Federal Reserve Power Unsupported by Credibility

Federal Reserve Power Unsupported by Credibility

By
Henry C.K. Liu

Part I: No Exit

This article appeared in AToL on September 11, 2009 as Boogged Down at the Fed

Ben S. Bernanke, a Republican who was first appointed by President Bush nearly four years ago as Chairman of the Board of the Federal Reserve, has been reappointed to a second term by Democratic President Obama. The announcement during the President’s summer vacation in Martha’s Vineyard served to divert attention from unwelcome figures released on August 25 by the White House budget office that forecast a cumulative $9 trillion fiscal deficit from 2010-2019, $2 trillion more than the administration estimated in May. The federal government will spend $2.98 trillion in fiscal 2009, $3.766 trillion in fiscal 2010 and $5.307 trillion in fiscal 2019, all substantially more than projected revenue.

Moreover, the figures show the national debt doubling by 2019 to $20.78 trillion, reaching three-quarters of the projected gross domestic product (GDP), with alarming projections of additional $2 trillion from $12.8 trillion in 2009 to $14.5 trillion in 2010. In fiscal 2008, according the Bureau of the Public Debt, a division of the Treasury Department, the federal government paid $451 billion in interest on the debt. In July 2008, the Treasury was paying an average interest rate of 4.382% on that debt. A year later, in July 2009, Treasury was paying an average interest rate of 3.418%, even as the Fed was doing its utmost to keep interest rates down. If interest rates go up in the out years as expected, the Treasury would be forced to pay more per year to service the national debt—even if the debt itself did not grow.

The President characterized Bernanke’s reappointment as seeking to keep “a mood of stability in the financial markets” while acknowledging that economic recovery can be expected to be a long way off. The reappointment was a sign of continuity of long-standing Fed monetary policy in contrast to Obama’s campaign rhetoric of “change we can believe in.”

Bernanke is closely identified with Fed policies that had landed the global economy in its current sorry state. Many, particularly conservative Republicans, Blue Dog Democrats, and even progressives, are concerned about Obama’s proposals to expand the powers of the Fed, in view of its history of persistent failure to spot and preempt pending systemic financial crises. Critics question the wisdom of giving an institution with such poor record of performance the prime role as a systemic risk regulator in the proposed regulatory overhaul of the financial system.

Opposition to the reappointment of Bernanke can be traced to three aspects. The first is ideological: despite Bernanke’s subscription to Milton Friedman’s non-provable counterfactual conclusion that central banks can eliminate market crashes with timely and aggressive monetary easing, Bernanke is on the same ideological side of his predecessor – serial bubble wizard Alan Greenspan – who had argued that monetary authorities are best positioned to clean up the mess after the bursting of asset bubbles than to pre-empt the forming of the bubble itself. This ideological fixation of the Fed proper role as a cleanup crew rather than the preventive guardian of good systemic health, which Greenspan has since acknowledged as a grievous error, eventually led to the systemic financial collapse of 2007. (Please see my August 24, 2007 AToL article: Central Bank Impotence and Market Liquidity)

The second aspect is analytical: Bernanke, as Fed chairman-designate waiting confirmation, argued in a speech on March 29, 2005 while still a Fed governor, that a “global savings glut” has depressed US interest rates since 2000. Echoing this view, Greenspan testified before Congress on July 20 that this glut is one of the factors behind the so-called “interest rate conundrum”, i.e., declining long-term rates despite rising short-term rates. In reality, there was no savings glut, only a dollar glut that went overseas as US debt from trade deficits and returned to the US as savings of low income Asians because of dollar hegemony in which Asians cannot spent dollars in their domestic economies without inflation. (Please see my January 11, 2006 AToL article: Of Debt, Deflation and Rotten Apples)

The third aspect relates to policy: Bernanke is a card carrying market fundamentalist who believes that markets can best be self regulated. He and Greenspan repeatedly opposed financial market regulation beyond even ideological grounds to argue also on operational ground that US regulation would merely drive market participants overseas to less regulated jurisdictions and that the US will not accept international coordination that threatens national sovereignty. On regulation, Bernanke is of the school of “if I don’t smoke, somebody else will”. (Please see my January 10, 2004 AToL article: Fed’s Pugnacious Policies Hurt Economies)

Need to Rein In the Wayward Financial Sector

In the aftermath of the outbreak of the financial crisis in July 2007, summit meetings of world leaders have since repeatedly focused on the need of international coordination of financial regulatory regimes. In an interview with the Financial Times, UK Prime Minister Gordon Brown expressed hope that the third G20 leaders summit meeting in Pittsburgh in September 2009 would agree on a “global compact for growth” that would include coordinated steps to withdraw stimulus packages and government support for banks, adding that the UK could not be expected to take action unilaterally on outsized banker remuneration.

Adair Turner, chairman of the Financial Services Authority (FSA), Britain’s top banking supervisor, now supports the idea of new global taxes on financial transactions, warning that a “swollen” financial sector paying excessive salaries has grown too big for society. This is an idea that is equivalent to a financial parallel to the Kyoto Protocol on climate change, which for years the US had dragged its feet in supporting.

In an interview in Prospect magazine published on August 27, Lord Turner says the debate on bankers’ bonuses has become a “populist diversion” from the real need for more drastic measures to cut the financial sector down to size. He also says the FSA should “be very, very wary of seeing the competitiveness of London as a major aim”, claiming the city’s financial sector has become a destabilizing factor in the British economy. The Bernanke Fed has yet to take similarly progressive positions in response to the financialization of the US and global economies and the role Wall Street plays in them.

On all three aspects, there are no signs that Bernanke has turned a new leaf intellectually or professionally from his sordid past. And his dysfunctional fixations have impaired the effectiveness of the Fed’s unconventional policy directions and unprecedented rescue actions in dealing with the two-year-old financial crisis. The Fed’s radical surgery is only revolutionary in operational protocol, aiming to keep the patient alive longer with the disease rather than to cure the disease.

Bernanke the Incredible Hero

Yet for Wall Street, Bernanke has become the hero of the hour. Not surprisingly, since his self-described “bold and creative” actions in the financial crisis have saved Wall Street from imminent total suicidal collapse at the expense of the long-term health of the economy and the sustainable strength of the dollar.

This is the hero who on March 28, 2007, some 100 days before worldwide spread of the US subprime mortgage crisis, told the Joint Economic Committee of Congress: “To date, the incoming data have supported the view that the current stance of policy [with Fed Funds rate target at a high 5.25%] is likely to foster sustainable economic growth and a gradual ebbing in core inflation.” Bernanke challenged market expectations of early Fed interest rate cuts, saying he was comfortable with rates on hold despite adverse economic data. This is the monetary equivalent of the captain of the Titanic ordering “steady as she goes” with a huge iceberg 100 yards ahead.

In the same testimony, Bernanke signaled that Fed policy had not shifted to even a neutral policy stance “away from an inflation bias”, let alone an accommodating stance in response to an imminent crisis that he failed to see coming at him like a runaway train at full speed. His remarks helped prompt a near 100-point fall in the Dow Jones Industrial Average the next day.

Bernanke also brushed aside comments by Alan Greenspan, his predecessor who at last began to see the light, that the expansion looked to be “ageing”, implying the possibility of a recession on the horizon. More ominously, Bernanke played down the threat from the subprime mortgage market on even the US financial system, let alone the global system which the US component dominated. He missed entirely the fast closing window of opportunity to stop the housing bubble from bursting abruptly with massive timely injection of money into the banking system.

Instead, Bernanke told Congress in a tone devoid of any sense of urgency: “The magnitude of the slowdown has been somewhat greater than would be expected given the normal evolution of the business cycle.” And he dismissed as alarmist the concern of some market analysts and participants over the clearly visible signs of distress in the subprime mortgage market and its serious systemic impact globally.

“At this juncture . . . the impact [of the distressed subprime mortgage market] on the broader economy and financial markets . . . seems likely to be contained," he said in a statement that will go down in history as being as infamous as President Hoover’s “prosperity is just around the corner” after the 1929 market crash.

Bernanke also told Congress that consumer spending “has continued to be well maintained so far this year,” and consumption “should continue to support the economic expansion in the coming quarters.” The economy has not recorded an expansion in the 5 quarters since that pathetic pronouncement and the consumer spending well has run dry.

Eleven days earlier, and four months before the credit crisis broke out in July, I had warned my readers about the inevitability of a global systemic crisis in my March 17, 2007 AToL article: Why the Subprime Bust Will Spread.

It is a puzzle that the Chairman of the Federal Reserve, even with the benefit of a huge research and analysis staff, supported by privileged access to early data, backed by a peerless academic reputation, could miss what appeared obvious to a lowly independent observer relying on the mass media for information.

Two years before the credit crisis first broke out in July 1007, I wrote in my September 14, 2005 article on AToL: Greenspan - the Wizard of Bubbleland:

The Kansas City Federal Reserve Bank annual symposium at Jackson Hole, Wyoming is a ritual in which central bankers from major economies all over the world, backed by their supporting cast of court jesters masquerading as monetary economists, privately rationalize their unmerited yet enormous power over the fate of the global economy by publicly confessing that while their collective knowledge is grossly inadequate for the daunting challenge of the task entrusted to them, their faith-based dogma nevertheless should remain above question.

That dogma is based on a single-dimensional theology that sound money is the sine qua non of economic well-being. It is a peculiar ideology given that central banking as an institution derives its raison d’etre from the rejection of a rigid gold standard in favor of monetary elasticity. In plain language, central banking sees as its prime function the management of the money supply to fit the transactional needs of the economy, instead of fixing the amount of money in circulation by the amount of gold held by the money-issuing authority.

Thus central bankers believe in sound money, but not too sound please, lest the economy should falter. Their mantra is borrowed from the Confessions of St Augustine: “God, give me chastity and continence - but not just now.”

This year [2005], the annual august gathering in August took on special fanfare as it marked the final appearance of Alan Greenspan as Chairman of the Federal Reserve Board of Governors. Among the several interrelated options of controlling the money supply, the Federal Reserve, acting as a fourth branch of government based on dubious constitutional legitimacy and head of the global central banking snake based on dollar hegemony, has selected interest rate policy as the instrument of choice for managing the economy all through the 18-year stewardship of Alan Greenspan, on whom much accolade was showered by invited participants in the Jackson Hole seminar in anticipation of his retirement in early 2006.

Greenspan’s formula of reducing market regulation by substituting it with post-crisis intervention is merely buying borrowed extensions of the boom with amplified severity of the inevitable bust down the road. The Fed is increasingly reduced by this formula to an irrelevant role of explaining an anarchic economy rather than directing it towards a rational paradigm. It has adopted the role of a clean-up crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health.

Greenspan’s monetary approach has been when in doubt, ease. This means injecting more money into the banking system whenever the economy shows signs of faltering, even if caused by structural imbalances rather than monetary tightness. For almost two decades, Greenspan has justifiably been in near-constant doubt about structural balances in the economy, yet his response to mounting imbalances has invariably been the administration of off-the-shelf monetary laxative, leading to a serious case of lingering monetary diarrhea that manifests itself in run-away asset price inflation mistaken for growth.

In my article: The Fed Created Serial Bubbles by Policy, posted on June 18, 2009 on the website of NewDeal20.org, a project of the Franklin and Eleanor Roosevelt Institute, I repeated my observation:

Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash the equity bubble, had this to say in 2004 in hindsight after the bubble burst in 2000: “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”

By the next expansion, Greenspan meant the next bubble which manifested itself in housing. The mitigating policy was a massive injection of liquidity into the banking system. There is a structural reason why the housing bubble replaced the high-tech bubble.

Alan Greenspan, who from 1987 to 2006 was chairman of the Board of Governors of US Federal Reserve - the head of the global central banking snake by virtue of dollar hegemony - embraced the counterfactual conclusion of Milton Friedman that monetarist measures by the central bank can perpetuate the boom phase of the business cycle indefinitely, banishing the bust phase from finance capitalism altogether.

Going beyond Friedman, Greenspan asserted that a good central bank could perform a monetary miracle simply by adding liquidity to maintain a booming financial market by easing at the slightest hint of market correction.
This ignored the fundamental law of finance that if liquidity is exploited to manipulate excess debt as phantom equity on a global scale, liquidity can act as a flammable agent to turn a simple localized credit crunch into a systemic fire storm.

Ben Bernanke, Greenspan’s successor at the Fed since February 1, 2006, also believes that a “good” central banker can make all the difference in banishing depressions forever, arguing on record in 2000 that, as Friedman claimed, the
1929 stock market crash could have been avoided if the Fed had not dropped the monetary ball. That belief had been a doctrinal prerequisite for any candidate up for consideration for the post of top central banker by President George W Bush. Yet all the Greenspan era proved was that mainstream monetary economists have been reading the same books and buying the same counterfactual conclusion. Friedman’s “Only money matters” turned out to be a very dangerous slogan.

Both Greenspan and Bernanke had been seduced by the convenience of easy money and fell into an addiction to it by forgetting that, even according to Friedman, the role of central banking is to maintain the value of money to ensure steady, sustainable economic growth, and to moderate cycles of boom and bust by avoiding destructively big swings in money supply. Friedman called for a steady increase of the money supply at an annual rate of 3% to achieve a non-accelerating inflation rate of unemployment (NAIRU) as a solution to stagflation, when inflation itself causes high unemployment.

Fight Fire by Throwing Sound Money out the Window

Now in August 2009, two years after the credit crisis imploded in a global full fledge financial crisis, as central bankers from around the world gathered again at their annual August ritual in Jackson Hole, the imperative of sound money, the key dogma of central banking, is temporarily discarded to the waste basket in order to bail out the world’s financial system that has collapsed from excess debt made possible by easy money with more easy money from central banks to shift the debt to the public sector.

The justification is the need to first put out the raging fire before arresting the responsible arson through a dragnet of regulatory reform. Yet the Fed’s way of fighting the raging fire was to pour on it more oil in the form of easier money. It is a case of the arson performing the role of the fire fighter, to direct the fire away from its path towards the few who caused it, towards innocent victims in the general population. Part of the fire has since burned itself out inside a firebreak built by an expanded Fed balance sheet, but the fire itself is far from being totally extinguished and is spreading underground in a classic coal mine burn that can be expected to smolder for years.

Irresponsible Optimism

In this context, the gathering central bankers at Jackson Hole reportedly expressed growing confidence that the worst of the global financial crisis is over and that a global economic recovery is beginning to take shape.

This is an irresponsibly optimistic assessment that borders on fantasy, by a powerful fraternity of questionable legitimacy and bankrupt credibility. The global financial system may be showing signs of zombie stirring caused by bailout money from the Fed and other central banks, but the toxic assets that plight the global economy have not been extinguished and still pose a major threat to real recovery. The global economy is still in need of intensive care with a debt virus that is mutating into a strain stubbornly resistant to monetary cures.

Transferring Private Debt into Public Debt

What the Fed has done in the past two years is to transfer massive amounts of private sector toxic debt to the public sector by ‘aggressively and innovatively’ expanding the Fed’s balance sheet. This approach may require a decade or more to unwound the massive amount of toxic debt in the system, both in the private and public sectors, delaying true economic recovery.

The approach adopted by the Treasury and the Fed to deal with a financial crisis of unsustainable debt created by excess liquidity is to inject into the economy more liquidity in the form of new public debt denominated in newly created money and to channel it to debt-laden institutions to re-inflate a burst debt-driven asset price bubble.

The Treasury does not have any power to create money. Its revenue comes mainly from taxes. But it has the ability to issue sovereign debt with the full faith and credit of the nation. When the Treasury runs a deficit, it has to borrow from the credit market, thus crowding out private debt with public debt.

The Fed has the authority to create new money which it can use to buy Treasury securities to monetize the public debt. But while the Fed can create new money, it cannot create wealth which can only be created by work. Unfortunately, the Fed’s new money has not been going to workers/consumers in the form of rising wages from full employment to restore fallen consumer demand, but instead has been going only to debt-infested distressed institutions to allow them to de-leverage toxic debt. Thus deflation in the equity market (falling share prices) has been cushioned by newly issued money, while aggregate wage income continues to fall to further reduce aggregate demand that will cause companies to layoff workers to reduce overcapacity. Until this vicious cycle is broken by proper monetary and fiscal policies, no economic recovery can come.

Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions de-leverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. De-leverage reduces financing costs while increases cash flow to allow zombie financial institutions to return to nominal profitability with unearned income while laying off workers to cut operational cost.

Thus we have financial profit inflation with price deflation in a shrinking economy. What we will have going forward is not Weimar Republic type price hyperinflation, but a financial profit inflation in which zombie financial institutions turning nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold only to lose more of it at the next market melt down which will come when the profit bubble bursts.

Ballooned Fed Balance Sheet

On April 3, 2009, Bernanke, Fed Chairman since February 1, 2006, opened his speech at the Federal Reserve Bank of Richmond 2009 Credit Markets Symposium held in Charlotte, North Carolina as follows:

In ordinary financial and economic times, my topic, “The Federal Reserve’s Balance Sheet," might not be considered a "grabber.” But these are far from ordinary times. To address the current crisis, the Federal Reserve has taken a number of aggressive and creative policy actions, many of which are reflected in the size and composition of the Fed's balance sheet. So, I thought that a brief guided tour of our balance sheet might be an instructive way to discuss the Fed's policy strategy and some related issues. As I will discuss, we no longer live in a world in which central bank policies are confined to adjusting the short-term interest rate. Instead, by using their balance sheets, the Federal Reserve and other central banks are developing new tools to ease financial conditions and support economic growth.

Bernanke then outlines some principles of a new creative Fed balance sheet policy at an unusual time when financial markets and institutions both in the US and globally have been under extraordinary stress for more than a year and a half. He asserts that relieving the disruptions in credit markets and restoring the flow of credit to households and businesses are essential for the gradual resumption of sustainable economic growth. To achieve this critical objective, the Federal Reserve has worked closely and cooperatively with the Treasury and other agencies. Such collaboration is not unusual. The Fed has traditionally worked in close concert with other agencies in fostering stable financial conditions, even as it maintained independent responsibility for making monetary policy.

While the Fed has been creative in deploying its balance sheet, using a multiplicity of new programs (and coining a multiplicity of new acronyms), Bernanke claims it has done so prudently. As much as possible, the Fed has sought to avoid both credit risk and credit allocation in its lending and securities purchase programs. Fed programs have been aimed at improving financial and credit conditions broadly, with an eye toward restoring overall economic growth, rather than toward supporting narrowly defined sectors or classes of borrowers.

Credit Easing, Not Quantitative Easing

In pursuing its strategy, which Bernanke calls “credit easing”, instead of the traditional “quantitative easing”, the Fed has also taken care to design its programs so that it can unwound them as markets and the economy revive, at least in theory. In particular, these activities must not constrain the exercise of monetary policy as needed to meet congressional mandate to foster maximum sustainable employment and stable prices. This may mean Fed emergency programs cannot be fully unwound for decades, thus hampering the achievement of sustainable long-term full employment and price stability.

On March 23, 2006, the Fed under Bernanke stopped tracking M3, the broadest measure of US money supply, arguing it had not been used in interest rate decisions for some time, as if that was a rational justification rather than an operational neglect that needed to be corrected. The term ‘credit easing’ reflects the Fed’s focus on bank balance sheets, rather than ‘quantitative easing’ which describes the boosting of the money supply.

Bernanke’s credit easing did not help consumer credit which decreased at an annual rate of 5-1/4% in the Q2 2009. Revolving credit decreased at an annual rate of 8-1/4%, and non-revolving credit decreased at an annual rate of 3-1/2%. In June, 2009, consumer credit decreased at an annual rate of 5%.

Consumer credit peak at $2.6 trillion in Q3, 2008 and fell to $2.5 trillion in June 2009 falling $100 billion. Outstanding consumer credit has been contracting for five months straight, falling $10.3 billion from May to June 2009 and down 4.9% on an annual basis. Credit throughout the US economy has been flat or in decline as banks tightened their lending standards, and as over-burdened businesses and households frantically tried to pay down debt accumulated during the boom.

A look at money rather than credit, however, shows clearly the effect of Fed credit easing policies. Broad money growth began to accelerate early 2009 in the US. Fed purchases of private sector toxic financial assets provide distress US companies and households with additional funds. Instead of spending, the recipients of such funds prudently paid down debt to avoid insolvency.

But the European Central Bank, which still tracks money supply, show no comparable upturn.

How and When

The Fed’s monetary myopia shifts the problem of exiting emergency policies from ‘how’ to ‘when’, with the flawed assumption that pain in the future must necessarily be less acute. Focusing on lagging indicators, which reflect past situations, increases the chances that the Fed will overshoot both in degree and duration with policy stance. Credit expansion through Fed credit easing can also cause excess money creation as de-leveraging runs its course. Hyman Minsky observed: whenever credit is issued, money is created.

Writing in defense of his strategy in the Financial Times on July 21, 2009 on The Fed’s Exit Strategy, Bernanke asserts that Federal Reserve reduction of the Fed Funds rate target nearly to zero, together with greatly expanded Fed balance sheet as a result of Fed purchases of longer-term securities and targeted lending programs aimed at restarting the flow of credit, “have softened the economic impact of the financial crisis” and “improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.”

Bernanke acknowledged that Fed accommodative policies will likely be warranted for “an extended period”. Yet he did not address the issue of what happens to the value of the dollar during this extended period. The US Treasury will not go bankrupt, but the US dollar can fall to a level that will threaten the US economy with bankruptcy.

At some point after the extended period, Bernanke wrote, as economic recovery takes hold, the Fed will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Bernanke reports that the Federal Open Market Committee, which is responsible for setting US monetary policy, has devoted considerable time to issues relating to an exit strategy, with confidence that the Fed has the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner. Thus the question is not ‘how, but ‘when’.

Bernanke notes that the Fed’s exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

The Fed and Liquidity Trap

This is known as the Fed pushing on a credit string with Fed money given to banks sitting idle in reserve accounts at the Fed because banks cannot find credit worthy borrowers. Keynes called this phenomenon a liquidity trap as nominal interest rate lowered to near zero, liquidity preference in the market fails to stimulate the economy to full employment. In an earlier speech, Bernanke had refered to a statement made by Milton Friedman about using a “helicopter drop” of money into the economy, presumably for everyone equally, to fight deflation, earning his nickname Helicopter Ben. But Ben’s helicopter so far is still sitting idle on the ground while shiploand of taxpayer money have been railroaded to distress institutions.

But Bernanke explains that as the economy recovers, banks should find more opportunities to lend out their reserves. Yet he was vague about how the economy would recover beyond a general faith that what goes down will eventually go back up. Yet in the history of nations, many have gone down without recovering their former greatness.

Bernanke argues that recovery when it comes would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless the Fed adopts countervailing policy measures. When the time comes to tighten monetary policy, the Fed must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

Bernanke believes that, to some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of the Fed’s short-term lending facilities, and ultimately to their wind down. He points out that short-term credit extended by the Fed to financial institutions and other market participants has fallen to less than $600 billion as of mid-July 2009 from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid.

However, Bernanke admits that reserves likely would remain quite high for several years unless additional policies are undertaken. He asserts that even if Fed balance sheet stays large for a while, the Fed still has two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. The Fed could use either of these approaches alone; however, to ensure effectiveness, it likely would use both in combination.

Congress granted the Fed authority in the fall of 2008 to pay interest on balances held by banks at the Fed. This is a controversial development because it reduces pressure on banking to lend money in the economy to finance economic activities.

Currently, the Fed pay banks an interest rate of 0.25%. Bernanke indicates that when the time comes to tighten policy, the Fed can raise the rate paid on reserve balances as it increases the federal funds rate target. Needless to say, this will retard economic recovery as it gathers steam.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they can be expected to compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.
Thus the interest rate that the Fed pays would tend to put a floor under short-term market rates, including its policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed. Thus market forces are really dictated by the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates. But these countries do not pretend they operate on a free market economy but a mixed market economy.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began paying interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system. But it may also be interpreted as a measure on how weak the economy actually was.

However, Bernanke observed that this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks in order to compete for scarce funds.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. Bernanke argues that if that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy.

Four Options to Tightening Monetary Policy

According to Bernanke, the Fed has four options for tightening monetary policy: First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Repos are useful to central banks both as a monetary policy instrument and as a source of information on market expectations. Repos are attractive as a monetary policy instrument because they carry a low credit risk while serving as a flexible instrument for liquidity management. In addition, they can serve as an effective mechanism for signaling the stance of monetary policy.

Repo markets can also provide central banks with information on very short-term interest rate expectations that is relatively accurate since the credit risk premium in repo rates is typically small. In this respect, they complement information on expectations over a longer horizon derived from securities with longer maturities.

The secondary credit market is where Fannie Mae and Freddie Mac, so-called GSEs (government sponsored enterprises, or simply agencies) which were founded with government help during the New Deal in the 1930s to make home ownership easier by purchasing loans that commercial lenders make, then either hold them in their portfolios or bundle them with other loans into mortgage-backed securities for sale in the credit market. Mortgage-backed securities are sold to mutual funds, pension funds, Wall Street firms and other financial investors who trade them the same way they trade Treasury securities and other bonds. Many participants in this market source their funds in the repo market.

In this mortgage market, investors, rather than banks, set mortgage rates by setting the repo rate. Whenever the economy is expanding faster than the money supply growth, investors demand higher yields from mortgage lenders. However, the Fed is a key participant in the repo market as it has unlimited funds with which to buy repo or reverse repo agreements to set the repo rate. Investors will be reluctant to buy low-yield bonds if the Fed is expected to raise short-term rates higher. Conversely, prices of high-yield bonds will rise (therefore lowering yields) if the Fed is expected to lower short-term rates.

In a rising-rate environment, usually when the economy is viewed by the Fed as overheating, securitized loans can only be sold in the credit market if yields also rise. The reverse happens when the economy slows. But since the Fed can only affect the repo rate directly, the long-term rate does not always follow the short-term rate because of a range of factors, such as a time-lag, market expectation of future Fed monetary policy and other macro events. This divergence from historical correlation creates profit opportunities for hedge funds, or dangers of loss if the hedge funds bet wrong. When hedge funds as a group command enormous financial position, it is possible that the Fed will view them also as being “too big to fail” and adopt policy stance that will reduce their chances of loss, but stance that may not be good for the economy long term.

The “term structure” of interest rates defines the relationship between short-term and long-term interest rates. Historical data suggest that a 100-basis-point increase in Fed funds rate has been associated with 32-basis-point change in the 10-year bond rate in the same direction. Many convergence trading models based on this ratio are used by hedge funds. The failure of long-term rates to increase as short-term rates rose beginning late winter 2003 can be explained by the expectation theory of the term structure which links market expectation of the future path of short-term rates to changes in long-term rates, as St Louis Fed President William Poole said in a speech to the Money Marketeers in New York on June 14, 2005. The market simply did not expect the Fed to keep short-term rate high for extended periods under then current conditions. The upward trend of short-term rates was expected by the market to moderate or reverse direction as soon as the economy slowed. (Please see my September 29, 2005 AToL article: The Repo Time Bomb)

The second of the four options to tighten monetary policy is for the Treasury to sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline. The Treasury has been conducting such operations since the fall of 2008 under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, the Fed must take care to ensure that it can achieve its policy objectives without reliance on the Treasury.

The third option is to use the authority Congress gave the Fed to pay interest on banks’ balances at the Fed. The Fed can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

The fourth option, if necessary, is for the Fed to reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Economic Conditions Not Likely To Require Monetary Tightening

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires it to do so. However, Bernanke thinks economic conditions are not likely to warrant tighter monetary policy for an extended period. The Bernanke Fed will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster its dual objectives of maximum employment and price stability.

The Exit Dilemma

Yet since the Fed’s exit strategy is predicated on an eventual economic recovery, the exit strategy itself by definition cannot possibly be a component that brings about early recovery. Bernanke has not told the world what the Fed’s game plan for recovery is, only the Fed’s ability to combat inflation when recovery comes.

An economy that has collapsed under the burden of excessive debt cannot recover until such debt has been extinguished. And debt can only be extinguished by wealth creation, not by creating more debt with easy credit. And wealth can only be created by employment and not by financial manipulation. Yet the Fed’s response to financial crisis thus far has been to delay the extinguishment of debts in the financial system to save it from collapsing. Recovery is not automatic and must be brought about by market correction or countervailing policies to bring about full employment. A depression begins when the business cycle fails to cycle for long periods, keeping unemployment permanent.

Principles for a New Resolution Regime

In his April 3, 2009 speech, Bernanke said the Fed is also committed to working with the Administration and the Congress to develop a new resolution regime that would allow the US government to effectively address, at an early stage, the potential failure of systemically critical nonbank financial institutions. Bernanke concedes that the lack of such a regime greatly hampered the Fed’s flexibility in dealing with the failure or near-failure of such institutions as Bear Stearns, Lehman Brothers, and American International Group (AIG).

The principles Bernanke outlined were recently formalized in a joint Federal Reserve-Treasury statement: (1) the Fed will cooperate closely with the Treasury and other agencies in addressing the financial crisis; (2) the Fed in its lending activities should avoid taking credit risk or allocating credit to narrowly defined sectors or classes of borrowers; (3) the Fed’s independent ability to manage monetary policy must not be constrained by its programs to ease credit conditions; and (4) there is a pressing need for a new resolution regime for nonbanks that, among other things, will better define the Fed’s role in preventing the disorderly failure of systemically critical financial institutions.

Yet, by treating risk-prone investment banks with the same Fed protection that supposedly risk-averse commercial banks enjoy, the Fed is essentially financing risk taking with tax payer money and allowing the high returns from high risk to bypass taxpayers. If a private institution rescues a distressed investment bank from imminent collapse, it will end up owning the entity and all its future profits. But all taxpayers got was a repayment of the Fed loans with low interest and warrants to buy stocks in the banks at a set price over ten years, while the investment bankers walked off with huge bonuses even when their banks were losing money. While the government is reported to have made a $4 billion profit from its rescue investments of $700 billion, analysts say that private investors would have realized a $12 billion return by paying market price rather than the bloated price that the government paid.

Fed’s Balance Sheet as a Tool of Monetary Policy

Bernanke observed that the severe disruption of credit markets that began in the summer of 2007 and the associated tightening in credit conditions and declines in asset prices have weighed heavily on economic activity in the US and abroad. The Fed has responded belatedly by reluctantly easing short-term interest rates, beginning only in September 2007, three months after the credit crunch began. A whole year later, only in October 2008, as the financial crisis intensified, did the Federal Reserve participate in an unprecedented coordinated rate cut with other major central banks.

At the Federal Open Market Committee (FOMC) December 2008 meeting, nine months after the March 14, 2008 JP Morgan Chase takeover of Bear Stearns with loans from the New York Fed then under now Treasury Secretary Tim Geithner to prevent a potential market crash that would result from Bear Stearns becoming insolvent; and three months after Lehman Brothers file bankruptcy, with Merrill Lynch being forced to sell itself to Bank of America for $50 billion, and with insurance giant American International Group (AIG) suffering losses stemming from the credit crisis, seeking a $40 billion lifeline from the Fed, without which the company might have only days to survive, the FOMC reduced its target for the federal funds rate close to its lower bound, setting a target range between 0 and ¼%. And with deflation expected for some time, the Committee indicated that short-term interest rates were likely to remain low for an extended period.

Danger of Keeping Low Interest Rates Too Long

Since then some economists have voiced concern that the Fed is in danger of putting itself in a position of holding interest rate too low for too long for the long-term health of the economy and the future strength of the dollar. The short-term benefits of low interest rate may be neutralized by the long-term cost of high inflation exacerbated by a falling dollar. Still, Bernanke asserts that with conventional monetary policy of interest rate targeting having reached its limit, any further policy stimulus requires a different set of tools.

New Tools

Bernanke says that the Fed has been a global leader in developing such tools. In particular, to further improve the functioning of credit markets and provide additional support to the economy, the Fed has established and expanded a number of liquidity programs and recently initiated a large-scale program of asset purchases. These actions have had significant effects on both the size and composition of the Federal Reserve’s balance sheet. Notably, the balance sheet has more than doubled, from roughly $870 billion before the crisis to roughly $2.11 trillion by the week ending November 5, 2008.

A good source of information on Fed balance sheet is a new section of the Board’s website, entitled Credit and Liquidity Programs and the Balance Sheet. This section brings together much diverse information about the Fed's balance sheet, including some only recently made available, as well as detailed explanations and analyses.

For decades, the Fed’s assets consisted almost exclusively of Treasury securities. Since late 2007, however, Fed holdings of Treasury securities have declined, as its holdings of other financial assets have expanded dramatically. Fed assets are grouped into three broad categories: (1) short-term credit extended to support the liquidity of financial firms such as depository institutions, broker-dealers, and money market mutual funds; (2) assets related to programs focused on broader credit conditions; and (3) holdings of high-quality securities, notably Treasury securities, agency debt, and agency-backed mortgage-backed securities (MBS). The Federal Reserve also has provided support directly to specific institutions in cases when a disorderly failure would have threatened the financial system. This is the too-big-to-fail syndrome.

Liquidity Programs for Financial Firms

The first of these categories of assets--short-term liquidity provided to sound financial institutions: commercial banks and primary dealers, as well as currency swaps with other central banks to support interconnected global dollar funding markets, for up to 90 days -totals almost $860 billion by April 2009, representing nearly 45% of the assets on Fed balance sheet.

Bernanke points out that from its beginning, the Federal Reserve, through its discount window, has provided credit to depository institutions to meet unexpected liquidity needs, usually in the form of overnight loans. The provision of short-term liquidity is, of course, a long-standing function of central banks. In August 2007, conditions in short-term bank funding markets deteriorated abruptly, and bank funding needs intensified sharply. In response to these developments, the Federal Reserve reduced the spread of the primary credit rate--the rate at which most institutions borrow at the discount window--relative to the target federal funds rate, and also made it easier for banks to borrow at term.

However, as in some past episodes of financial distress, banks were reluctant to rely on discount window credit to address their funding needs. The banks’ concern was that their recourse to the discount window, if it became known, might lead market participants to infer weakness--the so-called stigma problem. The perceived stigma of borrowing at the discount window threatened to prevent the Federal Reserve from getting much-needed liquidity into the system.

To address this issue, in late 2007, the Federal Reserve established the Term Auction Facility (TAF), which provides fixed quantities of term credit to depository institutions through an auction mechanism. The introduction of this facility seems largely to have solved the stigma problem, partly because the sizable number of borrowers provides anonymity, and possibly also because the three-day period between the auction and auction settlement suggests that the facility’s users are not relying on it for acute funding needs on a particular day.

As of April 1, 2009, the Fed had roughly $525 billion of discount window credit outstanding, of which about $470 billion had been distributed through auctions and the remainder through conventional discount window loans.

What the Fed did in reality was that against a general commitment to transparency and openness, it instituted a program that hides from the market the real liquidity condition of major banks. It turned out that quite a few of the major banks that escaped the stigma of weakness would have in fact faced insolvency without Fed help. Market participants were deprived of this important decision relating to the distressed banks.

September 7, 2009

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