However, our newly purchased Treasury securities and MBS will not mature or be repaid for many years; the loans we are making to back the securitization market are for three years, and their nonrecourse feature could leave us with assets thereafter. But we have a number of tools we can use to absorb the resulting reserves and raise interest rates when the time comes. We can sell the Treasury and agency debt either on an outright basis or temporarily through reverse repurchase agreements, and we are developing the capability to do the same with MBS.

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs.  To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities.  Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize.  In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize...

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline..  A significant shrinking of the balance sheet can be accomplished relatively quickly. .. as the various programs and facilities are scaled back or shut down.  As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters.  Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term, which will slow the rate at which our balance sheet can shrink.  We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

Moreover, other tools are available or can be developed to improve control of the federal funds rate during the exit stage.  For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control.  Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system.

Among the programs in force is the direct purchase of agency (Fannie Mae, Freddie Mac, etc.) notes and mortgage-backed securities. These securities are directly linked to mortgage rates. Purchases began just a few days ago. The goal of such a program is not, in my view, to engineer a particular interest rate level, that is, to hit a particular rate target. But direct purchases can promote directionally lower rates, help restore normal market functioning, and thereby achieve a return to reliance on private sector market-based credit allocation.

The introduction of targeted asset-side measures has been aimed squarely at the breakdown of credit markets, the circulatory system of our modern economy. In my view, a precondition of economic recovery is the return of the normal functioning of credit markets.

The Federal Reserve Act confines the System's outright asset purchases to securities issued or guaranteed by the U.S. Treasury or U.S. agencies. Even so, the Fed has the potential to use its balance sheet to restore functioning in other impaired financial markets. The recently announced Term Asset-Backed Securities Loan Facility (TALF) provides a model for doing so. This new Fed facility is designed to spur lending to meet the credit needs of households and small businesses. The facility will support the issuance of securities collateralized by auto, student, credit card, and Small Business Administration (SBA) loans—sectors where the issuance of new securities has slowed to a trickle. The high borrowing spreads on such securities, even when the underlying loans are government-guaranteed—as in the case of SBA and many student loans—suggest not only heightened credit risk but also an impairment of market liquidity which the facilities can address. The inability of financial institutions to securitize such loans, and of potential investors in such securities to borrow against them on reasonable terms, reflects an important breakdown in credit markets. By improving the functioning of markets for securitized assets, the Fed has the potential to boost private-sector credit flows in support of the economy. Under the TALF, which is a joint Federal Reserve-Treasury initiative, the Fed has agreed to provide nonrecourse loans to holders of eligible highly rated asset-backed securities. Cooperation with the Treasury is necessary because the program entails some risk of loss and, under the Federal Reserve Act, all Fed lending must be appropriately secured. The Treasury has committed $20 billion of TARP funds to protect the Fed against losses on the Fed's lending commitment of up to $200 billion.

You will note that the emphasis of our activities has been on expanding the asset side of our balance sheet—the left side, which registers the securities we hold, the loans we make, the value of our swap lines and the credit facilities we have created. We feel this is the correct side to emphasize. The right side of our balance sheet records our holdings of banks’ balances, Federal Reserve Bank notes or cash (currently over $830 billion) and U.S. Treasury balances.

When the Japanese economy went into the doldrums, the Bank of Japan emphasized the right side of its balance sheet by building up excess reserves and cash, only to find that accumulation did too little to rejuvenate the system.

As I said earlier, in times of crisis many feel that the best position to take is somewhere between cash and fetal. But it does the economy no good when creditors curl up in a ball and clutch their money. This only reinforces the widening of spreads between risk-free holdings and all-important private sector yields, further braking commercial activity whose lifeblood is access to affordable credit. We believe that emphasizing the asset side of the balance sheet will do more to improve the functioning of credit markets and restore the flow of finance to the private sector. In the parlance of central banking finance, I consider this a more qualitative approach to “quantitative easing.” It is bred of having learned from the experience of our Japanese counterparts.

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

But Stern said the so-called "money multiplier" effect of the expanded Fed balance sheet is less than it otherwise would be because of banks reluctance to lend in an uncertain economic and financial environment.

     "There certainly are a lot of excess reserves around, no question about that," he said. "That's a testimony to the caution and the desire to preserve liquidty and capital" among financial institutions.   "And uncertainty is very high," he continued. "People are concerned about the value of assets; that means for transactions the value of collateral. They're worried about the positions of their counterparties."

This expansion of the scope and scale of Fed lending may not have been so large had we had better resolution mechanisms to deal with such failing firms as Bear Stearns and AIG. And perhaps our lending would not have become so wide-ranging had there been better regulation or more resiliency in the payment and settlement systems, including more transparency about the markets for mortgage-backed securities and credit default swaps.
...

Some may think access to the Fed's lending facilities should be permanently expanded to include a wide range of financial institutions. I believe such expanded access to central bank credit would raise significant issues of moral hazard that would need to be addressed. And I have urged that we must continue to avoid compromising the Fed's independence — one of the great strengths of central banks.

Some people might think that expanding the Federal Reserve's regulatory and supervisory authority and giving it a sweeping mandate for financial stability would prevent the types of financial crises we have been experiencing this year. That is unrealistic.

...

Going forward our focus should be on better regulation, not necessarily more regulation. We need to focus on ways to strengthen our financial markets to make market discipline more effective at mitigating systemic risk. We should think about which financial markets are critical to the efficient functioning of the payment system rather than focusing on individual firms. Ideally, we need to determine which aspects of the financial system are critical and then make sure we have the market mechanisms, regulations, and supervision to ensure those sectors are resilient.

You can see the size and breadth of the Fed’s efforts to counter the collapse of the credit mechanism in our balance sheet. At the beginning of this year, the assets on the books of the Fed totaled $960 billion. Today, our assets exceed $1.9 trillion. I would not be surprised to see them aggregate to $3 trillion—roughly 20 percent of GDP—by the time we ring in the New Year. The composition of our holdings has shifted considerably. Previously, almost 100 percent of our holdings were in the form of core holdings of U.S. Treasuries; today, less than a third are. The remainder consists of claims deriving from our new facilities.

Normally, most central banks supply and absorb reserves primarily in the safest and most liquid parts of the money markets.  In these segments of the markets they can operate in size without distorting prices, and without preferential treatment for certain private borrowers or forms of collateral. The private sector then distributes the reserves around the markets--across counterparties, maturities, and degrees of creditworthiness. The resulting transactions enhance market liquidity and allow private market participants to allocate credit and determine the appropriate compensation for taking risk.

I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market--or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets. In fact, several of the Federal Reserve's new programs are designed to be self-liquidating as markets improve. Minimum bid rates and collateral requirements have been set to be effective when markets are disrupted but to make participation uneconomic when markets are functioning well. Under current law, our facilities for investment banks that don't involve securities eligible for open market operations (OMO-eligible paper) will necessarily be wound down when circumstances are no longer "unusual and exigent"; I'll come back to questions about these facilities in a minute.

However, the Federal Reserve's auction facilities have been an important innovation that we should not lose. They have been successful at reducing the stigma that can impede borrowing at the discount window in a crisis environment and might be very useful in dealing with future episodes of illiquidity in money markets. The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order. The latter might require that we allow the auction to set the price without a constraining minimum, but a small auction should not distort the allocation decisions of private participants.

[A shortage of Treasury securities] is not one of the things I'm worried about.

From audience Q&A as reported by Bloomberg News.

It is appalling where we are right now. [The Fed has introduced] a backstop for the entire financial system.