Friday, July 24, 2009

More on exit strategy for central banks

I had blogged earlier about the possible exit strategies for Central Banks from the extraordinary balance sheet expansions (through lower interest rates, targeted lending programs, purchases of long term and other securities etc) of the past few months. As economic recovery takes hold, it becomes imperative that the monetary base be contracted, so as to ensure that inflationary pressures are kept under leash.

Banks are required to hold a certain fraction of their liabilities - demand deposits and other checkable deposits - in reserves held at the Central Bank (on which the Central Banks pays no interest) or in vault cash. They are constrained in the amount they can lend by the statutory reserve requirements (like Cash Reserve Ratio, CRR, in India). The bursting of the sub-prime bubble had severely depleted their deposits and consequently the reserves available to leverage for lending. The Central Bank liquidity injections have had the effect of boosting bank reserves, and increasing their ability to lend. However, the increase in reserves have been much faster the growth in deposits and lending, leaving the banks with considerable excess reserves. Further, those banks with excess reserves, in turn on-led their excess reserves overnight to others with deficient reserves.

In the US, these reserve balances now total about $800 billion, much more than normal. In view of the uncertain economic conditions, banks have been holding even their excess reserves as balances at the Fed. However, as the economy recovers and banks find more opportunities to lend out their reserves, unless these excess reserves are eliminated, money supply will grow faster and set the stage for inflationary pressures.

As I had posted earlier, the Central Banks can prevent the reserves entering the money market (since the banks indulge in short-term, mostly overnight lending of tehse excess reserves) either by raising the statutory reserve requirements or by paying interest (higher than the prevailing money market rates) on the excess reserves. Across the world, a few central banks like the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility.

In a WSJ op-ed (and testimony before Senate), the US Federal Reserve Chairman, Ben Bernanke reassures about the massive Fed balance sheet and reserve supluses with banks and outlines four ways to reduce reserves and drain excess liquidity from markets, and thereby also raise short-term interest rates and limit the growth of broad measures of money and credit.

1. Fed could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

2. Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline. Treasury has been conducting such operations since last fall under its Supplementary Financing Program.

3. Fed could use the authority Congress gave it to pay interest on banks’ reserve balances at the Fed to offer term deposits to banks — analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

4. The Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Mohamed El-Erian of Pimco argues that Bernanke's message is a clear signal to the markets that the Fed has enough arsenal in its armory to move from arresting deflation to fighting inflation. He sees Bernanke's reiteration of the widely held perception that loose monetary policy will have to continue for an "extended time", atleast till the green shoots turn into saplings, as indication of the critical importance of fiscal policy in achieving the same.

In the final analysis, the critical issue, as both Mark Thoma and Economix writes, is not how the Fed drains out or prevents the excess reserves from flooding the market, but when should it start winding down these reserves. As Economix writes, "Unwind too soon, thereby draining liquidity from the system, and they short-circuit all the efforts to get the economy to recover. Take action too late and they cause massive inflation."

Update 1
Amidst the debate on exit strategies, with the dilemma in choosing between inflation and unemployment, all strategies have focussed on the role of bank reserves (or the money held by banks to meet their credit requirements and whose excess they lend out to other banks, as interbank loans, at the federal funds rate - if the Fed wants a higher fed funds rate, it drains reserves, and if it wants a lower one, it adds reserves). Free Exchange feels that the volume of reserves has almost no significance for the growth of bank lending and inflation when both credit demand and supply are constrained, especially at zero bound when they become irrelevant in managing the fed funds rate.

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