Sales present an unusual challenge for the Federal Reserve, because they require us to be able to make a particular kind of credible commitment. To understand this commitment, I think that it’s useful for me to talk through a situation that I see as roughly analogous.
Suppose Sarah owns two houses on the same block. Sarah decides that she wants to sell both houses. How should Sarah accomplish this change?
Clearly, if Sarah tries to sell both of her houses at once, she’s going to suffer some serious losses. The houses are on the same block, and so they end up competing with each other. Sarah needs to sell the houses slowly over time, so that they don’t compete with each other. Obviously, how slowly would depend on the particulars of market conditions. In my neighborhood right now, selling one house per year would be about the right speed.
So suppose Sarah puts one house on the market and tells everyone that she’s not going to sell the other one until a year later. Then, she sells the first house after a month. It sells at a high price, because the buyers don’t want to wait a whole year to get a house on this particular block.
At this stage, Sarah is supposed to wait a year to sell her second house. But Sarah was only planning to wait so long to sell the second house to protect the first house from competition. Once the first house is sold at a high price, she has no reason to wait. She will not fulfill her promise to wait a year.
Now think about what Sarah’s inability to wait means for her first sale. The potential buyers of the first house will all realize that they won’t have to wait a year to get a house on the same block. They will not be willing to pay a high price for the first house. And so Sarah’s lack of credibility means that the first house will necessarily sell at the same price as if she’s actually selling both houses at the same time.
The Federal Reserve faces exactly these same problems when undertaking to sell MBSs. Like Sarah, if the Federal Reserve were to sell its holdings of MBSs all at once, the sales price of the MBSs would be low. Long-term interest rates would spike up, which the Federal Reserve doesn’t want. Like Sarah, the Federal Reserve can avoid this problem by spacing its sales out over time. But just like Sarah, the Federal Reserve faces a commitment problem. The Federal Reserve wants to sell gradually in large part to ensure that its early sales of MBSs are at a high price. But once those early sales are made, the Federal Reserve has an increased incentive to sell its remaining MBSs rapidly. And as in Sarah’s case, if the market believes that the Federal Reserve will act on this increased incentive, the Federal Reserve will only be able to sell its early MBSs at a low price. Under this story, any MBS sales—no matter how small—may have big effects on long-term interest rates.
So far, sales sound pretty challenging! Fortunately, the analogy between the Federal Reserve and Sarah is incomplete. The difference gets at the very heart of what the Federal Reserve is about. Our structure—and in particular our independence from Congress and the president—means that we are set up to act in the public’s long-run interest, not to maximize short-run political or monetary gain. This structure means that, with the right set of policymakers on the FOMC, the Federal Reserve can credibly make and keep long-run commitments. Indeed, our credibility has been critical in the past crisis. Since July 2007, the monetary base has more than doubled, and the public debt has gone up by over 30 percent. At the same time, though, long-run inflationary expectations—as embedded in the prices of 5-year and 10-year inflation-indexed TIPS bonds—have moved slightly, if at all. The public and markets trust the Federal Reserve to keep inflation under control—and we will fulfill their trust.
Our structure means too that the Federal Reserve can credibly commit to selling its MBSs slowly over time. Along these lines, in testimony before Congress in late March, Chairman Bernanke described how he expected MBS sales to work. He emphasized that the timing of initiating sales, like any other move by the FOMC, would depend on its assessment of economic conditions. But once conditions are right, he suggested that the Federal Reserve could reduce its balance sheet by pre-announcing and then implementing a slow, gradual path of sales.