Monday, June 22, 2009

Exit strategies for Central Banks

This crisis has been marked by Central Banks resorting to unconventional monetary policy responses to both ease the frozen credit markets and bail out the beleaguered banks. Over the last few months, through its unconventional monetary policy actions, the Fed in the US has dramatically inflated (through purchases of even private financial assets, keeping liquidity windows open by lending against an expanded category of assets, and equity injections) the reserves available (over and above the statutory reserve requirements) with the banks (so as to enable them to make more loans). In fact, the Fed even started paying interest on these reserve deposits in excess of the statutory reserves. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans. At the end of 2007, reserve balances at Federal Reserve stood at about $8 billion, whereas currently they are closer to $900 billion.

Banks are required to hold a certain fraction of their liabilities - demand deposits and other checkable deposits - in reserves held at the Fed (on which the Fed pays no interest) or in vault cash. Banks are constrained in the amount they can lend by the statutory reserve requirements (like Cash Reserve Ratio, CRR, in India) and the actual reserves available with them. The bursting of the sub-prime bubble had severely depleted their deposits and consequently the reserves available to leverage for lending.

Federal funds rate (in the US) or the call money rate (in India) is the interest rate at which private depository institutions (mostly banks) with reserve balances in excess of reserve requirements, lend their excess reserves (available at the Federal Reserve or the Central Bank) overnight to other depository institutions with reserve deficiencies. In other words, it is the interest rate banks charge each other for loans, and is now touching the zero bound in many countries.

A Central Bank repo operation temporarily buys permitted securities in exchange for reserves, while a reverse repo temporarily sells Fed-owned securities in exchange for reserves. A repo is an asset on the Central Bank balance sheet that is matched by an increase in reserves on the liabilities side of the borrowing bank. In contrast, a reverse repo is a Central Bank liability that is matched by a decrease in reserves for the lending bank.

Alan Blinder has an excellent discussion about the build-up of excess bank reserves, what it means during such exceptional times when the credit markets are frozen, and the problems with exit strategies. He writes that "providing frightened banks with the reserves they demand will fuel neither money nor credit growth — and is therefore not inflationary".

As Brad DeLong points out, the recent actions of the Fed in buying a melange of financial assets has been funded by expanding the monetary base, which in turn has increased its liabilities. The Fed has increased the private-sector willingness to hold this monetary base by paying interest on reserve deposits it holds. This has added a fourth motive, profit, to the three traditional motives for holding reserve deposits at the Fed - the transactions demand, the emergency liquidity demand, and the speculative demand. With risk-free returns assured, the banks therefore naturally have little incentive to expand their lending operations (nor wind down their excess reserves) as long as the credit markets remain uncertain and frozen.

John Robertson at the Atlanta Fed feels that "if the federal funds rate target is going to be raised at some point in the future (as inflation threatens or recovery starts) then either the Fed needs to be able to simultaneously keep demand for reserves at a high level or it has to reduce the amount of reserves available in order to drive the market rate higher. In other words, a positive interest rate would require eliminating a large portion of the excess reserves or elevating the demand for reserves in a way that is consistent with the market rate near the desired (target) level."

Here are five possible alternatives for Central Banks to control the reserves and thereby keep a lid on inflationary pressures.

1. Economists like Arthur Laffer have argued that the Fed should "contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion. Fed can reduce bank reserves and also reduce the overall size of the Fed's balance sheet by the same amount by outright sales of assets — Treasury securities, agency debt, and agency mortgage-backed securities — held in the Fed's portfolio." This would suck out atleast some part of the monetary base from the system, including the excess reserves with the banks.

However, Arthur Laffer cautions that a reduction in the monetary base by $1 trillion, which would require selling a net $1 trillion in bonds, "would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds."

2. In the absence of a major contraction in the monetary base, the Fed can increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

3. Another possibility is to have the demand for excess reserves at a high level, with the interest rate paid on reserves being the primary lever for the implementation of monetary policy. In other words, the interest rates paid on excess reserves could be adjusted to incentivize banks to maintain the demand for these reserves. Accordingly, in recent times, the US banks have foregone their overnight call money market lending and preferred maintaining (interest bearing) reserve deposits. Similarly, in New Zealand, a large level of bank reserves have replaced the central bank daylight overdraft facilities for the purposes of meeting payment system needs. However, as John Robertson points out, "it remains an open question as to whether market rates could be controlled satisfactorily by adjusting the interest rate paid on excess reserves alone given the size and complexity of the US banking system".

4. The Central Bank can undertake reverse repo transactions (temporarily selling Fed-owned securities in exchange for reserves) to mop up the extra reserves available with banks. While a reverse repo does not reduce the size of the Central Bank balance sheet, it does reduce the amount of reserves available with banks.

5. The Central Bank could issue its own unsecured debt, which be similar in effect to a reverse repo — replacing reserves with interest-bearing Fed obligations, but these obligations would not be backed by Fed-owned collateral. During the peak of the 2008, sterling bills and reserve bank bills have been used in the United Kingdom and New Zealand, respectively, as the primary means of draining reserves when reserves were created as a result of short-term liquidity facilities.

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There is an interesting discussion about the merits of having separate interest rate (to maintain overall macroeconomic stability) and bank reserve polices (to address financial market objectives). It is argued that linking the policy rate to the interest rate paid on reserve balances means that a change in the interest rate does not require changing the supply of reserves. More on this is also discussed here.

John Robertson points to a hypothetical scenario when this could be useful, "Suppose the Fed needed to keep bank reserves at a high level because of lingering demand for liquidity in financial markets that is not being provided by the private sector. Now, suppose the Fed also wanted to tighten monetary policy because of separate macroeconomic stability concerns. Interest on reserves provides a tool to meet both a financial stability objective (by helping the functioning of credit markets) and a macroeconomic stability objective (by influencing banks’ willingness to lend to private borrowers)."

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