In January, Ben Bernanke gave a very important speech at the London School of Economics where he laid out the Federal Reserve’s strategy in fighting the forces of deflation and market illiquidity (see post with videos here). His was a strategy that took the Japanese variant of quantitative easing one further – toward what I call qualitative easing.
Earlier this decade the Japanese faced deflation in the wake of the recession after the Tech Bubble. Interest rates were already zero percent (they conducted a never before tried Zero Interest Rate Policy – ZIRP, but this proved inadequate in the face of massive deleveraging). With the recession, outright deflation was sure to follow as interest rates could be cut no more. As a result, the Japanese started quantitative easing, a technobabble term for printing money. The goal was to flood the economy with money which created inflation as the mountains of debt in Japan meant deflation could cause a downward spiral.
Fast forward to 2009 and we see Bernanke embarking on the same path. The twist however is that he has focused on the asset side of things. So while the Fed balance sheet has ballooned in both assets and liabilities, the mix of assets has changed considerably from almost all Treasuries to a bunch of Treasuries and a lot of assets of more dubious quality as well. (This chart, courtesy of Zero Hedge, shows the change). Clearly, this should leave you with a sense of unease as it is the collapse in value of these same assets which were largely responsible for the global panic last year.
One Fed President, Philadelphia’s Charles Plosser, is fed up with this and wants change.
Federal Reserve Bank of Philadelphia President Charles Plosser said the central bank should limit the securities on its balance sheet to Treasuries and create a policy for serving as lender of last resort.
The Fed’s emergency-credit programs and inconsistency in bailout decisions created confusion and showed the central bank “lacked a well-communicated, systematic approach,” Plosser said yesterday in a panel discussion at Palo Alto, California. Policy rules “would yield better economic outcomes for both monetary policy and financial stability policy,” he said.
Plosser’s comments rank him among the strong internal critics of the Fed’s efforts to stem the worst financial crisis in seven decades. The Fed “strayed into credit allocation” that should be the purview of fiscal authorities, not the central bank, he said at Stanford University.
“Developing such a systematic approach is not easy,” Plosser said at a forum hosted by the Stanford Institute for Economic Policy Research.
“Making a credible commitment to stick to such a lending policy in good times and bad is even more difficult,” he said. “Nevertheless, that is what we must tackle if we are going to achieve better results the next time a crisis arises.”
In effect, Charles Plosser is saying that the Federal Reserve become the handmaiden of the executive branch, conducting fiscal policy on its behalf. This is a clear no-no and the major reason the federal reserve has received so much scrutiny.
In my July post “Is quantitative easing really inflationary,” I said the following:
Because the Federal Reserve has been acting in concert with the executive branch since the credit crisis began, many are beginning to question its quasi-fiscal role in supporting the wider financial system with bailouts, subsidized borrowing, guarantees and liquidity. Add in the QE and a ballooning Fed balance sheet as the central government deficit spends and you have an organization that seems to be acting on behalf of the executive branch.
I gather Plosser agrees with this assessment given his recent remarks. If the Fed wants to remain independent, or at a minimum resist the legislative branch’s desire for greater oversight, it needs to get rid of these toxic assets and stay out of fiscal policy for good. How the Fed disposes of these junk assets is the $1.25 trillion question.
Originally published at Credit Writedowns and reproduced here with the author’s permission.
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