Among the many questions surrounding the Federal Reserve's program of quantitative easing is what will happen to the vast stockpile of bonds it has built up in its efforts to lower interest rates. A new paper from two former advisers to the bank suggests a potential plot twist.
The problem with the Fed's pile of assets is that it has a corollary in the form of a hoard of cash kept at the Fed by banks. Banks have long been required to deposit reserves at the central bank to ensure they can meet their daily obligations. But since the Fed began buying bonds from them, usually by crediting the accounts in which their reserves are held, this stash has swollen to around $2.6 trillion.
The problem is that there are so many dollars sitting idle that they risk interfering with the Fed's conventional method for setting short-term interest rates. In the past, the Fed would raise what is known as the federal funds rate by selling assets and thus draining the supply of reserves, forcing banks who need more to borrow from others. But this won't work if banks have so much cash they need never borrow.
Happily, in 2008 the Fed received the authority to push up interest rates in another way, by paying banks interest on their reserves. In their paper Brian Sack and Joseph Gagnon argue that the Fed should stop worrying about the federal funds rate, and instead focus on this new tool.
This would have several advantages. First, the banks could keep their huge reserves, and could worry less about running short of cash. Second, if panic selling were affecting a certain financial instrument, the Fed could intervene by buying it without worrying whether the reserves it creates in the process send interest rates down sharply.
To some, that may be a reason to oppose the idea: During the crisis the Fed waded into unfamiliar markets as a last resort, and has in theory been trying to extract itself ever since. The new proposal looks a lot like institutionalizing what is supposed to be an aberration.
But for the time being, the Fed will have to continue using such measures, since it will probably need to raise interest rates long before its balance sheet returns to normal. If it likes what it sees, supersized may be the new normal.
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