In 2003, then Federal Reserve Governor Ben Bernanke urged the Japanese government to protect the Bank of Japan from capital losses on its massive holdings of domestic government bonds. In a speech to the Japan Society of Monetary Economics in Tokyo, he argued that "heated and unproductive debate" over the impact of capital losses on the BoJ's balance sheet would interfere with the rational conduct of monetary policy. Japan's central bank, he said, was insufficiently aggressive in its response to deflation because it had one eye wrongly trained on an accounting issue.
Fast forward 10 years, and the Fed is in a comparable position. The minutes of the January Federal Open Market Committee meeting revealed concern that the "risks of asset purchases" might cause the Fed to "taper or end its purchases" before "improvement in the outlook for the labor market had occurred." In other words, the concern of some members of the FOMC over potential losses on the Fed's massive holdings of mortgage-backed securities was affecting the central bank's thinking about monetary policy. That's what Mr. Bernanke had warned Japan not to let happen.
Mr. Bernanke had urged the BoJ and the Japanese Ministry of Finance to enter into an interest-rate swap that would move the risk of capital losses off the central bank's balance sheet. We believe the Fed needs a similar swap with the U.S. Treasury today.
The Fed currently holds $1.1 trillion in mortgage-backed securities. Given Wednesday's FOMC announcement that it would continue purchasing these securities at a pace of $40 billion a month, the bank is on track to increase its MBS holdings to $1.5 trillion by the end of the year—around 27% of the market.
The FOMC has already expressed a desire to reduce such holdings as a means of normalizing the size and composition of its balance sheet (typically comprised overwhelmingly of short-term Treasury securities) when the time comes to bring to an end its policy of maintaining near-zero short-term interest rates. The problem: Selling MBS into the shallow market for these securities could drive down their prices, drive up mortgage rates, and depress house and real estate prices. Such a development might not only derail the economic recovery but trigger intervention from policy makers reacting to angry constituents. Rising interest rates also threaten large capital losses on the Fed's portfolio of these securities.
Chairman Bernanke is well aware of these risks. He has emphasized that the Fed has other tools for tightening monetary policy besides asset sales. These include term deposit auctions (term deposits are like certificates of deposit, or CDs) to entice banks to lock up their funds with the Fed for a fixed period. Yet the Fed is unlikely to be willing to allow rates to rise as far and as fast as the market may demand in a term deposit auction.
The European Central Bank—which has carried out many such auctions since 2010—places caps on the rates it pays. As a result, seven of its auctions have failed, meaning that the ECB failed to withdraw euros from the market despite its public pledges to do so. The Fed will lose credibility at a crucial time if it says that it will drain liquidity from the financial system but fails.
Therefore, a conventional approach to monetary tightening—selling securities from the Fed's bloated balance sheet—is the sounder choice, at least provided that it is not forced to sell illiquid, sector-specific securities like MBS. To accomplish this, the Fed should sell its MBS portfolio to Treasury at face value in exchange for an equivalent amount of Treasury securities issued for the purpose of facilitating the swap. There is precedent for this: The Housing and Economic Recovery Act of 2008 gave Treasury the authority to purchase MBS guaranteed by Fannie Mae FNMA +1.83% and Freddie Mac FMCC +1.46% . Our plan is logically identical to the one that Mr. Bernanke urged on Japan 10 years ago.
Concern may still be raised that Treasury would be aiding the Fed in escaping responsibility for managing the necessary aftermath of its extraordinary market interventions. If financial risks can be dumped onto another government body, they may be insufficiently accounted for when the Fed acts. The Housing and Economic Recovery Act offers a template for future crisis interventions that addresses this concern—a template in which only Treasury, and not the Fed, intervenes in markets for securities other than those that Treasury itself issues.
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