Free the Fed! -- to issue bonds: Christopher Swann

-- Christopher Swann is a Reuters columnist. The views expressed are his own --

By Christopher Swann

NEW YORK (Reuters) - The powers of the Federal Reserve have become so vast that the central bank could almost qualify as the fourth branch of government.

Its balance sheet has more than doubled to an imposing 14 percent of gross domestic product, and President Obama wants to endow it with ever greater regulatory control. But there is one basic central banking prerogative that the Fed still lacks: the right to issue its own bonds. The reluctance of Congress to confer this authority may end up retarding America's economic recovery.

Bond issuing privileges will be increasingly important for central banks worldwide because they offer the neatest way of mopping up the vast amounts of liquidity they have pumped into the financial system. Bank chiefs with this right will find it easier to pivot when the economy revives, tightening monetary policy swiftly to avoid any inflationary threat. Knowing that they have this policy dexterity makes it easier to justify bold action now to stimulate growth.

Several months ago, Ben Bernanke and other Fed officials made no secret that they coveted the ability to issue bonds, which most other major central banks take for granted. Sensing pushback from lawmakers -- many of whom are intimidated by the Fed's expanding muscle -- they have discreetly dropped this request. This was a mistake.

There is strong evidence that the Fed may now have to rely on lesser tools when the time comes to drain liquidity. The Fed will face several challenges. First, it may not be immediately able to flog off the mountain of assets it has accumulated before it raises rates. Many of these securities are illiquid and selling off Treasuries may unnerve markets and push up rates.

To tighten policy before shrinking its balance sheet, the Fed's chief method will probably be to raise the interest it pays on commercial bank reserves. If the Fed offers risk-free rates to banks, it would make little sense for them to lend at a lower rate to each other in the interbank market. This should in theory put a floor under the fed funds rate.

In practice, however, there are institutions like Fannie Mae that are not paid interest on deposits at the Fed and that can be expected to put any extra liquidity to use in the interbank bank market. When the Fed started their credit easing program, this flaw deprived them of their previous pin-point mastery of the funds rate.