Opinion
The Fed’s Mortgage Favoritism
When the central bank buys private assets, it distorts markets and undermines its claim to Independence.
By Jeffrey M. Lacker And John A. Weinberg
Oct. 7, 2014 6:42 p.m. ET
Modern central banks enjoy extraordinary independence, typically operating free from political interference. That has proved critical for price stability in recent decades, but it puts central banks in a perpetually precarious position. Central-bank legitimacy will wane without boundaries on tools used for credit-market intervention.
Since 2009 the Fed has acquired $1.7 trillion in mortgage-backed securities underwritten by Fannie Mae and Freddie Mac , the mortgage companies now under government conservatorship. Housing finance was at the heart of the financial crisis, and these purchases began in early 2009 out of concern for the stability of the housing-finance system. Mortgage markets have since stabilized, but the purchases have resumed, with more than $800 billion accumulated since September 2012.
We were skeptical of the need for the purchase of mortgage assets, even in 2009, believing that the Fed could achieve its goals through the purchase of Treasury securities alone. Now, as the Fed looks to raise the federal-funds rate and other short-term interest rates to more normal levels, that normalization should include a plan to sell these assets at a predictable pace, so that we can minimize our distortion of credit markets. The Federal Open Market Committee’s recent statement of normalization principles did not include such a plan. For this reason, the first author, an FOMC participant, was unwilling to support the principles.
The Fed’s MBS holdings go well beyond what is required to conduct monetary policy, even with interest rates near zero. The Federal Reserve has two main policy mandates: price stability and maximum employment. In the past, the pursuit of higher employment has sometimes led the Fed (and other central banks) to sacrifice monetary stability for the short-term employment gains that easier policy can provide. This sacrifice can bring unfortunate consequences such as the double-digit inflation seen in the 1960s and 1970s.
But during the Great Moderation—the period of relatively favorable economic conditions in the 1980s and 1990s—a consensus emerged that, over time, the central bank’s effect on employment and other real economic variables is limited. Instead, the central bank’s unique capability is to anchor the longer-term behavior of the price level. Governments came to see that entrusting monetary policy to an institution with substantial day-to-day independence could help overcome the inflationary bias that short-term electoral pressures can impart.
The independence of the central bank cannot be boundless, however. In a democracy, the central bank must be accountable for performance against its legislated macroeconomic goals.
What is essential for operational independence is the central bank’s ability to manage the quantity of money it supplies—that is, the monetary liabilities on its balance sheet—because this is how modern central banks influence short-term interest rates.
A balance sheet has two sides, though, and it is the asset side that can be problematic. When the Fed buys Treasury securities, any interest-rate effects will flow evenly to all private borrowers, since all credit markets are ultimately linked to the risk-free yields on Treasurys. But when the central bank buys private assets, it can tilt the playing field toward some borrowers at the expense of others, affecting the allocation of credit.
If the Fed’s MBS holdings are of any direct consequence, they favor home-mortgage borrowers by putting downward pressure on mortgage rates. This increases the interest rates faced by other borrowers, compared with holding an equivalent amount of Treasurys. It is as if the Fed has provided off-budget funding for home-mortgage borrowers, financed by selling U.S. Treasury debt to the public.
Such interference in the allocation of credit is an inappropriate use of the central bank’s asset portfolio. It is not necessary for conducting monetary policy, and it involves distributional choices that should be made through the democratic process and carried out by fiscal authorities, not at the discretion of an independent central bank.
Some will say that central bank credit-market interventions reflect an age-old role as “lender of last resort.” But this expression historically referred to policies aimed at increasing the supply of paper notes when the demand for notes surged during episodes of financial turmoil. Today, fluctuations in the demand for central bank money can easily be accommodated through open-market purchases of Treasury securities. Expansive lending powers raise credit-allocation concerns similar to those raised by the purchase of private assets.
Moreover, Federal Reserve actions in the recent crisis bore little resemblance to the historical concept of a lender of last resort. While these actions were intended to preserve the stability of the financial system, they may have actually promoted greater fragility. Ambiguous boundaries around Fed credit-market intervention create expectations of intervention in future crises, dampening incentives for the private sector to monitor risk-taking and seek out stable funding arrangements.
Central bank operational independence is a unique institutional privilege. While such independence is vitally important to preserving monetary stability, it is likely to prove unstable—both politically and economically—without clear boundaries. Central bank actions that alter the allocation of credit blur those boundaries and endanger the stability the Fed was designed to ensure.
Mr. Lacker is the president of the Federal Reserve bank of Richmond, where Mr. Weinberg is the director of research.
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