On February 10, Ben Bernanke testified to the House Financial Services Committee. The topic: “Federal Reserve’s exit strategy.” His printed testimony contained the familiar promises. The Federal Reserve System will unwind when the economy recovers. Speaking of the TAF and TALF programs, he said:
The exit from these programs is substantially complete: Total credit outstanding under all programs, including the regular discount window, has fallen sharply from a peak of $1-1/2 trillion around year-end 2008 to about $110 billion last week.
This sounded good, but as the charts of the FED’s balance sheet indicate, there has been no reduction of the monetary base.
Bernanke mentioned one tool by which the FED can force up the Federal Funds rate, the rate at which banks lend to each other overnight.
By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.
Why should long rates not decline under such a scenario? If the FED starts hiking the rate paid on reserves, the effect will be to raise short-term rates, no question about that. Banks will lend to the FED and pocket no-risk money. The effect of this will be to end the economic recovery. Why? Because banks will lend to the FED, not to the commercial loan markets.
This will send a signal to investors in long bonds: rates will fall because of recession. People will try to lock in long rates before they fall. Long rates fall in depressions.
The FED is trapped. All policies of unwinding will shrink the monetary base. The recovery is being sustained by a zero percent Federal Funds rate. It will not survive an increase in this rate, which is why Bernanke keeps repeating his mantra about a zero-percent rate for an indefinite time period.
Yet Bernanke insisted that the day of balance sheet contraction will come.
The Federal Reserve also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve’s balance sheet.
To which I reply: “Go ahead, make my day.” The FED has vastly expanded the monetary base to produce the anemic recovery we now see. Yet Bernanke expects Congress to believe this threat.
The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments.
He is leaving his options open. He is not about to say exactly what the FED will do under which circumstances. The FED will make it up as it goes along.
I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery.
THE MORTGAGE MARKET: “NO PROBLEM!”
The posted transcript of Bernanke’s testimony does not include the post-presentation Q&A. Here is where things sometimes get interesting. We can piece things together by means of news reports.
Bernanke says that the FED will cease buying Fannie and Freddie bonds. It has bought $1.2 trillion of these toxic assets. But, he suggests, the FED’s departure from this market will have only marginal results. Reuters reported this:
We’re interested to see what the effect is going to be on mortgage rates. So far the evidence suggests it’ll be a modest effect, which wouldn’t have a big impact.
If you’re talking about interest rate risk for the GSEs, I do believe that they’re mostly hedged by holding Treasuries and other securities. I don’t know how much the modest increase in mortgage rates would affect their balance sheet. I don’t think it would be catastrophic in any case.
The Federal government now accounts for about 95% of all residential mortgages. He is saying that the removal of the FED’s supply of fiat-money funding of the mortgage market will be replaced by new investors. These investors did not provide $1.2 trillion in new mortgage money, but now they will.
I am curious. How sound are these two institutions? They continue to announce losses in the tens of billions. Fannie’s fourth quarter loss was $16 billion. It was $20 billion in the third quarter. So far, taxpayers have suffered losses of $127 billion.
Why will profit-seeking investors want to buy long-term bonds from these agencies after the FED ceases? Bernanke needs to address this issue in public.
I was asked earlier about what is the right long-term solution for Fannie and Freddie and that obviously needs to be worked out.
I see. The right solution “needs to be worked out.” I am sure that it does. What does he have in mind? Lots of things. Lots and lots of things. His cup runneth over.
But many possible outcomes would involve not having a substantial portfolio. So it would have to be a transition to that.
I see. A transition. There must be a transition. What kind of transition?
The sooner you get some clarity about the ultimate objective, the better. Of course, you don’t necessarily have to get there by the end of the year. It’s going to take some time to make a transition.
I see. It will take “some time.” That is the trouble with transitions. They take time.
THE FEDERAL DEFICIT: “NOT THE FED’S PROBLEM”
Then there is the problem of the Federal deficit. The world expects the Federal Reserve to serve as the lender of last resort. This has been the official take of central banks for over 300 years.
One risk that I’ve described is that if there’s a long-term loss of confidence in the long-term ability of the government to balance its affairs, that could raise interest rates today, which would have a drag effect on the economy. Another possibility, which I think is relatively unlikely, but it’s certainly possible, is that if there’s a loss of confidence in the government’s ability to achieve fiscal stability . . . the dollar could decline, which would have a potential inflationary impact on the economy.
This was the version of the exchange reported by Reuters. The Washington Times added this:
It’s not something that is 10 years away. It is possible that bond markets will become worried about the sustainability [of yearly deficits over $1 trillion], and we may find ourselves facing higher interest rates even today.
One Congressman, Brad Sherman of California, cited the International Monetary Fund’s recommendation that the FED purchase Treasury debt to keep rates low. The IMF recommended a price inflation rate of 4% to 6%. Bernanke cut this off at the pass.
“We’re not going to monetize the debt,” Mr. Bernanke declared flatly, stressing that Congress needs to start making plans to bring down the deficit to avoid such a dangerous dilemma for the Fed.
“It is very, very important for Congress and administration to come to some kind of program, some kind of plan that will credibly show how the United States government is going to bring itself back to a sustainable position.”
There is no doubt that Congressional Democrats will scream bloody murder if T-bill rates climb and the FED does not intervene. Bernanke talked tough. There will be no monetization of Treasury debt. The problem is, the FED has usually capitulated. There are only two major exceptions: 1951 and 1979—82. The second event, when Paul Volcker was in charge, drove 90-day T-bill rates to over 21%. It produced back-to-back recessions.
Despite his gloomy testimony, Mr. Bernanke dismissed concerns that the United States will lose its gold-plated AAA credit rating any time soon. Moody’s Investors Service recently said that the U.S. rating would come “under pressure” at some point if Congress does not rein in the budget deficit.
The Fed chairman said repeatedly that he understands how difficult it will be for Congress to tame deficits by curbing spending in popular programs like Social Security, Medicare and defense, while also considering tax hikes. But he said there would be an immediate payoff: lower interest rates.
“It would be very helpful, even to the current recovery, to markets’ confidence, if there were a sustainable, credible plan for a fiscal exit,” he said.
Yes, it would be wonderful if there were such a plan. There isn’t one, and there is not the slightest hint that one will be forthcoming from the White House or Congress. Everyone in Washington knows this, I think. The capital markets know it. There will be trillion-dollar deficits for the remainder of the decade. Yet Bernanke wants Congress to believe that the FED will not intervene and buy Treasury debt when rates climb.
A plan that eases market worries by laying out how Congress will address the long-term insolvency of Social Security, Medicare and other entitlement programs also would give Congress more room to take the actions needed today to address the jobs crisis, Mr. Bernanke added.
We have waited for such a proposal for approximately 25 years, when Social Security went bankrupt in 1983. Alan Greenspan headed Reagan’s Social Security Commission. It recommended applying the FICA tax to more wages and also to delay retirement. As of this year, Social Security will go into the red. It will have to be paid out of the general fund. Medicare has been in this situation for two years.
There is no politically acceptable answer. Bernanke knows this. Congress knows this. No one cares. They kick the can.
I think it would be helpful for the current situation if the Congress and the administration . . . could provide a plan which shows how the deficit will fall to this two-and-a-half, three percent level, at least, over the next 10 years.
I am sure this would be very helpful. We have seen no indication that this is forthcoming.
What about a downgrade of U.S. Treasury debt? He assured Congress that this will not happen.
Not unless Congress decides not to pay, which I don’t anticipate. No, I don’t anticipate any such problem. I don’t anticipate any downgrade. Of course, there are real long-term budget problems that need to be addressed.
Let’s put the pieces together.
The FED will unwind by selling assets from its portfolio. Which assets? He did not say. When? He did not say.
The FED will not monetize the Treasury’s debt. It will let rates climb. He is stating that he is Volcker in 1979—81.
We need a solution to Medicare and Social Security. He did not mention one.
I don’t know exactly which programs, what taxes, what changes you would make. That’s certainly up to Congress. But a concerted effort to do that would be, I think even a strong effort, would probably be good for confidence.
It is certainly up to Congress. Congress has decided to kick the can. It always does.
The FED will cease buying Fannie and Freddie mortgage bonds. This will have no adverse effect on the supply of mortgage money.
There will be no downgrading of Treasury debt. Yet rates may increase at any time.
Bernanke outlined the problem of the Federal debt. It needs a solution. He did not suggest any.
He insisted that the FED will not monetize debt, yet no FED chairman has monetized more debt than he has.
He kicked the can. He told the Committee that Congress should not kick the can. In short, “Do as I say, not as I do.”