Saving the Fed from itself

Among the priorities of the mega-plan to resurrect the financial sector should be measures to save the Fed from itself.

Yes, “save.” As in, protect its financial independence and allow it to pursue its mandate of maximum employment and stable prices without undue interference from Congress, the Treasury or, indeed, anyone eyeing a cheap buck.

(I take it we all agree that an independent central bank is good for macroeconomic stability… And that financial independence is critical for buttressing a central bank’s policy credibility.¹).

So here is the issue: Over the course of the past year, the Fed has set up numerous creative facilities to prevent a severe liquidity crisis from blowing up (entirely) our financial system. It has also acted as lender of last resort to a bunch of bankrupt financial giants that were deemed too big to fail.

In the process, the Fed has amassed a multibillion dollar collection of “stuff”, some of which toxic and already bleeding with losses. Not great for the Fed’s own finances.

But market risk is not the only source of Fed troubles. Political risk is another. For example… The Fed announced last week it plans to modify the terms of some of the mortgages which underly the residential mortgage-backed securities (MBS) the Fed acquired after bailing out out Bear Stearns and AIG. The modifications are bound to lead to losses for the Fed (though it’s hard to tell how big compared to the losses incurred if the homes were foreclosed).

Now this makes me a bit uncomfortable. Not that stemming foreclosures is not a laudable objective. It’s just that the composition of the Fed’s assets has become such as to invite requests (worthy or not) that are not only politically motivated, but have also the potential of weakening its finances.

The Fed’s purchases of Fannie and Freddie debt and MBS add to this problem. I’ve complained about this program already (here), partly on the grounds that Ben has too weak a case for picking housing as a recipient for Fed lending rather than, say, small businesses, ailing automakers or… me, for a $35,000 commode (with legs) I’ve been dying to buy.

But it goes beyond that. The MBS program subjects the Fed to more political interference and to potential losses. Why? First, it’s Fannie and Freddie we’re talking about: Our bankrupt mortgage couple! Until their status and finances are resolved, the Fed risks making losses on its MBS holdings.

Second, the accumulation of MBS in its balance sheet may complicate the conduct of monetary policy once conditions normalize. For example, “politics” may have a say as to the pace and size of MBS sales by the Fed, if these were deemed to raise mortgage rates “unduly.” Alternatively, the Fed could hang on to its MBS holdings but raise the interest it pays on banks’ excess reserves, to keep the price of credit close to target. But higher interest payments imply a cost for the Fed, again weakening its finances (esp. if higher rates result in capital losses on its longer-term MBS securities).

So what can be done about it?

Now, first of all, I myself have been crying for Bernanke to go out there and start buying toxic assets from banks’ books. The idea was to exploit the Fed’s flexibility to move fast, and its deep pockets, to finance a giant investment vehicle that would carve out the toxic assets form banks’ books. A TARP, in other words, only bigger and faster (and with a plan for capital refills at the same time).

The idea also was that, once there was an Administration in place that could actually make decisions, the Fed would transfer these assets to the government entity to whom it “belonged”—the US Treasury.

But the TARP as such never really happened and now the dialogue has advanced sufficiently to let Treasury take the lead. That is, take over (together with the FDIC) the cost of financing/guaranteeing the toxic assets and eschew the interim Fed intervention altogether.

In the same spirit, the Fed should transfer its toxic portfolios (from AIG, Bear, Citi, etc) to the “bad bank”/ Treasury. This would deliver it both from further losses and from any Congressional interference on how to manage these assets.

Finally we have the TALF. I can see the case for a TALF vehicle, financed by the Fed, if its mandate is to provide interim liquidity to support lending to solvent borrowers, and to unwind its positions once liquidity is restored. But it should be managed independently, from both the Fed’s monetary policy and from Congress. As to MBS purchases, they could occur within this independent TALF framework, rather than under an explicit policy to support housing.

The Fed’s financial position may still be robust. But the changes in its asset composition are making it vulnerable to political interference, at a time when the political heat is rising. There is no reason for the Fed to engage in policies that would open the door to (or even call for) such interference.

In fact it shouldn’t! As Marvin Goodfriend wrote back in 1994, “the Fed should perform only those functions that must be carried out by an independent central bank.”

Credit allocation is not a “must” function of an independent Central Bank in a democratic, free-market society. The Fed should arguably stay away to avoid (due) challenges to its independence.

At the same time, measures should be taken to protect its independence when that's called for: The Fed should not bear the losses from the rescues of insolvent institutions (or of overvalued sectors such as housing). It should only be in the business of providing liquidity assistance to illiquid institutions. If such bailouts are deemed "socially desirable", their cost should be assumed by the Treasury.

So let’s get the mega-plan right, and free the Fed from what it shouldn’t be doing. That’s not meant to put Ben into a straitjacket... It’s to make sure he can keep on operating without one.



Glossary: Insolvent vs. illiquid, fiscal vs. monetary authority, political vs. financial independence, straitjacket

[1] For those in doubt about the need of central bank independence, you can start by reading the 1993 paper by Alberto Alesina and Larry Summers here. On the degree of a central bank’s financial independence and its impact on the credibility of its policies, you can take a look at a recent paper by Peter Stella from the IMF here.