The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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April 08, 2011

Monetary policy exit: Is a bad bank the solution?

It is not difficult to find people who espouse the following belief:

"One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its 'quantitative easing' policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?"

I dare say that I hear that criticism, in one form or another, nearly every day. So the claim above might only merit notice here because it comes from a Wall Street Journal op-ed penned by Professor Allan Meltzer, the eminent monetary macroeconomist and chronicler of Federal Reserve history. But what really distinguishes the critique is that it comes with a fairly novel and creative way of resolving the perceived problem:

"One idea is for the Fed to create its own version of a 'bad bank.' The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank’s assets. (The $1 trillion in Fed-created 'excess' bank reserves as a result of quantitative easing would become the liabilities of the bad bank.)

"The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline. The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away. Letting the market know precisely when the mortgage-backed securities would be sold makes the adjustment to the future elimination of excess reserves manageable."

Generally speaking, the Meltzer strategy offers what I perceive to be two critical criteria for a viable exit plan. One is that the winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible. The second is, of course, that the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.

It should not go unmentioned that these criteria are also features of exit plans that have been sketched by Federal Reserve officials—by Chairman Bernanke last year and by Philadelphia Fed President Charles Plosser more recently, for example. What distinguishes the Meltzer plan is less in approach and more in timing.

In fact, the Meltzer approach is similar in spirit to the Fed's Term Deposit Facility that became operational last summer. The simplified description of this facility is that it involves the Federal Reserve temporarily taking onto its own accounts the excess reserves of banks. If you want to call that account a "bad bank," you're getting close to the Meltzer plan.

Expanding just a bit, in a term deposit facility the private banking system deposits its excess reserves—an asset of private banks—with the Fed. In exchange, banks receive an asset in the form of interest-bearing "accounts," the analog of a time deposit that you might purchase from your bank. Just as you cannot spend the funds you put into a time deposit you own, banks cannot use funds deposited in the Term Deposit Facility to support credit expansion (at least not until the term of the deposit expires).

Which brings me to a point that I don't quite follow about the Meltzer plan: If reserve assets are removed from the banking system, what are the corresponding offsets on the balance sheets of private banks? My guess is you end up with something like term deposits or their economic equivalent—nonnegotiable sterilization bonds, for instance. And if you match the maturities of those deposits with the maturities of the MBS and long-term security portfolio, it becomes pretty clear that the debate is really less about tactics and more about some pretty familiar, but difficult, issues: When is it time to stand pat on policy, and when is it time to reverse course?

On this conversation, I will, as I often do, give the last word to Dennis Lockhart, our Bank's president, who spoke earlier today in Knoxville, Tenn.:

"My view of the future permits a degree of patience as regards monetary policy. There is still a halting and fragile quality to the economy. I think the process of restoration of full economic strength with higher employment continues to require support. That said, planning for an eventual change of course is completely appropriate as long as public discussion about planning deliberations and the plan itself don't create premature expectations of tightening."

Photo of Dave Altig By Dave Altig
Senior vice president and research director at the Atlanta Fed

April 8, 2011 in Federal Reserve and Monetary Policy , Inflation , Monetary Policy | Permalink


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If the American people ever allow private banks to control the issue of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered.
- Thomas Jefferson

Posted by: MC | April 09, 2011 at 05:49 AM

The difference between Meltzer's bad bank concept and Bernanke's exit is cosmetic only. If the bank's excess reserves are "off the table", i.e they can not be lent out, then their existence in the first place is arbitrary. The only real issue here is the fact that the excess reserves are the creation of the Fed (via monetary creation) in the first place. It is truly reaching Alice in Wonderland proportions. The Fed buys assets from banks with money created out of thin air, which it credits to the bank's account which is held at the Fed. It then requires such reserves remain at the Fed and can not be lent out. Then why bother? Why not just call this like it is, and allow the banks true reserves to fall below their required level? Why manufacture reserves out of thin air just to say they are there and pretend the bank's are now healthy?

Probably the single greatest error I see among virtually all economists is this notion that if the funds are not lent out, there is no "real" monetary creation" and therefore no multiple effect, and therefore no inflation. If you only define inflation as an increase in prices...that might well be true. But preventing prices from falling to their natural, market driven prices...is an inflation of prices. If supply and demand leads to an item declining to $10, but monetary policy is propping up the price to $12, that is still a 20% inflation of prices.

Looking at a free market alternative shows this plainly. If the Fed did not intervene with the massive purchase of securities, and some banks would be forced to liquidate assets, and therefore liquidate the banks...what would happen to prices then? Of course they would deflate. They were ALREADY inflated...

So why allow prices to deflate? Isn't deflation "bad"? Having inflated asset and consumer prices leads to locking up resources in assets to which capital never should have been allocated in the first place. The approaches outlined above virtually guarantees that the natural flows of capital will be slowed for some time to come. Instead of perpetuating the problem, let the short sales and over-priced homes be liquidated (as they are going to do anyway). Yes it will be painful, but then capital can resume its flow to the places it should be flowing. Having a massive portion of the capital stock in housing is not exactly a good long-term policy anyway...even if one does wish for the Fed to skew the allocation of capital.

Posted by: Chris | May 26, 2011 at 08:13 PM

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