Needed: A Federal Reserve Exit from Preferential Credit Allocation
As Jeffrey Hummel (2014) notes, there is a “real danger” that the Fed feels “no real need to normalize its balance sheet and therefore may not do so.” In that case, to remove the Fed from preferential credit allocation, Congress would have to require it to normalize. Declarations by FOMC officials that they will act according to self-adopted “guidelines” are not time consistent. Fed leadership will find ample good reasons to use preferential credit allocation when the time comes to offset weakening in housing finance or other perceived threats to financial stability. To paraphrase what Buiter has said about a former Treasury official and moral hazard, Fed officials address the issue of undoing the Fed’s huge holdings ofmortgage-backed securities only when they feel the need to defend their continued preferential credit allocation by declaring that “now is not the time to worry about it.” On the contrary, the moment when sticking to a principle seems difficult is exactly the time to worry about the long-run consequences of breaching it.
A straightforward way to separate the Fed from preferential credit allocation among sectors of the private economy, without major changes to the institutional status quo, is to require the Fed to hold only U.S. Treasury obligations on its balance sheet, as recommended by Marvin Goodfriend.