It concerns me that liquidity is omnipresent on bank and corporate balance sheets, and yet it is not being used to hire American workers.

It also concerns me that the most recent Lipper/AMG financial market data show year-to-date flows into virtually all asset classes except money market funds. The flows are strong into every category: high-risk to low-risk bond vehicles, taxable and nontaxable, domestic and external, fixed and floating rate, and, of course, commodities. Margin debt remains shy of 2007 highs but is fast approaching levels that prevailed before the NASDAQ implosion in 2001; in fact, margin-account debit balances as a percentage of the market capitalization of the S&P 500 now exceed the precrash level of 1987 and 2001.

Junk yields are at their lowest levels since October 2007. And the leveraged buyout market is back to paying 2006 levels of EBITDA (earnings before interest, taxes, depreciation and amortization) of 6 to 8.5 times, with the recent announcement of Carlyle Group’s reported 11 times EBITDA purchase of Syniverse Holdings echoing the peak of the precrash craze. As you know, buyout people do not typically acquire companies with a plan to expand the workforce, but instead with an eye to tighten operations, drive productivity, rejigger balance sheets and provide an attractive payback, usually in shorter time than under normal corporate horizons. And the corporations I talk to that are eyeing possible acquisitions with their surplus cash and ready access to the credit markets are not given to thinking of strategic acquisitions as a way to expand payrolls.

In sum, scanning the business landscape and the conditions of the financial markets, I concluded as a golfer that the greens are playing very fast and must be approached with great caution. At a minimum, I concluded, the committee would need to be very careful in how we calibrated our next strokes, lest we overplay it.

I fully understand the theoretical impulse to drive long-term interest rates to lower levels in hopes of stimulating loan demand and challenging the propensity for economic actors to hoard rather than invest. Given that foreign exchange markets react to interest rate differentials between countries, one effect of engineering lower rates would be to devalue the dollar, presumably to create demand for exports. The ultimate objective would be to advance final demand, generate employment for American workers and revive output.

In fact, right now the economy and banking system are awash in liquidity with trillions of dollars lying idle or searching for places to be deployed or, perhaps more recently, going into inflation hedges. Dumping another trillion dollars into the system now will most likely mean they will follow the same path into excess reserves, or government securities, or “safe” asset purchases. The effect on equity prices is likely to be minor as well. There simply is no strong evidence the additional liquidity would be particularly effective in spurring new investment, accelerating consumption, or cushioning or accelerating the deleveraging that is hopefully winding down.

We've done a lot in terms of monetary policy. We continue to look at the options in either direction, but I am wary of how effective [further asset purchases] would be at this juncture.

Some Fed officials regret the U.S. central bank's decision to purchase $300 billion in longer-term Treasury securities during the crisis because it suggested the Fed was prepared to fund the U.S. fiscal shortfall, Fisher said.

Yes, I think that you're right that shrinking the balance sheet is akin to a monetary tightening...  You sell mortgages on the market, you're going to tend to raise mortgage rates, for example, and that will tend to tighten the housing market and slow the economy.

...

...We certainly don't want to hold this stuff 30 years. So the key here, I think, is, when we do come to the point we want to sell assets, is to do it in a gradual and predictable way so it has minimal impact.

Even when we get back to the pre-crisis balance sheet, we'll still be able to manage the short-term interest rate and the federal funds rate, much as we have in the past, so, if the economy needs stimulus, we'll still be able to do that. But we just won't be doing it through the balance sheet.

...

But, again, my expectation is that sales would be slow, gradual, announced in advance, and would not create undue market impacts. 

You mentioned adding insult by selling into a weak market. Of course, in a situation where we'd be selling, this would be one where we'd be trying actually to tighten policy because the economy was back on a growth track and we were trying to avoid future inflation risks.  So we wouldn't be doing that in a really weak economy.

During the Q&A session

The asset purchases are being financed by reserve creation, or ‘printing money.’  The monetary base has expanded rapidly.  In contrast to the liquidity programs, the expansion of the monetary base associated with the asset purchase program is likely to be very persistent.  This has created a medium-term inflation risk.

“When we get to the point where we feel like we need to reduce bank reserves, we will have a number of options to choose from,” he said to reporters.
“The natural place to start is asset sales,” he said.  “It is the one, to my mind, that we are the most sure that it would bring about a reduction in our monetary liabilities.”

From the Q&A session, as reported by Bloomberg News

Although the Federal Reserve's approach also entails substantial increases in bank liquidity, it is motivated less by the desire to increase the liabilities of the Federal Reserve than by the need to address dysfunction in specific credit markets through the types of programs I have discussed. For lack of a better term, I have called this approach "credit easing." In a credit-easing regime, policies are tied more closely to the asset side of the balance sheet than the liability side, and the effectiveness of policy support is measured by indicators of market functioning, such as interest rate spreads, volatility, and market liquidity. In particular, the Federal Reserve has not attempted to achieve a smooth growth path for the size of its balance sheet, a common feature of the quantitative-easing approach.

Still, draining reserves at some point also will be an aspect of exiting. The large volume of reserves is contributing to the loose relationship of our deposit rate and market rates. In addition, although to date the high volume of reserves evidently has not increased bank lending or reduced spreads of rates on bank loans or other assets relative to, say, Treasury rates, it could begin to do so if banks start to perceive the risk-adjusted returns on loans as superior to our deposit rate. An increase in lending and narrowing of spreads on bank loans is a necessary and desirable aspect of the return to better-functioning markets and intermediation to promote economic growth. But spreads eventually could become narrower than what would be consistent with underlying risk, and lending could grow more quickly than appropriate for price stability if very high levels of reserves remain in place. We are developing new techniques for draining reserves, including reverse repurchase agreements against mortgage-backed securities and time deposits for banks at the Federal Reserve. And, of course, we retain the option to sell securities from our portfolio on an outright basis. The range of tools will permit us to drain large volumes of reserves if necessary to achieve the policy stance that fosters our macroeconomic objectives.

Our framework for {the large-scale asset purchase} aspect of our credit policies relied on preferred habitats of investors and imperfect arbitrage. There was ample evidence that private agents had especially strong preferences for safe and liquid short-term assets in the crisis; in those circumstances, sizable purchases of longer-term assets by the central bank can have an appreciable effect on the cost of capital to households and businesses. The marked adjustments in interest rates in the wake of the announcements of such actions, both in the United States and elsewhere, suggest that market participants also saw them in this light.

St. Louis Fed President James Bullard, speaking to reporters in Little Rock, Arkansas, said “it might not be necessary” {to purchase the full amount of MBS by year-end}.

…

While purchasing the full amount of $1.25 trillion in mortgage-backed securities may not be necessary, “even if we stop short, it would be close,” Bullard, 48, told reporters after a speech.

As reported by Bloomberg.

I think what we’re going to have to do is sell off the mortgage-backed securities portfolio as appropriate when the time comes. That would be a difficult decision to make. It would put upward pressure on interest rates. You wouldn’t want to do it too soon, but that’s what we’re going to have to do in order to work down this very large set of assets that we have on our balance sheet… At some point in the future we may have to start selling off as appropriate.

As reported by Bloomberg Audio.

[C]oncern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature...Why do I believe it is so important to explain the issue of “how” having just argued that “when” is not yet a pressing issue? The reason is that if people believe—correctly or incorrectly—that the Federal Reserve could have a problem managing a smooth exit from its accommodative policy stance, this belief alone could have the adverse effect of causing inflation expectations to become less well anchored and risk premia on long-dated debt securities and loans to rise. These effects could conceivably make it more difficult to generate a sustainable economic recovery.

The program {asset purchases} appears to be having its intended effect. Yields on mortgages relative to Treasury yields have come down since November 2008...[T]he 30-year fixed mortgage rate relative to the 5-year constant maturity Treasury rate benchmark has declined about 1-1/4 percentage points since the first MBS purchase program was announced. Indeed, today mortgage spreads are a lot closer to their mean for 2000-2007 than they were in November. That said, mortgage rates have recently risen with the increase in Treasury rates.

In our open market operations, we have embarked on large-scale purchases of intermediate- and long-term Treasury securities, agency debt, and agency-guaranteed mortgage-backed securities (MBS) in order to put further downward pressure on borrowing costs, greatly increasing the degree of maturity transformation on our balance sheet. In addition, our traditional liquidity operations have been extended to include new borrowers and new markets, with the potential for greater credit risk than usual.

...

In open market operations, we have announced our intention to purchase up to $1.75 trillion in longer-term Treasury notes and bonds, agency debt, and agency MBS during this year. This program is intended to stimulate real economic activity by holding down intermediate- and long-term interest rates by bringing down the term premium on these securities--a mechanism that is distinct from the traditional channel whereby a shift in the stance of monetary policy affects longer-term yields by changing the expected path of short-term interest rates.⁵ The preliminary evidence suggests that our program so far has worked; for example, our announcements regarding the large-scale asset purchase program coincided with cumulative restraint on the average level of longer-term interest rates, perhaps by as much as 100 basis points by some estimates.