Fed Exit Strategies: Are They Needed? What Would They Look Like?
Western Asset
6 August, 2009
Executive Summary
The Fed has eased in a massive and somewhat unconventional manner since the onset of acute financial crisis last September, and some investors are asking about the Fed’s exit strategies from this policy stance in order to prevent a resurgence of inflation.
Financial market disruption is a monetary shock to the economy. Our analysis indicates that the Fed’s actions since September 2008 are not even enough to fully offset the deflationary impetus from market disruptions, let alone spark inflation. No exit strategy is likely to prove necessary.
Nevertheless, should an exit strategy prove necessary, it would not be difficult for the Fed to enact.
About half of net liquidity provisions are still being held as idle, excess cash assets by banks, and these could be reversed by the proverbial stroke of a bookkeeper’s pen.
Reversing remaining injections would require reverse open-market operations. However, there is no reason to expect such operations to disrupt financial markets, since the reverse operations would become necessary only if financial market conditions had first improved enough that special liquidity provisions were no longer necessary.
Introduction
In the months following the financial system’s near meltdown in September 2008, the Federal Reserve (Fed) injected massive amounts of liquidity into the financial system to lower private-sector borrowing rates, stimulate growth in the money stock and generally assuage stress on the economic system. In the wake of these operations, speculations abound about whether and how the Fed will be able to reverse the monetary stimulus without generating rising U.S. inflation and without disrupting financial markets. We discuss these issues here.
Our first point is that it is most likely that no exit strategy will be necessary. The injections of liquidity dwarf anything seen in our lifetimes, but the adverse monetary shocks that buffeted the U.S. and world economies late last year also dwarf anything in our experience. The Fed’s liquidity injections were intended to offset the deflationary effects of these shocks, and whether Fed actions will prove to be inflationary on net can only be determined by analyzing both shocks and policy response together.
Such analysis indicates that all the monetary stimulus the Fed has provided thus far has not even been sufficient to fully offset the deflationary pressures already in place. Furthermore, while recent events are outside the range of our personal experience, they are not unprecedented. Historical analysis indicates that the effects of such shocks eventually peak but do not reverse in subsequent years. On both of these grounds, no exit strategy is likely to be necessary.
For those unconvinced by monetary arithmetic or by history, we also walk through the nuts and bolts of reversing the Fed’s outstanding liquidity injections should the need arise. Out of some $1.1 trillion of cash and reserves injected into the system by the Fed, the majority of these funds sit idle as bank cash assets, providing emergency liquidity if needed but not being used to fund new loans or back new deposits. (Cf. Exhibit 8 on page 6.) These excess reserves were funded via loans from the Fed. Banks have already begun to pay down some of these loans, and it would be a trivial matter for the Fed to call the rest of the loans and thus extract the resulting liquidity should the need arise.
The rest of the Fed’s liquidity injections were accomplished by unconventional open-market operations: purchases of assets other than Treasuries. Reversing these would require reverse open-market operations: sales of these assets. Would this unduly disrupt financial markets? It would if one assumes no change in market efficacy from the conditions of last fall. However, if there is no improvement, there is also no reason to withdraw the stimuli that were put in place to counter market dysfunction. Reversal of Fed stimuli would potentially prove necessary only if the financial markets heal quickly and completely, but in that event, extracting excess liquidity would not be disruptive.
In sum, we argue that those fearing inflation from the Fed’s stimulus operations are both ignoring the effects of the monetary shocks that gave rise to the stimuli and are also posing a false dilemma for the Fed: fretting over disruption of markets from removing liquidity when their argument is predicated on that liquidity becoming unnecessary. The next section walks through the monetary arithmetic to shed light on whether an exit strategy might be needed. The following section discusses possible exit strategy mechanics should they prove necessary, and the final section both concludes and considers federal funds rate issues.
Is an Exit Strategy Necessary?
The Fed’s massive stimulus occurred in response to similarly massive adverse monetary shocks that buffeted the financial system and the economy in September 2008 and after. The shocks provided a substantial deflationary impetus to the economy that expansive monetary policy sought to offset. In other words, what would in normal conditions have been inflationary policy became necessary during the crisis in order to prevent deflation.
We are accustomed to describing inflation as too much money chasing too few goods. The emphasis here should be on “too much” money. Monetary shocks increase the demand for money. What might have been excessive money growth prior to the crisis is now barely sufficient to support GDP, thanks to the stresses affecting the financial system. Banking system dysfunction means that an existing stock of bank liquidity supports a smaller money stock than previously (lower money multiplier). Consumer and business panic result in each dollar of money stock being spent more slowly (lower velocity of money). The presence of these effects means that higher levels of bank liquidity and money stock are now necessary to support a given level of GDP.
In these statements, we have distinguished between bank liquidity and the money stock. By bank liquidity, we mean the (cash) reserves available to commercial banks. Add to this currency in circulation, and the total is the monetary base, described by Milton Friedman as “high-powered money.” This aggregate is essentially equal to the total liabilities of the Federal Reserve (differing only by Fed actions in offshore markets). By the money stock, we mean a monetary aggregate such as M1 or M2, consisting of currency in circulation and different combinations of bank deposits used for transactions.
History shows that the broader M1 and M2 monetary aggregates are better indicators of trends in the economy and inflation than the narrower monetary base. However, while the Fed can directly control the base, it can only influence—and expect to affect—the money stock by expanding its balance sheet.
When banking system distress interrupts banks’ lending and deposit-creation activities, the result is a decline in the money multiplier, the ratio of the money stock to the base. Banks hold higher reserves as a precaution against liquidity problems, and so a given stock of base—of reserves—supports a smaller stock of money in times of crisis. Meanwhile, anxiety among consumers and businesses leads them to spend their money stock holdings more slowly, and so the same stock of money supports a smaller flow of spending—thus of GDP. In other words, there is a decline in the velocity of money, the ratio of GDP to the money stock.
Both of these developments are typical responses by a financial system and by an economy to the turmoil of severe monetary distress. Indeed, the severity of declines in the money multiplier and in the velocity of money can be taken as the primary indicators of the severity of monetary shocks and thus of the amount of monetary stimulus that is necessary to offset these deflationary shocks without causing actual inflation.
The economy’s plunge in 3Q08 and after occurred in an environment where money stock growth had been remarkably stable. We can therefore impute all the slowing in nominal GDP to declines in velocity.1 After growing at average rates of 5.7% per year over 2003-07 and 3.9% from 2007 through 2Q08, nominal GDP grew only at a 1.4% rate in 3Q08 and then plunged at annualized rates of -5.4%, -4.6%, and -0.8% in 4Q08, 1Q09, and 2Q09, respectively. All told, this means a decline in nominal GDP from trend of somewhere between -6.3% and -9.5% as of 2Q09 (Exhibit 1). This range is a minimum estimate of the drop in velocity, since there is no guarantee that declines in nominal GDP have yet been stemmed.
Exhibit 2 displays the stable growth in the M2 money stock prior to the Fed’s stimulus last September. From September 2008 through early July 2009, M2 has increased by a cumulative $378 billion—or +4.7%—relative to preceding trends. This increase in M2 is well below the range of estimated declines in velocity that have already been experienced (to say nothing of further velocity declines that may yet occur). In other words, the effects of the Fed’s massive easing do not appear to be enough to fully offset the deflationary effects of financial crisis, let alone to generate an actual upturn in inflation. On these grounds, no exit strategy will be necessary.2
The Fed has more than doubled the monetary base since September 2008. However, banking system stress has prevented this infusion from driving as large an increase in the money stock as would normally be expected. In other words, the money multiplier has plunged by more than half. (Cf. Exhibit 6.)
As stated previously, the declines in the velocity of money gauge the extent of effects of financial crisis on the economy, and the declines in the money multiplier gauge the effects of crisis directly on the banking system. The observed increase in the money stock was not sufficient to fully offset deflationary pressures. The increase in the monetary base was necessary to drive this (non-inflationary) increase in money.
Similar disruptions were evident in the 1930s. In that episode, while the monetary base was little changed, the money stock plunged thanks to bank failures and the economy crashed with the money stock.3 Based on observed declines in velocity and the multiplier, the Fed of the early 1930s could have effected a 125% increase in the monetary base without any inflationary impact on the economy.
Thankfully, the current economy has not declined as sharply as it did in the 1930s, but the observed declines in velocity and the multiplier presently are of comparable magnitude to those seen in the 1930s. It would appear that the liquidity infusions the Fed has provided since September are what prevented a rerun of the 1930s’ economic experience. In any case, the observed behavior of velocity and the multiplier indicate that the Fed’s recent actions were not inflationary.
History also indicates that the recent velocity and multiplier declines will not reverse in the future, further arguing against any flare-up of inflation pressures down the road. Exhibits 3 and 4 show velocity and multiplier behavior during the Great Depression. The early 1930s’ declines in the money multiplier were not even partially reversed through 1940. The declines in the velocity of money were mostly still in place through 1940, and none of the declines in the velocity of the monetary base were reversed. Exhibit 5 shows the post-1960 velocity experience. At various points during the 1980s’ disinflation and during the bursting of the tech bubble over 2000-02, velocity declined sharply. None of those declines were reversed in subsequent years. Similarly, Exhibit 6 does not indicate any tendency for recent swings in the multipliers to reverse.
Another consideration is that it is continuing excessive money growth that drives sustained inflation. A one-time burst in the money stock can cause, at most, a one-time (short-lived) rise in the price level, not the continuing inflations that raise nominal interest rates such as were experienced from the late 1960s through the early 1980s. Not only is there no indication that the Fed’s recent actions have been excessive, but also they have ceased since early this year. After doubling over four months in late 2008, the monetary base has declined on net since January. In line with that, M2 growth since January has been even slower than prior to Fed actions in September 2008 (Cf. Exhibit 2.) On these grounds, there is no reason to expect a sustained inflationary burst from the Fed’s actions over the last ten months.
In sum, by even the most conservative estimates of the magnitude of the monetary shocks that have buffeted the U.S. financial system and economy in the last year, the Fed’s response has not been sufficient to fully stem deflation, let alone to spark inflation. History does not provide any reason to expect that recent monetary shocks will be reversed. Therefore, we find it unlikely that an exit strategy will be necessary.
Exit Strategies Anyway
Just for the sake of argument, suppose the Fed eventually does have to reverse some of its easing. Suppose that further easing in the coming months goes overboard, or that either velocity or the money multiplier behave counter to history and reverse their declines. Even under such circumstances, the Fed should have an easy time reversing the effects of its actions.
After financial crisis emerged in August 2007, the Fed announced its first special lending facility, the TAF, on December 13, 2007. Between that date and September 2008, while the Fed had greatly expanded its special lending facilities, this had been fully financed by reductions in Fed holdings of Treasuries, with zero effect on the size of the Fed’s balance sheet or the money stock (Exhibit 7).
This all changed in September 2008 and after. Between September 2008 and January 2009, the Fed expanded its balance sheet by nearly $1.3 trillion, with $0.8 trillion of this going to the (domestic) monetary base and $0.5 trillion to offshore markets via foreign exchange swaps. The $0.8 trillion domestic infusion was accomplished by $0.75 trillion of loans: term auction credit (TAF, etc.), the Commercial Paper Funding Facility (CPFF) and direct loans (to banks, primary dealers, and others), as well as Bear Stearns and AIG assets purchased by the Maiden Lane LLCs owned by the Federal Reserve Bank of New York.
Between January 2009 and May 2009, the Fed managed to keep its total balance sheet relatively unchanged, even while it purchased $100 billion of Treasuries and more than $400 billion of mortgage-backed securities (MBS). These open-market operations were “funded” by eliminating repurchase agreements, cutting loans to banks, sharply reducing holdings of commercial paper and reducing offshore foreign exchange (FX) swap facilities. Since May 2009, the Fed has actually reduced the size of its balance sheet by nearly $200 billion through paying down various loans and further reducing FX swaps, even as it purchased further Treasuries and MBS.
Some fear that eventual Fed sales of MBS securities, if necessary, would disrupt the mortgage market in particular and the financial markets in general. However, notice that Fed holdings of Term Auction Credit, commercial paper and direct loans have been reduced by a collective $423 billion since January 2009 without disrupting the short-term money or commercial paper markets. If anything, conditions in these markets have improved immensely since June, as have conditions across the financial system. Such improvements are the reason the Fed could reduce these facilities in the first place. As stresses decline in the mortgage market, the Fed should similarly be able reduce its holdings there without disrupting that market. If mortgage market stresses do not ease, then there is no reason to reduce Fed support. How do we get inflationary pressures from a market if that market is still exhibiting deflationary stress?
Notice also that current Fed holdings of Treasuries are still lower presently than they were at the outset of the crisis. This puts to rest any claims that the Fed is directly monetizing federal deficits. Furthermore, Fed holdings of MBS and agency debt still represent only half of the net liquidity injections it has made since September 2008. In the previous section, we found that there is no presumption that any of the Fed’s recent liquidity injections would have to be reversed. Sales of MBS and agency debt would become necessary only if the Fed had already reversed the other half of its injections.
Presently, over $500 billion of “special” credits provided to the financial system remain in place. These were made available when the financial system was dysfunctional or at least not fully functional. The prima facie evidence of such reduced financial market function is the staggering drop in the money multiplier detailed above. Of $1.1 trillion injected into the financial system since September 2008, more than half is being held by banks as cash assets (Exhibit 8), reserves held far in excess of the minimum requirements established by the Fed and serving only to cushion banks from another run on their financing sources. If and when banks’ desire for such massive excess reserves/liquidity fades, those funds would need to be extracted from the system. However, at that point, extracting them would perforce not be a problem, as they are, again, presently idle and as these circumstances postulate that banks would no longer need such extremely high liquidity. Extracting these funds would not even require reverse open market operations, merely a “calling” of $500 billion in loans outstanding, whereupon the banks’ deposits at the Fed would be extinguished via the bookkeeper’s pen. To repeat, there has not been any currency printed in creating these loans, so extinguishing them would not be an issue.
Sales of MBS securities, of agency debt or of troubled assets purchased by the Maiden Lane facility would not become necessary unless and until the Fed first divested all special lending facilities from its portfolio. In that event, the financial markets and the economy would have to have recovered so forcefully—and so much more than was seen in previous experiences—that reversing these extraordinary open-market operations would not be a crushing blow to the system.
Conclusion
The Fed’s special injections of credit to date were a justifiable response to the monetary shocks that have buffeted the economy in the past year. If anything, the Fed has not fully arrested deflationary forces in play, let alone turned potential deflation into inflation. If the effects of those shocks linger—as history indicates they will—no reversal of the Fed’s stimuli will be necessary. If the effects of those shocks should reverse, then a reversal of some of the Fed stimulus would be necessary, but in that case, the need for those stimuli would also disappear, allowing the Fed to reverse its stimulus without unduly disrupting financial markets or aborting economic recovery.
There is no technical problem that would arise from reversing the special liquidity injections. At present, more than half are mere strokes of the pen: loans extended by the Fed to banks, primary dealers and others, effected by crediting banks’ deposits at the Fed, with those funds then sitting idle as cash assets. Removing the remaining stimuli, if necessary, could be accomplished by sales of corresponding assets in (presumably) fully healed financial markets.
This analysis has focused on the Fed’s extraordinary provisions of liquidity (quantitative easing) since September 2008, as these operations are the departure from previous experience for which an exit strategy is most properly of interest. It is also the case that economic recovery will eventually necessitate an increase in the Fed funds rate to more sustainable levels than the 0.00-0.25% range currently in place. However, the Fed’s quantitative easing occurred after the funds rate was already near zero, and reversing the extraordinary liquidity provisions, if necessary, is an issue wholly distinct from that of raising the funds rate. Furthermore, we have a wealth of experience with the Fed restoring sustainable levels of the funds rate without disrupting financial markets or nascent economic recoveries. So the real, substantive issues of exit strategies concern the Fed’s liquidity provisions since September 2008, not the Fed funds rate, and the analysis in this white paper has already dealt with these substantive issues in detail.
Footnotes
Since money affects the economy with a lag, calculating money velocity properly involves imposing the correct lag from money onto nominal GDP: i.e., calculating velocity as the ratio of GDP to the properly lagged value of the money stock. Because money growth trends had been stable for so long prior to 3Q08, determining the proper lag to impose on money becomes a non-critical issue. The decline in velocity relative to trend can be determined merely by looking at how much nominal GDP has fallen relative to its preceding trend.
Similar calculations can be performed with respect to the pick-up in the M1 monetary aggregate, with somewhat different results. M1 has picked up since September 2008 by a larger percentage than M2, and so not all of its increase is offset by declines in velocity. Then again, M1 velocity trends have been more haphazard than those of M2 throughout the last 30 years (cf. Exhibit 5). Also, a good bit of the faster growth in M1 is due to deposit shifts out of money funds and passbook saving accounts into checking accounts as short-term interest rates have approached zero levels, thus reducing the “opportunity cost” of holding funds in non-interest-bearing checking accounts. These shifts have no effect on the size of M2, but they increase M1. Because of similar periodic shifts in deposit forms—and consequent aberrations in M1 velocity—M2 has been a more reliable indicator of monetary trends in recent decades, hence our emphasis of it in the text. Then again, it should be noted that all the monetary aggregates have experienced curious movements in their growth trends and in velocity in recent decades, which is one reason that central bank and academic analysis of monetary policy trends have generally shifted over toward a focus on central bank policy rates as the prime indicators of monetary policy effects. While this emphasis on interest rates was critiqued in a white paper earlier this year, titled “What Is the Fed Doing?”, the increased volatility—thus reduced reliability—of money stock measures in recent decades should be kept in mind when contemplating the inflationary import of current money growth trends.
Cf. “What Is the Fed Doing?” January 2009, available on our website.
Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).
Western Asset
6 August, 2009
In the months following the financial system’s near meltdown in September 2008, the Federal Reserve (Fed) injected massive amounts of liquidity into the financial system to lower private-sector borrowing rates, stimulate growth in the money stock and generally assuage stress on the economic system. In the wake of these operations, speculations abound about whether and how the Fed will be able to reverse the monetary stimulus without generating rising U.S. inflation and without disrupting financial markets. We discuss these issues here.
The Fed’s massive stimulus occurred in response to similarly massive adverse monetary shocks that buffeted the financial system and the economy in September 2008 and after. The shocks provided a substantial deflationary impetus to the economy that expansive monetary policy sought to offset. In other words, what would in normal conditions have been inflationary policy became necessary during the crisis in order to prevent deflation.
Just for the sake of argument, suppose the Fed eventually does have to reverse some of its easing. Suppose that further easing in the coming months goes overboard, or that either velocity or the money multiplier behave counter to history and reverse their declines. Even under such circumstances, the Fed should have an easy time reversing the effects of its actions.
The Fed’s special injections of credit to date were a justifiable response to the monetary shocks that have buffeted the economy in the past year. If anything, the Fed has not fully arrested deflationary forces in play, let alone turned potential deflation into inflation. If the effects of those shocks linger—as history indicates they will—no reversal of the Fed’s stimuli will be necessary. If the effects of those shocks should reverse, then a reversal of some of the Fed stimulus would be necessary, but in that case, the need for those stimuli would also disappear, allowing the Fed to reverse its stimulus without unduly disrupting financial markets or aborting economic recovery.
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Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).