Benn Steil on Federal Reserve Exit Strategy
Council on Foreign Relations
MICHELLE CARUSO-CABRERA: Hi, everyone. Thanks so much for joining us on this call about this op-ed piece written for The Wall Street Journal by Benn Steil and Dinah Walker, "Bernanke Should Follow the Advice He Gave to Japan." Joining us is the director of international economics at he Council on Foreign Relations, Benn Steil, the author of that op-ed. He also wrote the book "The Battle of Bretton Woods," and there's a longer version of the op-ed at -- (inaudible) -- at the bottom of the email that you received, "Exiting from Monetary Stimulus: A Better Plan for the Fed." This is part of the Policy Innovation Memorandum series that is put out by CFR.
So Benn, let me start with something basic. You write the op-ed and policy memorandum because there's a particular problem the Federal Reserve has right now. Please describe. What is it?
BENN STEIL: Yeah. That's right. The piece Dinah and I wrote for the journal last week was specifically motivated by the debate which has heated up, not least within the Federal Open Market Committee, about the future problems which the Fed may be creating for itself through its extraordinary monetary stimulus efforts, in particular the accumulation by the end of this year of about $1.5 trillion in mortgage-backed securities.
We emphasize in the piece that it's the composition of the Fed's balance sheet that's the problem. It's not the size. The Fed's balance sheet will be very large by the end of the year, about $4 trillion. But if it were comprised of U.S. Treasury securities -- normally the Fed's balance sheet is comprised overwhelmingly of Treasury securities -- when it comes time to tighten monetary policy in the future, it would just sell those securities at a measured pace into the market. The problem specifically derives from the $1 1/2 trillion in mortgage-backed securities. The -- selling MBS when you want to tighten monetary policy is problematic. And I'm going to emphasize two factors in particular.
First, by the end of the year, the Fed's going to control almost 30 percent of the MBS market. They're really going to dominate this market. And selling MBS, particularly into a market as thin as this one will be, will have a much more direct impact on mortgage rates and housing prices than selling Treasuries. In other words, selling MBS when you want to tighten monetary policy can be expected to push up mortgage rates and push down housing prices, precisely the opposite of what the Fed has sought to achieve over the past few years.
Second, the FOMC is specifically concerned with the capital losses that the Fed would bear in selling mortgage-backed securities in an environment of rising interest rates. They're concerned about this not merely from an economic perspective but from a political perspective because it might mean a steep decline in remittances to the U.S. Treasury, and that could of course stoke political conflict about what the Fed is doing and whether new restrictions have to be put on their activities.
Now, with regard to this second issue concerned within the FOMC about capital losses on its own balance sheet, we've been through this before. Ten years ago Chairman Bernanke, then-Governor Bernanke, was forthright that Japan was mishandling its own very similar situation when the BOJ, the Bank of Japan, was worrying about its own exposure to interest rate risk through its massive holdings of JGBs, Japanese government bonds.
He argued at the time at the BOJ was doing precisely the right thing to combat deflation and should not get sidetracked by essentially an accounting issue, that is, which balance sheet within the Japanese government was holding these JGBs. And so he proposed that the BOJ should simply enter into an interest rate swap with the Japanese treasury, which would take this risk off the balance sheet of the Bank of Japan.
And we argue that the Fed needs to conduct a similar swap with the U.S. Treasury today, that is, the Fed would swap its portfolio of $1.5 trillion of mortgage-backed securities with the U.S. Treasury in return for an (actuarially ?) equivalent amount of U.S. Treasuries.
Now, what if they don't do this? Because Chairman Bernanke has already argued that the Fed has alternatives to selling its MBS. It doesn't need to sell the MBS in order to tighten monetary policy.
But we think that the proposals that he've made -- he's made had some flaws to them. The one we emphasize is the use of so-called term deposit auctions. These are like certificates certificates of deposit, or CDs. These would be used to entice banks to lock up their funds with the Fed for a fixed period.
The problem with term deposit auctions is that the Fed has to allow the market to determine short-term interest rates. In other words, the banks will tell the Fed what it wants in terms of an interest rate return in order to lock up its money and not make it available for lending out. And the Fed is highly unlikely to be willing to lose control over short-term interest rates. How do we know that? Well, the ECB uses term deposit auctions. They've used quite a few over the past several years. And we've documented that seven of those auctions have failed. That is, the banks have demanded a higher interest rate than the ECB was willing to pay. Now, this hasn't caused any great problems in the market because the ECB hasn't been in a tightening mode, but if the Fed were in a tightening mode and the auctions failed, this might damage its credibility significantly.
The final thing I would say is that there is indeed legal precedent for what we are suggesting. The Housing and Economic Recovery Act of 2008 explicitly gave the Treasury authority to purchase mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac. So what we're proposing would not in any sense be legally revolutionary.
CARUSO-CABRERA: You talked about this a little bit, but I'm just going to ask, very basically, how exactly would the swap work logistically?
STEIL: Yeah, it's actually not very complicated. The Treasury would issue new Treasury securities that are equivalent in value to the mortgage-backed securities held by the Fed. There is a determination to be made about what the maturity of those securities would be. For example, if they were overwhelmingly short-term securities, say, like, three-month Treasury bills, then that portfolio would actually run off very quickly, and the Fed would effectively be tightening monetary policy very quickly. If the swap comprised mainly longer-term securities, let's say, like 30-year Treasury bonds, then the Fed would sell those bonds into the market at a measured pace over time in order to tighten monetary policy. We suspect that the Fed and the Treasury would naturally agree that the Treasury would create a stock of Treasury securities for them that's somewhere in the middle there.
CARUSO-CABRERA: Doesn't this expose the taxpayer to risk if when Treasury sells, then end up selling at a loss?
STEIL: Well, and one of the reasons that we support this proposal is because we don't expect Treasury to sell the securities. It's much more likely that the Fed would wind up selling the securities, and that's where the problems would -- (inaudible) --
CARUSO-CABRERA: So the Treasury would hold them to maturity -- (inaudible) --
STEIL: Treasury would hold them to maturity. That's right.
CARUSO-CABRERA: Have you gotten any response -- do you know if this is moving through the halls of the Federal Reserve or Treasury and what they think about it?
STEIL: Yeah, I mean, we have gotten some responses, including some former FOMC members. I think the -- the response has been generally very favorable. There have been some objections raised. For example, aren't we essentially proposing to increase U.S. debt? And the answer to that is no, that the U.S. net debt is completely unaffected by this swap. That is, new Treasury securities are indeed being created, but in return for them, the U.S. Treasury would be receiving financial assets of equivalent value, so the U.S. net debt is not affected by this.
CARUSO-CABRERA: You hinted at this a little bit when Bernanke was critical of Japan, but give us a little bit more of the tonality. He was scathing, wasn't he, about what Japan was doing wrong at the time?
STEIL: That's right. And Bernanke believed that Japan needed to be more aggressive in countering deflation, and he was very concerned with what he was reading about the debate within the policy board of the Bank of Japan about the potential impact of capital losses on BOJ's holdings of JGBs on the balance sheet of the BOJ and therefore its political relationship with the government. He argued, essentially, this is polluting the thinking behind the conduct of monetary policy at the Bank of Japan.
And indeed, we're seeing exactly the same thing today. And a -- with -- in the January minutes of the FOMC meeting, you actually see members expressing concern about the risks involved in asset purchases, things like what would happen if our remittances to the U.S. Treasury were to decline significantly. And this is precisely the sort of warning sign that triggered Bernanke to intervene, as it were, in the Japanese debate 10 years ago.
CARUSO-CABRERA: So -- and -- so could it have negative effects both -- when I think about the thinking in the Federal Reserve and the members of the board, when they say -- if they're nervous, one is being nervous about the exit strategy and what that would do to the mortgage market, but could it also make them nervous in not doing enough because they're so worried about the exit strategy they don't want to go even higher than 85 billion (dollars) a month? (Inaudible.)
STEIL: Yeah, I mean, that concern has already been expressed. In fact, you see it in the January minutes. You have members expressing concern that the risks of asset purchases might cause the Fed to, quote, "taper or end its purchases before improvement in the outlook for the labor market had occurred," unquote. So what we see here is what is in essence an accounting issue coloring debate within the Fed about how to conduct monetary policy, both in the loosening phase and in the tightening phase to come in the future. That's what we find worrying, and that's what we think needs to be addressed now.
CARUSO-CABRERA: Let's turn this over now to the participants on the call to ask questions. We'll get some instructions on how you can do that.
OPERATOR: (Gives queuing instructions.) We have a question from Cy Jacobs with Jacobs Asset Management.
QUESTIONER: Hi, Benn. It's Cy Jacobs. How are you?
STEIL: Hi, Cy. Very well. How are you?
QUESTIONER: I'm doing well. I have a series of questions, so let me just get them out in one question, then have you respond. You mentioned several times the better alternative of doing the Treasury sales, and I feel like with great -- you make it sounds with great ease that the Treasury can sell at a, quote-unquote, measured pace.
STEIL: The Fed -- the Fed can sell at a measured pace.
QUESTIONER: Oh, at a -- at a measured pace -- but you know, the Fed has been the largest buyer, and when the largest buyer becomes a big seller, what makes you think that selling Treasurys can be done at a measured pace, whereas MBSs can't be sold at a measured pace? That's the first part. Secondly, you know, the advantage of holding the MBS and unwinding, I would think, is that they amortize on their own; you know, people move and pay down their mortgages or pay off their mortgages, and the balance will shrink over time faster than Treasurys will shrink -- (audio interference) -- the Fed having to (hit bid ?). So isn't that a more attractive holding? The last part of it is -- and related is selling Treasurys -- again, the largest buyer becoming a large seller -- you will pressure -- I would think, will pressure MBS anyway. They trade at a spread versus Treasurys. There's a huge seller of Treasurys. You know, MBS prices will come under pressure, and interest rates will rise, and housing market will get hurt anyway. So why not just sell what you have instead of swapping into one and selling that?
STEIL: OK. Well, there are a lot of good questions there. The first one, selling Treasurys -- whether you do it at a measured pace or a more robust pace, the underlying point we're making is that the U.S. Treasury market is the deepest and most liquid in the -- in the world. So this is the market in which you would want to be conducting asset sales.
If they do it in a sector-specific market like the MBS market, they are going to be hitting one specific sector of the economy, and they're going to be hitting it specifically hard -- particularly hard because the Fed represents such a significant portion of that market.
The second question you had was about whether the Treasury could just sit tight on its MBS. And indeed, it could conduct its initial tightening entirely through the sale of Treasury securities. The problem is -- and the Fed has already acknowledged this -- at some point they're going to be concerned about their balance sheet being overwhelmingly dominated by mortgage-backed securities, which is why Bernanke has proposed that the tightening could occur through means other than securities sales. I already talked about term deposit options. In the policy innovation memorandum that Michelle had mentioned at the outset, we talk about reverse repos, which really are conceptually identical. So the point I'd emphasize there is that there are more problems involved in those unconventional methods of tightening, such as the possibility of failed options.
Your third point, selling Treasuries will of course impact the MBS market. Any form of monetary tightening is going to affect the MBS market and, indeed, all asset markets. That's inevitable. But it will not have a disparate impact on the MBS market, the sort of impact you would have when you're selling specifically mortgage securities into, again, a very thin market.
QUESTIONER: OK. Great. Well, thanks for that, Benn.
OPERATOR: Thank you, ladies and gentlemen. (Gives queuing instructions.)
Question from Mark Scradley (ph) with Nesow Capital (ph).
QUESTIONER: Hi, Benn. What impact would a rating change have, whether it's an upgrade or downgrade, once the swap took place?
STEIL: A rating change in terms of --
QUESTIONER: U.S. sovereign debt.
STEIL: -- U.S. sovereign debt?
STEIL: Well, as you know, the last time we got a major ratings change, it was a complete nonevent in the market. In fact, Treasuries rallied. So my view is that a ratings event as such would probably not be significant. What would be significant is if we were in an environment of rising interest rates generally. That could have a very significant impact on the Fed's balance sheet and remittances to the Treasury. And in fact, the FOMC has already expressed concern about that.
QUESTIONER: Thank you.
OPERATOR: Thank you. (Gives queuing instructions.)
We have a question from Jay Collins with Citigroup.
QUESTIONER: Hi. Just two questions related to what you just said. In terms of the threshold at which people would become concerned of the proportionality of MBS to Treasuries, do you have some sense of where that is? And in terms of the amount of absolute selling in the -- in the Treasury market, at what point -- I mean, just give us an order of magnitude of how much could be sold you would feel that you needed to use the MBS.
STEIL: OK. I think perhaps the best way to look at it is to think about what a normal Federal Reserve balance sheet looks like. Before the crisis, the Fed's balance sheet was about $800 billion. By the end of the year it's going to be $4 trillion. Now, even if the Fed worked to sell off all its Treasury stock, which is obviously not something it would ever want to do, it would have a balance sheet of $1.5 trillion, again comprised of an asset that the Fed would be very uncomfortable having, that is, mortgage-backed securities. That -- the mortgage-backed portfolio alone would be twice the normal size of the Fed's balance sheet. And that's why we argue that one way or the other, the Fed's going to have to deal with this stock of mortgage-backed securities as part of the process of monetary tightening and normalizing both the composition and size of its balance sheet. Does that -- does that address your question?
QUESTIONER: Yes, very much.
OPERATOR: (Gives queuing instructions.) We have a question from Steven Toddler (sp) from CFR.
QUESTIONER: I'm sorry. Hello, Benn.
QUESTIONER: What if the new normal is not 800 billion (dollars) but 8 trillion (dollars) or 10 trillion (dollars) or 14 trillion (dollars)? What if all the rules of the game change and the Fed basically says, we're going to run a $10 trillion balance sheet?
STEIL: Well, the Fed could say that.
QUESTIONER: Why won't they say that?
STEIL: Well, they have suggested that the Fed balance sheet will be a lot larger than the old normal for some time to come. And that's why Bernanke has sought to emphasize to the market that he has other means of conducting monetary tightening besides asset sales.
So to go back to the point I made before, we agree with him in principle that there are other methods that could work. But they would require a radical shift in the way the Fed conducts monetary policy. Again, with term deposit auctions, the short-term interest rate which the Fed has sought to control, the fed funds target rate, since 1994 -- that short-term rate would now be determined entirely in the marketplace. Now, we think that the Fed will have particular difficulty explaining this to the market and justifying it to Congress that the Fed no longer controls short-term interest rates because these are being set entirely by an auction process involving the major U.S. banks, who, as you know, are not in great favor in Washington at the moment.
So -- and if we're right, the Fed will almost certainly do what the ECB has done and put caps on the rates that it will pay in those auctions. And we are very concerned that if those auctions start failing that the Fed would really lose significant credibility in the market, and that could lead to a spike in interest rates on its own. So that's why we say that a conventional approach to Fed tightening, that is, selling securities from an oversized balance sheet, is the right one, and in order to allow the Fed to do that, we need to normalize the composition of the Fed's balance sheet, that is, make it overwhelmingly U.S. Treasury securities.
QUESTIONER: Thank you.
OPERATOR: Thank you. (Gives queuing instructions.) And Ms. Cabrera, did you have any questions for Mr. Steil?
CARUSO-CABRERA: Well, I was going to say that there are a number of formal (sic) Federal Reserve governors, leaders, et cetera, involved with the Council on Foreign Relations, Bill McDonough, Alan Blinder also, an economist who's involved. If you are at liberty to say, have you shown -- have they responded to this, seen it in the journal or had any commentary about it?
STEIL: Yeah, well, I'm not going to name specific names and associate them with specific comments because that wouldn't be fair to them. They'll -- they have to decide what issues they want to comment on publicly themselves. But yes, I have spoken to Bill McDonough. Yes, I have spoken to Alan Greenspan -- Alan Blinder. (Laughter.) I've spoken to a number of former members of the FOMC, and you know, there are -- there are technical concerns that have been raised about this: What impact will it have on the debt debate in Washington? What impact could it have on the deficit? But I haven't yet received any, shall we say, conceptual complaints about it. I think there's a generally positive disposition towards the idea of trying to normalize the composition of the Fed's balance sheet before the tightening process has to start.
CARUSO-CABRERA: What do you think the chances are that this will actually happen?
STEIL: Well, look, there will be a political debate about it in Washington if we want to go forward. This is not a legal revolution we're proposing. As we emphasized, this has been done before in a slightly different context through the Housing and Economic Recovery Act of 2008. Treasury was specifically given the authority to buy mortgage-backed securities backed by Fannie Mae and Freddie Mac, and they obviously had to issue Treasury securities in order to do this. They issued hundreds of billions.
So we know how to do this. We know how to do it practically and we know how to do it legally.
Now, I'm not naive, and I'm sure that there will be issues raised so that, for example, even though we may be absolutely right that this has no impact on the U.S. net debt, it could become part of the whole debt ceiling debate just because the debt ceiling debate is defined in rather blunt terms with reference to the amount of Treasury securities that are issued. We would naturally find this unfortunate because it's certainly not our aim to increase U.S. debt; far from it. All we're seeking to do is address an accounting issue that we believe is polluting the conduct of monetary policy, and we would emphasize we believe that Ben Bernanke himself believes has polluted the conduct of monetary policy in another setting: Japan.
CARUSO-CABRERA: Well, Ben, this has been terrific. Thanks so much for taking the questions.
This ends the call. A reminder, if you click at the -- on the link at the bottom of the email that you received you can read the policy innovation memorandum that Ben has written, "Exiting from Monetary Stimulus: A Better Plan for the Fed." And thanks so much for joining us.
STEIL: Thanks, Michelle.
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