« links for 2011-04-08 | Main | A Coincidence? »

Saturday, April 09, 2011

Fed Watch: Meltzer, Part II

Tim Duy follows up his post about Allan Meltzer:

Meltzer, Part II, by Tim Duy: David Altig gives Allan Meltzer a more charitable read than I did:

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.

I take Altig seriously, but believe he is giving Meltzer far too much credit.

First off, there is nothing in the Meltzer plan that keeps the excess reserves “locked up.” Instead, Meltzer claims that simply moving a portion of the assets and corresponding liabilities off the Fed’s balance sheet onto another bank’s balance sheet somehow magically changes the monetary situation. From the Wall Street Journal:

The Fed's current operating balance sheet would be back to a more manageable range of about $1 trillion. This proposal removes some of the risk of inflation by removing some of the bank reserves that threaten to fuel it.

This seems pretty clear – Meltzer suggests that bank reserves that are not “officially” part of the balance sheet are no longer available to fuel inflationary pressures. Why? If we split the Fed in half, call one part the “official” Fed, and the other part the “bad” Fed, does the aggregate size of the balance sheet change? Does the aggregate amount of excess reserves change? I don’t see how.

Altig, in the above quote, shows a preference for an orderly plan to wind down the balance sheet. I agree, but think there needs to be flexibility to wind down quickly should the need arise. Meltzer’s plan does not offer that flexibility:

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.

Again, Meltzer implies that if he simply changes the location of the assets, that if they are not “official Fed assets,” they magical change from inflationary to inert. Moreover, he ensures that the assets are not available for immediate sale should it become necessary, thereby depriving the Fed of one tool to rapidly drain reserves.

What I suspect is that Meltzer does not trust the Fed to reduce the balance sheet and thus seeks to create a mechanism that forces it to do so. He thinks this reduces the inflationary risk; I would say just the opposite.

Altig then nails down the fatal flaw of the Meltzer plan:

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?

The potential problem is that the excess reserves held by private banks do not have to stay at the Federal Reserve – they are free to leave and becoming new lending. Something needs to occur to draw them into the Fed, or any quasi-Fed bad bank. If you want to take away one asset, cash, you need to give them another. It is not an issue of Altig not being able to “follow the Meltzer plan.” Again, he is giving Meltzer too much credit. Meltzer simply does not address this issue. In contrast, Altig does address this issue, and his post contains numerous example of mechanisms, either directly or indirectly through links, to draw excess reserves into the Fed. For example:

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?

Exactly. Meltzer offers nothing new, just another voice that saying the Fed needs to act sooner than later. Otherwise, he is empty of new ideas. The Federal Reserve staff have already devised a number of actual and potential tools to drain reserves, all of which can be done without creating a “bad” bank. Meltzer offers up an accounting slight of hand that fails to address the key issue of what will prevent private banks from lending out the excess reserves rather than parking them at the Fed. That hole – the crux of the issue – is filled by Altig.

    Posted by on Saturday, April 9, 2011 at 12:15 AM in Economics, Fed Watch, Inflation, Monetary Policy | Permalink  Comments (2)


    Feed You can follow this conversation by subscribing to the comment feed for this post.