Philly Fed’s Plosser Not Keen re PPIP, Fed’s Quasi-Fiscal Role

The Financial Times has a brief write up of an interview with the head of the Philadelphia Fed, Charles Plosser. His remarks seem more anodyne than they really are:

The Federal Reserve should not be involved in financing toxic assets that date from the bubble era, Charles Plosser, president of the Philadelphia Fed, has told the Financial Times.

“I think it is a bridge too far,” said Mr Plosser, arguing that such proposed Fed loans would expose the US central bank to credit risk and tie up a sizable chunk of its balance sheet in long- term assets that would be hard to price and liquidate.

The Fed agreed to consider providing investors with loans to buy these assets – including bubble-era subprime securities – as part of a wider effort to clean up bank balance sheets involving the Treasury and the Federal Deposit Insurance Corporation.

His comments challenge Fed chairman Ben Bernanke’s view that the Fed can help to restart trading in these assets without unduly limiting its balance sheet flexibility or taking on too much credit risk, once haircuts on loans and Treasury risk capital are taken into account…..

“I have reservations about the Fed intervening in private credit markets as a matter of principle. I think it confuses monetary and fiscal policy,” Mr Plosser said.

Willlem Buiter has been characteristically blunt on this topic:

I consider this use of the Federal Reserve as an active (quasi-)fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US.

There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – taxpayers’ money.

As for the Fed’s independence (whatever independence remains), first, even if the central bank prices the private securities it purchases appropriately (that is, there is no ex ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player or a debt collector. The ex post transfers or subsidies involved in writing down or writing off private assets are (quasi-)fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework.

Of course, given that the signals are increasingly that the PPIP is dead on arrival, Plosser’s opposition is a mere shot across the bow. The Fed, after all, has entered into such a myriad of “rescue the market” arrangements that it is hard to keep tabs on them.

But his other comments were noteworthy as well:

By contrast, Mr Plosser is less concerned than some of his colleagues about buying government debt. “I do not think that buying Treasuries is more inflationary than buying mortgage-backed securities,” he said, while operating in the Treasury market carried fewer costs.

He said the Fed needed to focus on the medium to longer term rather than the short term, and ensure it was in a position to raise rates when it needed to in order to prevent excessive inflation.

Mr Plosser cares about the overall size of the Fed balance sheet but he said facilities involving short-term loans should be allowed to fluctuate, at least in the short term, based on market demand without the Fed feeling the need to offset them to maintain a target balance sheet size.

“We still have $500bn to $600bn to go in planned asset purchases, so I am not too worried,” he said.

Mr Plosser is much less confident than the Fed leadership that a large projected gap between demand and supply will offer strong protection against post-crisis inflation. He said this was the mistake made in the 1970s.

Real-time estimates of spare capacity were unreliable, he said. “We have had a tremendous shock to the financial sector and to the housing sector. It could lower the level of potential output even if it does not change the potential growth rate very much.”

However, one factor in the new inflation worries that has not gotten much attention is that credit is shrinking despite the Fed’s Herculean efforts. As Marshall Auerback noted via e-mail:

Before this rise in Treasury yields, bank loans and credit was declining. Now it is declining at an even faster pace. Indeed, bank credit is declining at the fastest pace on record and this is also the case when commercial paper issues are added to bank credit. Moreover, these increased yields are occurring when the economy is still in recession.

True. like japan, they will probably reverse soon when the technicals have run their course and the reality of an extended period of 0 rates sets in.

While the Fed’s balance sheet is still nearly two and a half times the size it was a year ago, it has shrunk by $102b since the end of 2008. Total assets held by US commercial banks have also shrunk by $50b through mid May. Commercial banks are still sitting on $1tr in cash reserves, just as they were at the turn of the year. They have been unwilling to lend those reserves or invest them in securities like Treasuries. No doubt, banks are bracing for further loan losses from credit cards, commercial real estate, and the continuing home price deflation.

Contracting credit hasn’t gotten the attention it deserves, and with good reason. The powers that be are keen for banks to get as much private fundraising done as possible, so nary a negative word will be said. The Treasury was shockingly open in saying the objective of the stress tests was to restore confidence, and all of the shenanigans confirmed that it was an exercise in form over substance. That speaks volumes as to what the real priorities are right now.