No Exit

FOMC, Interest on excess reserves, negative interest rates, reverse repos, Stanley Fischer
World Economic Forum, "The Rise of Unconventional Monetary Policy, Fischer," CC BY 2.0

Fischer ThirdSartre famously wrote, "L'enfer, c'est les autres" (“Hell is other people").  In his recent speech, Fed Vice Chairman Stanley Fischer, assisted, as he says, by William English of the Board's staff, supplies an example of hell being the "other policy."

The last substantive paragraph of Fischer’s speech includes the following summary of current FOMC policy:

The Committee has indicated that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively.  But that statement leaves open the question of when we should begin to reduce the size of our balance sheet.  Because the tools I mentioned earlier — the payment of interest on reserve balances and the overnight reverse repurchase facility — can be used to raise the federal funds rate independent of the size of the balance sheet, we have the flexibility to adjust the size of our balance sheet at the appropriate time.  With the federal funds rate still quite low and expected to rise only gradually, I think there is some benefit to maintaining a larger balance sheet for a time.  Doing so should help support accommodative financial conditions and so reduce the downside risks to the economic outlook in the event of a future adverse shock to the economy.  Consistent with this view, the Committee has decided to continue to reinvest principal payments from its securities portfolio until normalization of the federal funds rate is well under way.  The decision about when to cease or begin phasing out reinvestment will depend on how economic and financial conditions and the economic outlook evolve.

From this statement one gathers a number of facts.  First, the Fed remains determined to stay on an interest rate-raising path, as circumstances allow.  The question here is, just what are the circumstances presently pointing to the desirability of further raising interest rates?

Second, the Fed plans to maintain its bloated Fed balance sheet, including reinvesting maturing asset balances, for the indefinite future, instead of looking hard for a chance to reduce it, as it has long promised to do.

Third, we're still going to pay increased interest rates on excess reserve balances (a subsidy) and maintain the raised rate on the already subsidized reverse repo transactions (principally for nonbanks).  One wonders what would happen in the market to those rates if the Fed allowed the balance sheet to shrink, even short of outright asset sales, by simply allowing maturing assets to roll off and stopping the implicit subsidy of reverse repos.  Has anyone on the Board's or FRBNY's staff done such a study?  If not, isn't the absence of such a study a hallmark of willful indifference to "data-driven policy"?  If such a study exists, shouldn't the transparent Fed release it so that we might see it?

Finally (a case of omission), Fischer’s speech says not a word, either in his summary or in the rest of his speech, about negative rates.  If the Fed (which created a generation's worth of new reserves in recent years) stopped intervening in the Federal funds market, one wonders where market rates would go.  I think they would go negative, at least briefly, before eventually recovering with normal economic activity.

A negative rates environment might be a powerful incentive to bankers, encouraged if need be by bank examiners and discount window officers, finally to restructure legacy (that is, pre-2009) debt at the household and firm level (the one very big thing that was done in the 1930s that was not done after 2008).  The payoffs for such restructuring would be resumption of natural economic growth as debt burdens are eased, with positive (but significantly lower than present) interest rates on the restructured debt.  In my tax practice, I still encounter too many households paying 8 or 9 percent interest on legacy mortgage, car loan, and student loan debt.  It won't do to say that credit scoring requires such outrageous spreads; credit scoring is rotten to the core, and bankers know it (or should know it).  The scores are low because the debt is not restructured.  Also, the insurance industry now sets rates using credit scoring; no one at the Fed appears to be concerned about this expansion of the use of credit scoring.  This bankers' and insurers' sword is not what was intended when credit scoring was invented as a shield for use in the banking industry in judging patterns of racial discrimination in mortgage lending in the 1980s and 1990s.  Congress and the Fed gave bankers a shield and they turned it into a sword.

In short, it looks as though the Fed is persuaded that economic growth will resume and increase once the prices of oil and other commodities stop falling.  If there is a historical or an econometric policy model supporting the Fed's current policy mix, I'd like to know what it is.  The data so far, and the Japanese experience since the 1990s, seem to suggest that maintenance of Fed-managed low interest rates to stimulate economic growth against a backdrop of elevated excess reserve levels tends, if anything, to depress economic activity.  (Japan finally took its official rates into negative territory last week, by the way.)  What Vice Chairman Fischer describes is but a procrustean attempt to make the Fed’s model fit the data.  One wonders what economy, shorn of its limbs, will emerge from the other side of the Fed’s latest, indefinite policy commitment.

I’m not suggesting that negative rates are a cure for all that ails us.  The Swiss experience indicates that negative rates merely stop the bleeding (in this case, adverse domestic economic effects of high foreign exchange value of the dollar), giving the patient a respite during which natural healing forces might take over.  In any case, Fed tolerance of temporarily negative rates cannot possibly have worse cumulative economic effects than the bloated balance sheet policy that actually has been followed, with no exit in sight.