NEW YORK - Philadelphia Federal Reserve Bank President Charles Plosser warned Monday that the Fed would go down "a dangerous road" if it were to indefinitely maintain a large balance sheet and use it as an alternative or parallel monetary policy tool.
In a speech prepared for delivery to a Bank of France conference in Paris, Plosser said the Fed should shrink its roughly $3 trillion balance sheet, which it built up in the course of buying assets to push down long-term interest rates after it exhausted its ability to cut the federal funds rate, and return entirely to pegging the funds rate as its primary means of operating monetary policy as soon as possible.
In its June 2011 minutes, the Fed's policymaking Federal Open Market Committee indicated it plans to take a sequence of "exit" steps that would accomplish just that -- eventually.
But Fed Chair Ben Bernanke said in January the whole exit process, including reductions in bank reserves, would not commence until at least "late 2014" -- consistent with the FOMC's expected period of keeping the federal funds rate between zero and 25 basis points.
One of those exit steps would be to stop reinvesting proceeds of maturing securities so as to start letting the Fed securities portfolio shrink "naturally," but gradually.
Outright asset sales, which would shrink the balance sheet more actively and quickly, are expected to happen only later in the process -- all contingent on economic conditions.
Actual, meaningful shrinkage of the balance sheet may not occur until well after the FOMC starts raising the funds rate and the rate of interest it pays on excess reserves.
And, as Plosser noted with chagrin, some think the Fed should purposefully keep a large balance sheet -- and a large amount of excess reserves -- even after the economy and the financial system fully recover to give itself an additional policy lever.
Plosser said such an approach would exacerbate a problem that already exists -- the "blurring" of the boundary between monetary and fiscal policy.
Framing the issue in prepared remarks, Plosser asked, "Do central bankers anticipate that their balance sheets will shrink to more normal levels as they move away from the zero lower bound? Is it desirable to do so? Or should monetary policy now be seen as having another tool, even in normal times?"
Plosser noted that "some have suggested that central banks adopt a regime in which the monetary policy rate is the interest rate on reserves rather than a market interest rate, such as the federal funds rate. This would then permit the central bank to manage its balance sheet separately from its monetary instrument, freeing it to respond to liquidity demands of the financial system without altering the stance of monetary policy."
"In principle, this would take pressure off central banks to shrink their balance sheets from the current high levels and simply rely on raising the interest rate on reserves to tighten monetary policy," he said.
Plosser did not say who he was referring to. Bernanke and other Fed officials have often said the Fed's ability to pay interest on reserves enables it to raise the funds rate even while maintaining a large balance sheet, but they have not explicitly advocated perpetuating a dual track monetary policy indefinitely, as have some private economists.
Plosser said "the alternative is to return to a more traditional operating regime in which the central bank sets a target for a market interest rate, such as the federal funds rate in the U.S., above the interest rate on reserves."
"Implementing this regime would require a smaller balance sheet," he said, making clear that this is his preference.
"I am very skeptical of an operating regime that gives central banks a new tool without boundaries or constraints," he said. "Without an understanding, or even a theory, as to how the balance sheet should or can be manipulated, we open the door to giving vast new discretionary abilities to our central banks."
Plosser said "this violates the principle of drawing clear boundaries between monetary policy and fiscal policy."
"When markets or governments come to believe that a central bank can freely expand its balance sheet without directly impacting the stance of monetary policy, I believe that various political and private interests will come forward with a long list of good causes, or rescues, for which such funds could or should be used," he warned.
As it is, he said, the Fed already stepped over the line into fiscal policy when it engaged in "credit allocation" favoring the housing industry by purchasing hundreds of billions of dollars worth of mortgage-backed securities.
He said its support of the commercial paper market and money market funds in wake of the Lehman Brothers bankruptcy in late 2008 was also an example of the Fed breaching the wall between monetary and fiscal policy.
Plosser said "economic theory and practice teach us that monetary policy works best when it is clear about its objectives and systematic in its approach to achieving those objectives. Granting vast amounts of discretion to our central banks in the expectation that they can cure our economic ills or substitute for our lack of fiscal discipline is a dangerous road to follow."
Plosser said the sequence of probable exit steps, or "principles," announced by the FOMC last June "represented an important first step in the FOMC's attempt to restore the boundaries between monetary and fiscal policies."
"In particular, the FOMC clearly stated its desire to return to an operating environment in which the federal funds rate is the primary instrument of monetary policy," he said. "To achieve that objective, the Fed will have to shrink its balance sheet to a more normal level."
"I interpret this as saying that our balance sheet should not be viewed as a new independent instrument of monetary policy in normal times," he said.
Plosser also approvingly noted that "the exit principles also indicated the Committee's desire to return the Fed's balance sheet to an all-Treasuries portfolio. This re-establishes the idea that the Fed should not use its balance sheet to actively engage in credit allocations."
Plosser's broader point -- one which he has made many times before -- is that the Fed and other central banks must guard their independence and not allow themselves to be drawn into helping their governments finance the huge budget deficits accumulated during the financial crisis and recession.
Deficits can only be financed through taxation, debt or printing money, he observed, and "the temptation of governments to exploit the printing press to avoid fiscal discipline is often just too great."
"Thus, it is simply good governance and wise economic policy to maintain a healthy separation between those responsible for tax and spending policy and those responsible for money creation," he said.
The central bank's main task should be maintain the purchasing power of the nation's currency, he said.
"Yet, that task can be undermined, or completely subverted, if fiscal authorities set their budgets in a manner that ultimately requires the central bank to finance government expenditures with significant amounts of seigniorage in lieu of current or future tax revenue."
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