House Panel to Ask Experts About Unwinding Stimulus

The House Committee on Financial Services, chaired by U.S. Rep. Barney Frank (D-Mass.) will soon meet to consider when would be the best time to unwind the stimulus by the Federal Reserve. The hearing, titled "Unwinding Emergency Federal Reserve Liquidity Programs and Implications for Economic Recovery," was scheduled for Wednesday, but was postponed because of weather conditions in Washington, D.C. The capital is forecast to receive 10 to 20 inches of snow between Tuesday and Wednesday, on top of the 2 feet that fell last weekend.Federal Reserve Chairman Ben Bernanke will be first up on the agenda. Based on the Federal Open Market Committee statement of Jan. 27, Bernanke likely will repeat the information about the stimulus programs that have already wound down or are near their end, but likely won't call for an immediate move toward raising interest rates to avoid inflation. The FOMC said, "Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls."

The FOMC also said, "With substantial resource slack continuing to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time." Both statements seem to indicate that the Federal Reserve will not make moves toward tightening the money supply and raising interest rates any time soon.

But Bernanke likely will outline the plans he has to unwind the stimulus when the time comes. He laid out those plans in detail at a speech on Oct. 8 as part of the Federal Reserve Board Conference on Key Developments in Monetary Policy in Washington, D.C. At that time, Bernanke indicated that while economic conditions were not right for unwinding the stimulus, the "ability to pay interest on reserves should be sufficient to allow the Federal Reserve to raise interest rates and control money growth."

Carefully Draining the Excess Liquidity

Since October 2008, the Fed has had the authority to pay explicit interest on the reserve balances banks hold. By raising these rates, the Fed will encourage banks to increase their excess reserves. This gives the Fed the ability to vary the amount of our money held by banks, as well as the federal funds rate.

He then went on to explain the three steps the Fed would use to unwind the stimulus:
  • Large-scale reverse purchase agreements (reverse repos), which involve the sale by the Federal Reserve of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date. These reverse repos drain liquidity from the money supply as purchasers transfer cash to the Fed.
  • Offer term deposits to banks. These are similar in concept to the Certificates of Deposit offered by banks to their customers. Money held in such term deposits would not be available to the federal funds market.
  • Reduce reserves by selling a portion of its holdings of long-term securities in the open market.
"Each of these policy options would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy," Bernanke explained in his speech. He added that the Fed has a wide range of tools for tightening monetary policy when necessary. "We will calibrate the time and pace of any future tightening, together with the mix of tools, to best foster our dual objectives of maximum employment and price stability."

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, echoed Bernanke's exodus plans when he spoke about the new tool of interest on bank reserves as just another weapon in the arsenal available for unwinding the stimulus. In a speech before the Maryland Bankers Association on Jan. 8, he said that during the recovery period, there will be a risk of inflation edging upward, which has occurred during some past recoveries. He believes the risk appears to be minimal right now. But, he said, "we will have to be careful as the recovery unfolds to keep inflation and inflation expectations from drifting around."

Based on both the FOMC statement of Jan. 27 and Lacker's January speech before the Maryland Bankers Association, it's likely Bernanke will say it's not time to unwind the stimulus, but that the Federal Reserve has the tools that it needs in place to do so when the time comes.

Round Two: A Lively Debate About Monetary Policy


Following Bernanke's testimony, a second panel will offer their opinions to the committee. The economic luminaries scheduled to speak are: Marvin Goodfriend, professor of economics and chairman of the Gailliot Center for Public Policy at Carnegie Mellon University; Jan Eberly, John L. and Helen Kellogg professor of finance at the Kellogg School of Management, Northwestern University; Richard Koo, chief economist, Nomura Research Institute; Laurence Ball, professor of economics at Johns Hopkins University; and John B. Taylor, Mary and Robert Raymond professor of economics at Stanford University.

While DailyFinance did contact each of these people for comment on their intended testimony, none responded. Instead, we look at what some of these people have said publicly about the stimulus in the past.

Goodfriend, in an interview on the Pittsburgh television show Our Region's Business on Oct. 14, 2009, indicated that he thought the stimulus was moving too fast. He said, "When money comes from the Fed, we all worry about inflation coming down the road." He thinks of inflation as a tax of its own. In Goodfriend's opinion, the Fed needs an agreement with Congress and the Treasury department on a inflation target.

Koo, by contrast, will likely discuss his theory of "balance-sheet recession," based on Japan's experience over the past 15 years. He believes that even though the Bank of Japan brought interest rates down to zero and did massive quantitative easing, it had no impact because of a balance-sheet recession. He explains that this happens because the "private-sector companies are no longer maximizing profits; they are minimizing debt." He calls this "balance-sheet-repair mode."

He believes government fiscal stimulus saved Japan from a Great Depression and thinks GDP never fell into a deflationary spiral because of government spending and borrowing. While he thinks Japan is finally on the exit side of the balance sheet recession, it took too long to recover because in 1997, "Japan made that stupid mistake of cutting our deficit, and that lengthened our suffering for five years." He thinks a country "can't repair the government balance sheet until the private sector starts to borrow again."

So Koo will likely call for caution before the U.S. starts unwinding its stimulus and working on deficit reduction. He says, "In this type of recession, government has to be in there in a sustained fashion to take this entire excess savings in the private sector and put that back into the income stream." The government must stimulate the economy "until the private sector deleveraging is over."

Tyler will likely repeat views similar to those he expressed in a September 2009 op-ed piece in The Wall Street Journal, in which he explained why the stimulus hadn't worked. He said "there was no noticeable impact on personal consumption" when the government implemented temporary changes in income with various transfer and rebate payments. He suggested that the largest contribution to improvement in the GDP was private investment that "went from minus 9% to minus 3.2%, an improvement of 5.8% and more than enough to explain the improved GDP growth." He pointed to investments by private business firms in plant, equipment and inventories rather than residential investment as "the major contributors to the investment improvement." Based on his previous comments, he will likely favor a government exodus from stimulus programs as quickly as possible, but will likely support any package that encourages more business investment.

Ball is one of the co-authors of "The Deficit Gamble." This paper focuses on the historical behavior of interest rates and growth rates in the U.S. The authors think "the government can, with a high probability, run temporary budget deficits and then roll over the resulting government debt forever." While the authors say they "do not imply that deficits are good policy" and note that an attempt to roll over debt forever might fail, they do believe that the adverse effects of deficits "occur with only a small probability."

Based on this diversity of views, it looks like that second panel discussion will be much more lively than the first with Bernanke. Yet since this will be Bernanke's first Congressional testimony since he was sworn in for a second term as chairman of the Federal Reserve, House members will likely have a lot of questions about his plans for the Fed.

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