Exit Strategy, Tactics, and Decision Makers

Vincent Reinhart, resident scholar at the American Enterprise Institute and former senior official of the Federal Reserve Board of Governors, heard the Chairman speak and seems to have come away not wholly satisfied.

“… Bernanke will talk about reverse repurchase agreements and interest on excess reserves as congressional committee members nod in agreement. Mastery over tactics, the bet runs, will restore faith in an otherwise undefined future. It is a difficult trick, this confidence game. The Fed will provide enough detail about its tactical exit from its unusual policy accommodation to allay concerns, but not so many specifics as to lead market participants to believe it intends to head for the exit soon.

“Lost in this thicket of expertise will be important public policy questions basic enough to be assigned as homework in a high-school journalism class.

“When will the Fed begin to raise the short-term market interest rate?”

Interestingly, Reinhart himself has his own answer to that question:

“The Fed has the dual responsibility of fostering employment and price stability. As of now, the Fed continues to forecast substantial and lingering unemployment that puts downward pressure on inflation. Until policy makers can produce a forecast that gives a reason to tighten, they will not tighten. That outlook is not likely to change until late this year.”

That judgment is certainly not a matter of inside information or any special insight, as there are plenty of statements like this one from Dennis Lockhart, our boss here at the Atlanta Fed:

“I continue to support an interest rate policy described in recent FOMC statements as low for an ‘extended period.’ What does ‘extended period’ mean? I don’t want to put a date on it. To me, it means the policy rate will be kept low until recovery has shown momentum that is based on private business and consumer demand, job growth is established or at least imminent, and the downside risks appear to be safely navigable. This unwinding is in the context of well-behaved inflation, of course.”

In fact, Chairman Bernanke said very much the same thing Wednesday in the first installment of his semiannual testimony before Congress:

” ‘The federal funds rate is likely to remain exceptionally low for an extended period,’ Bernanke said, repeating language that has been in every Fed statement on monetary policy for the past 14 months…

” ‘As the impetus provided by the inventory cycle is temporary and as the fiscal support for economic growth will likely diminish later this year, a sustained recovery will depend on continued growth in private-sector final demand for goods and services,’ Bernanke said. ‘The job market remains quite weak.’ “

Though much of the discussion lately has been about the tools of implementing policy decisions, that is only natural. The objectives of the central bank—including a broad understanding of what sort of economic conditions will drive a change in policy direction—seem to be well understood. What is new is the instruments that may be brought to bear in light of the very large size of the Fed’s balance sheet, a legacy of what I view as successful efforts to manage the fallout of the financial crisis.

Reinhart does make note of an interesting governance question that presents itself if the so-called “exit strategy” involves the payment of interest on reserves that banks deposit with the central bank:

“How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. …[T]he Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

“Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.)”

The institutional fact is certainly correct—the authority to set the interest rate paid on reserves is granted to the Board of Governors, not the FOMC. But, in my view, this is of more theoretical than practical interest. The minutes of the January meeting of the FOMC made clear that, though no definitive decision has yet been made, it may well be the case that the payment of interest on reserves is employed as a transitional tool employed along the road to an environment in which the federal funds rate again reigns supreme:

“With respect to longer-run approaches to implementing monetary policy, most policymakers saw benefits in continuing to use the federal funds rate as the operating target for implementing monetary policy, so long as other money market rates remained closely linked to the federal funds rate. Many thought that an approach in which the primary credit rate was set above the Committee’s target for the federal funds rate and the IOER [interest on excess reserves] rate was set below that target—a corridor system—would be beneficial. Participants recognized, however, that the supply of reserve balances would need to be reduced considerably to lift the funds rate above the IOER rate. Several saw advantages to using the IOER rate, rather than a target for a market rate, to indicate the stance of policy. Participants noted that their judgments were tentative, that they would continue to discuss the ultimate operating regime, and that they might well gain useful information about longer-run approaches during the eventual withdrawal of policy accommodation.”

It is also worth noting that if you  pick up any old money and banking textbook, you will likely see listed a trio of tools that the central bank has to affect the money supply: open market operations, reserve requirements, and the discount rate. The latter two have always been the sole or primary province of the Board of Governors. In practice, however, they have been employed as adjuncts to the decisions of the FOMC. As of now, there really is no indication that this is likely to change.

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