainable economic growth to determine the time to begin to “exit” will be a key challenge for central banks during the next few years.
The writer is Norman R. Bobins professor of economics at the University of Chicago’s Booth School of Business and a former governor of the US Federal Reserve
Copyright The Financial Times Limited 2009
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