Global Post-Crisis Economic Outlook
Henry C.K. Liu

Part I:  Crisis of Wealth Destruction   
Part II: Two Different Banking Crises - 1929 and 2007

Part III: The Fed’s No-Exit Strategy
This article appeared in AToL on April 21, 2010


In Testimony before the Committee on Financial Services of the House of Representatives in Washington, DC on February 10, 2010 regarding “Federal Reserve’s Exit Strategy” from the extraordinary lending and monetary policies that it implemented to combat the financial crisis and support economic activity, Chairman Ben S. Bernanke said that the Federal Reserve’s response to the crisis and the recession can be divided into two parts.
First, the financial system during the past two and a half years has experienced periods of intense panic and dysfunction, during which private short-term funding became difficult or impossible to obtain for many borrowers, even those with good credit standing in normal times. The pulling back of private liquidity at times threatened the stability of major financial institutions and markets and severely disrupted normal channels of credit.
Yet Bernanke skirted over the fact that for several large institutions, the liquidity crunch was inseparable from an insolvency problem. What these distressed institutions needed was more than a liquidity tie over, but an injection of capital.
In response, performing its role as liquidity provider of last resort, the Federal Reserve developed a number of programs to provide supposedly well-secured, mostly short-term credit directly to the financial system. These programs, which Fed Chairman Bernanke alleged rather simplistically as imposing no cost on the taxpayer, were a critical part of the government’s efforts to stabilize the financial system and restart the flow of credit.
As noted in Part II of this series, the tax exemption granted distressed institutions had cost the Internal Revenue Service tax revenue in amounts that exceeded the estimated positive returns from disposing distress assets that the Treasury had acquired. Yet, the true cost of Fed intervention to the integrity of the market system cannot be fully evaluated until the unintended consequences surface years later. Free market capitalism may well be history after government intervention in this crisis as Fed exit strategy may never be completely carried out or Fed direct intervention will be expected in all future crises.
What Bernanke did not say in his testimony was that these programs were not macro monetary measures addressed at the overall capitalist financial market system, but direct micro intervention into selected wayward distressed financial firms deemed to big to fail. The approach has set a pattern of fearlessness among gigantic financial institutions. Yet the net result of the government approach to the banking crisis is to impose of the market an oligarchy of a small number of large surviving banks.
The Fed was providing more than liquidity to the financial system. It took over toxic assets from distress banks and bank-holding companies which had ventured into the non-bank financial sector and the shadow banking sector. The Fed acted as the White Knight to save a market failure in the entire global debt securitization arena. The Fed took on the role of protector of miscreants from market disciplinary penalties, straying from its official mandate as protector of the faith on financial market fundamentalism.
Economist Randall Wray wrote in the website of Roosevelt Institute’s New Deal 2.0 Project:
But in those areas in which the government believes markets do work, there should never be any intervention to subvert market forces that want to punish miscreants. Treasury Secretaries Rubin, Paulson, and Geithner’s repeated claim that we cannot allow market forces to operate on the downside is logically nonsensical. Markets cannot work if downside risks are removed. In any area in which the downside is going to be socialized, the upside MUST also be socialized — that is, removed from the market. If the market is to work on the upside, it must be allowed to operate also on the downside.
What about systemic risk? Yes, if government had allowed markets to operate as Bear and Lehman went down, all of the big financial institutions would also have been brought down. As Bernanke now apparently realizes, that would have been a good thing. The market would have accomplished what Bernanke now professes to desire: resolving the problem of “too big to fail”. We would have been left only with smallish institutions — those not too big to fail. And as [Roger] Lowenstein forcefully argues, those big financial institutions do very little that is desirable from a public purpose perspective. Whatever good they do accomplish can just as easily be done by small institutions or directly by government where the market fails.
After all, this ain’t rocket science. It is just finance: determine who is credit-worthy, provide a loan financed by issuing insured deposits, and then hold the loan to maturity. If the underwriting is poor, the institution will fail and the government will protect only the insured depositors. No individual institution will have an incentive to grow quickly (rapid growth is almost always associated with reducing underwriting standards, and fraud) since once it reaches a one percent share of deposits its access to more insured and cheap deposits is cut-off. Small institutions would not have to compete against the large “systemically dangerous” institutions that now enjoy a huge advantage because even their uninsured liabilities are thought to have the Treasury standing behind them. With a level playing field, even “average skill and average good fortune will be enough”, as J.M. Keynes put it. (End of Except)
Bernanke asserted that as financial conditions have improved, the Fed has substantially phased out these lending programs. What Bernanke failed to tell Congress was that while the phasing out in this case meant only that the transfer of troubled debt from the private sector into the public sector had been a one time measure that was not expected to be repeated with more Fed funds, the return of the troubled debt from the public sector back to the private sector remains on an open schedule. No matter how carefully the Fed intends to carry out this return of liabilities from the public sector to the private sector, it will unavoidably cause head wind for the seriously impaired economy.
Bernanke said the second part of the Fed’s response, after reducing short-term interest rate target nearly to zero, involved the Federal Open Market Committee (FOMC) providing additional monetary policy stimulus through large-scale purchases of Treasury and government sponsored enterprise securities.
Bernanke claimed correctly that these asset purchases had the additional effect of substantially increasing the reserves that depository institutions hold with the Federal Reserve Banks, and had helped lower interest rates and spreads in the mortgage market and other key credit markets. But his claim that, thereby these purchases promoted economic growth is subject to debate and not supported by actual data. What Bernanke did not acknowledge to Congress was that the effect of Fed purchase of government debt instruments had not alleviated the rise of unemployment or foreclosures, much less promoting economic growth.
While admitting that at present the US economy continues to require the support of highly accommodative monetary policies, Bernanke warned Congress that at some point the Fed will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding. “We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively,” said Bernanke. He only glossed over the details on these tools and gave no indication on when the appropriate time might be. The fact remains the Fed’s tool box is very limited as monetary policy is generally understood as a very blunt instrument for affecting economic trends.
Yet the market is keenly aware that the date of a Fed exit from the financial markets may well be followed by the date for a double dip in the nervous market that would add more weight to the already impaired economy. Meanwhile the exchange value of the dollar is kept up only by other currencies falling faster as the result of looming sovereign debt crises world wide, not by the strength of the dollar’s purchasing power.
The Fed’s Liquidity Programs

Bernanke told Congress that with the onset of the crisis in the late summer and fall of 2007, the Fed aimed tactically to ensure that sound financial institutions had sufficient access to short-term credit to remain sufficiently liquid and able to lend to creditworthy customers, even as private sources of liquidity began to dry up.
Yet what the Fed actually did was to ensure the survival of unsound institutions on the verge of insolvency that were deemed too big to fail. The funds that went to these institutions actually failed to reach even the dwindling number of creditworthy borrowers. Instead of lending more, much of the bailout money was used by recipient financial institutions for de-leveraging to shrink their liabilities.
Bernanke said to improve the access of banks to backup liquidity, the Fed reduced the spread the target federal funds rate over the discount rate--the rate at which the Fed lends to depository institutions through its discount window--from 100 basis points to 25 basis points, and extended the maximum maturity of discount window loans, which had generally been limited to overnight, to 90 days.
Many banks, however, were evidently concerned that if they borrowed from the discount window, they would be perceived in the market as weak, and consequently, might come under further pressure from creditors.
To address this so-called stigma problem, the Fed created a new discount window program: the Term Auction Facility (TAF). Under the TAF, the Fed regularly auctioned large blocks of credit to depository institutions. For many reasons, including the competitive format of the auctions and the fact that practically all institutions were in distress, albeit at different degrees, the TAF has not suffered the stigma of conventional discount window lending and has proved effective for injecting liquidity into the financial system.  Another possible reason that the TAF did not suffered from stigma was that auctions were not settled for several days, which signaled to the market that auction participants did not face an imminent shortage of funds. On the other hand, it showed that serious market failure could still emerge in a matter of days, a possibility that Bernanke did not mention. 
Liquidity pressures in financial markets were not limited to the United States, and intense strains in the global dollar funding markets began to spill over back on US markets. In response, the Fed had to enter into temporary currency swap agreements with major foreign central banks. Under these agreements, the Fed provided dollars to foreign central banks in exchange for an equally valued quantity of foreign currency.  The foreign central banks, in turn, lent the dollars to banks in their own national jurisdictions.
The currency swaps helped reduce stresses in global dollar funding markets, which in turn helped to stabilize US markets. Bernanke said, importantly, the swaps were structured so that the Fed bore no foreign exchange risk or credit risk due to dollar hegemony. In particular, foreign central banks, not the Fed, bore the credit risk associated with the foreign central banks’ dollar-denominated loans to financial institutions in their respective financial system. Left unspoken was that in protecting the Fed from exchange rate risks, the Fed in effect neutralized the equilibrium function of the exchange markets by manipulating the global supply of dollars.
Thus it is ironic that some US politicians, unwashed in monetary economics, urged on by economist-turned-propagandist Paul Krugman, accused China of manipulating the exchange value of its currency by keeping its peg to the dollar. When one currency is pegged by policy to another over a long period, the manipulator can only be the issuer of the currency to which the peg has been set for a decade.
The only way to maintain stability in the exchange rate market is for the US Treasury, supported by the Fed, to give weight to the slogan that a strong dollar is in the US national interest. Unfortunately, the strong dollar slogan will remain an empty one for a long time to come, as the prospect of US economic policy giving the dollar strong support is highly unlikely. On the positive side, the Obama administration is at least soft peddling the irrational push toward a destructive trade war with China over the yuan exchange rate issue. A trade war is the last thing the impaired US economy needs at this precarious juncture.
As the financial crisis spread, the continuing pullback of private funding contributed to illiquid and even chaotic conditions in wholesale financial markets and prompted runs on various types of financial institutions, including primary dealers and money market mutual funds. To arrest these runs and help stabilize the broader financial system, the Fed had to invoke a seldom used emergency lending authority under Section 13 (3) of the 1932 Federal Reserve Act, as amended by the Banking Act of 1935 and the FDIC Improvement Act of 1991, not used since the Great Depression, to provide short-term backup funding to select non-depository institutions through a number of temporary facilities.
In March 2008, invoking Section 13 (3), the Fed created the Primary Dealer Credit Facility (PDCF), which lent to primary dealers on an overnight, over-collateralized basis. Subsequently, the Fed created facilities to help to stabilize other key institutions and markets, including money market mutual funds, the commercial paper market, and the asset-backed securities market.
The Fed reports that use of many of its lending facilities has declined sharply as financial conditions stabilized. In designing its facilities, the Fed in many cases incorporated features such as pricing that was unattractive under normal financial conditions, aimed at encouraging borrowers to reduce their use of the facilities as financial conditions returned to normal. In the case of other facilities, particularly those that made available fixed amounts of credit through auctions, the Fed has gradually reduced offered amounts.
Some facilities were closed over the course of 2009, and most other facilities expired at the beginning of February 2010. At the time of this writing, the only facilities still in operation that offer credit to multiple institutions, other than the regular discount window, are the Term Auction Facility (TAF - the auction facility for depository institutions) and the Term Asset-Backed Securities Loan Facility (TALF), which has supported the market for asset-backed securities, such as those that are backed by auto loans, credit card loans, small business loans, and student loans. Bernanke told Congress that these two facilities are expected to be phased out soon. The final TAF auction was conducted on March 8, and the TALF was closed on March 31, 2010 for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and scheduled for June 30, 2010 for loans backed by newly issued CMBS.
The TALF extends three- and five-year loans, which will remain outstanding after the facility closes for new loans. The extension of the CMBS portion of the facility reflects the Fed’s assessment that conditions in that sector will remain highly stressed, as well as the fact that CMBS securitizations are more complex and take longer to arrange than other types. Many in the market expect commercial real estate loan default to be the next crisis faced by banks. Some are describing it as a slow train wreck.
In addition, Bernanke told Congress that the Fed was in the process of normalizing the terms of regular discount window loans. It has reduced the maximum maturity of discount window loans to 28 days, from 90 days set in the fall of 2007, and is considering whether further reductions in the maximum loan maturity are warranted.
Also, Bernanke told Congress that the Fed expected to consider a modest increase in the spread between the discount rate and the target federal funds rate. These changes, like the closure of a number of lending facilities earlier in February, 2010, should be viewed as further normalization of the Fed’s lending facilities, in light of the improving conditions in financial markets; they are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January 2010 meeting of the FOMC.
Bernanke maintained that to help stabilize financial markets and to mitigate the effects of the crisis on the economy, the Fed established a number of temporary lending programs. Under nearly all of the programs, only short-term credit, with maturities of 90 days or less, was extended, and under all of the programs credit was over-collateralized or otherwise secured as required by law. Bernanke told Congress that the Fed believes that these programs were effective in supporting the functioning of financial markets and in helping to promote a resumption of economic growth. The Fed has borne no loss on these operations thus far and anticipates no loss in the future. The exit from these programs is substantially complete: Total credit outstanding under all programs, including the regular discount window, has fallen sharply from a peak of $1.5 trillion around year-end 2008 to about $110 billion by February 2010.
Separately, Bernanke told Congress that to prevent potentially catastrophic effects on the US financial system and economy, and with the support of the Treasury Department, the Fed also used its emergency lending powers to help avoid the disorderly failure of two “systemically important” financial institutions, Bear Stearns and American International Group, which economist Bill Black suggests “systemically dangerous” as a more appropriate description. Why Lehman was allowed to go bankrupt was conveniently skirted over by Bernanke.
Credit extended under these arrangements currently totals about $116 billion, or about 5% of the Fed’s balance sheet. The Fed expects these exposures to decline gradually over time. The Federal Reserve Board continues to anticipate that the Fed will ultimately incur no loss on these loans as well. Bernanke admitted to Congress that these loans were made with great reluctance under extreme conditions and in the absence of an appropriate alternative legal framework. To preclude any future need for the Federal Reserve to lend in similar circumstances, Bernanke said that the Fed strongly supports the establishment of a statutory regime for the safe resolution of failing, systemically important non-bank financial institutions.
Fed Monetary Policy and Trouble Asset Purchases

In addition to supporting the smooth functioning of financial markets, the Fed also applied an extraordinary degree of monetary policy stimulus to help counter the adverse effects of the financial crisis on the economy. In September 2007, the Fed began in a number of steps to reduce the target for federal funds rate from an initial level of 5-1/4% to near zero.
By late 2008, this target reached a range of 0 to 0.25%, essentially the lowest feasible level, since that rate cannot go below zero. With its conventional policy arsenal depleted and the economy remaining under severe stress, the Fed decided to override the limits of monetary measures to provide additional stimulus through large-scale purchases of federal agency debt and mortgage-backed securities (MBS) that are supposed to be fully guaranteed by federal agencies, though not by the Treasury. In March 2009, the Fed vastly expanded its purchases of agency securities and began to purchase longer-term Treasury securities as well. All told, the Fed purchased $300 billion of Treasury securities and purchased $1.25 trillion of agency MBS and $175 billion of agency debt securities at the end of March 2010.
The Fed’s purchases have had the effect of leaving the banking system in a highly liquid condition, with US banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks. Bernanke claimed that a range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in private credit markets and put downward pressure on longer-term private borrowing rates and spreads.
As part of its quantitative easing (QE), the Fed first announced in November 2008 “Large-Scale Asset Purchases” (LSAPs) of GSE debt, mortgage-backed securities (MBS) and US Treasuries, expanded it in March 2009 and concluded it in March 2010.

The objective behind the purchases of Mortgage Backed Securities (MBS), $1.25 trillion and Government Sponsored Enterprises (GSE) debt, $200 billion, was clearly stated at the November 2008 Fed statement: “to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets”

The Fed in effect provided massive support to the collapsed housing sector, deemed important in its effort to “improve conditions in financial markets more generally.” This approach distorted the market’s normal function in credit allocation. The Fed’s purchase of MBS bid up prices and lowered yields at a time when price should fall and yield rise not only to attract buyers but to reflect true values. Similarly, houses continue to face slow sales despite low mortgage rates because house prices are still artificially held up by Fed subsidy while potential buyers know prices are still at bubble levels. As a result, the housing market has remained lifeless while foreclosures continued nationwide. In some regions, such as California and Florida, the housing market stay in deep depression .

But the Fed’s QE has also been design with the systemic objective of combating general price deflation. It hoped to achieve that systemic objective by intervening in the housing credit market and boost equity and bond prices through the portfolio balance effect. New York Fed Executive Vice President Brian Sack explained in a speech on The Fed's Expanded Balance Sheet, at New York University on December 2, 2009:
“The [Fed] purchases bid up the price of the [housing credit] asset and hence lower its yield. These effects [of the purchases] would be expected to spill over into other [non-housing] assets that are similar in nature, to the extent that investors are willing to substitute between the assets. … With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.”

But the problem with the above statement is that Agency MBS and Treasuries are not assets that are “similar in nature” with corporate bonds and equities, as a 2004 paper (Quantitative Monetary Easing and Risk in Financial Asset Markets) by Takeshi Kimura of the Bank of Japan and David Small of the Federal Reserve Board, showed:
“… the portfolio-rebalancing effects were beneficial in that they reduced risk premiums on assets with counter-cyclical returns, such as government and high-grade corporate bonds. But, they may have generated the adverse effects of increasing risk premiums on assets with pro-cyclical returns, such as equities and low-grade corporate bonds.”

QE operations that withdraw “safer” assets such as Treasuries or Agency MBS from the market turn optimally-balanced portfolios into ones heavily “overweighted” with pro-cyclical assets such as equities and high-yield corporate bonds, the market values of which depend on a strong economic recovery. In a protracted recession, portfolio managers will respond by shedding pro-cyclical assets to rebalance and raise their risk premium. The Fed’s LSAPs during 2008-2010 actually produced the opposite spillover effects from what the Fed had wanted to achieve, which was “to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets”.
Low Interest Rates and Inflationary Pressures
The Fed Open Market Committee (FOMC), which sets the Fed funds rate target, anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period going forward from 2010. In due course, however, as the expansion matures, the Fed will need to begin to tighten monetary conditions to prevent the development of inflationary pressures and expectations. Bernanke, as the nation’s central banker, assured Congress that the Fed has a number of tools that will enable it to firm the stance of policy at the appropriate time. Yet Bernanke, as an economist, must know that the Fed does not have a reliable way to predetermine when it is the appropriate time to firm policy stance.
More importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on banks’ holdings of reserve balances at Federal Reserve Banks. By increasing the interest rate on reserves, the Fed will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.
While this is the accepted theoretical correlation, in recent years Alan Greenspan had been baffled by what he called the “Interest Rate Conundrum”.  Greenspan’s February 2005 testimony to Congress referred to the behavior of low long term rates as a “conundrum”:
“In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.”

Greenspan was referring to the expectations theory of interest rates where long rates are the geometric average of expected future short rates plus a risk premium that would usually increase with duration of the instrument. This theory assumes that arbitrage between instruments of different durations will set the price. It is also possible for the risk premium to change over time. As an example, changes in the perceptions of the Fed’s credibility on fighting inflation will change the risk premium. 
Increases in the interest rate paid on reserves are unlikely to prove a net subsidy to banks, as the higher return on reserve balances will be offset by similar increases in banks’ funding costs. On balance, banks’ net interest margins will likely continue to decline when short-term rates rise.
Reverse Repos as Addition Tool to Reduce Bank Reserves
Bernanke told Congress the Fed has also been developing a number of additional tools it will be able to use to reduce the large quantity of reserves held by the banking system when needed. Reducing the quantity of reserves will lower the net supply of funds to the money markets, which will improve the Fed’s control of financial conditions by leading to a tighter relationship between the interest rate on reserves and other short-term interest rates.
One such tool is reverse repurchase agreements (reverse repos), a method that the Fed has used historically as a means of absorbing reserves from the banking system. In reverse repos, the Fed sells securities to counterparties with an agreement to repurchase the security at some date in the future. The counterparties’ payments to the Fed have the effect of draining an equal quantity of reserves from the banking system.
Recently, by developing the capacity to conduct such reverse repos transactions in the tri-party repo market, the Fed has enhanced its ability to use reverse repos to absorb very large quantities of reserves. The capability to carry out these transactions with primary dealers, using the Fed’s large holdings of Treasury and agency debt securities, has already been tested and is currently available, according to Bernanke. To further increase its capacity to drain reserves through reverse repos, the Fed is reportedly also in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as collateral in these transactions.
As a second means of draining reserves, Bernanke said the Fed is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Fed would likely auction large blocks of such deposits, thus converting a portion of depository institutions’ reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves. A proposal describing a term deposit facility was recently published in the Federal Register, and the Fed is currently analyzing the public comments that have been received. After a revised proposal is reviewed by the Board, the Fed expects to be able to conduct test transactions in the spring of 2010 and to have the facility available if necessary shortly thereafter.
Bernanke said reverse repos and the deposit facility would together allow the Fed to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so. The question has been left unanswered as to under what economic conditions would the Fed choose to do so. If the conditions include good employment figures, the Fed’s need to use this new option to drain reserves from the banking system may not arise for a long time.
In the mean time, the scars of the financial crisis remain highly visible in a key part of the US fixed income universe – the repo market. As a barometer of borrowing by the financial sector, the size of the repo market peaked in early 2008 at nearly $4.3 trillion, before the demise of Bear Stearns revealed how much major investment banks had depended on this short-term funding market to finance their balance sheets.
In April, 2010, the overall use of repo at about $2.5 trillion remains more than 40% below its peak. This is evidence showing how, in the wake of the Lehman failure in September 2008, large dealers have cut back their balance sheets and are now less reliant on short-term leverage. Instead, they are funding themselves with long-term debt outside the repo sector. A reluctance by repo lenders to accept lower-quality assets as collateral has also hit the market.
At the peak of repo activity in 2007 and early 2008, a sizeable portion of collateral involved securitized mortgages and structured credit securities, which subsequently collapsed in marked-to-market value as the mortgage and credit bubble burst and credit markets imploded. The subsequent large drop in repo usage partly reflects how credit standards have tightened, with only super good-quality collateral being accepted by short-term lenders of cash.
The current lack of appetite for extending money to lower-quality collateral via repo helps explain why the use of securitization among banks has not come roaring back. Another factor limiting the use of repo financing is the current low level of interest rates, which has resulted in some investors not lending their holdings of bonds as the potential returns are too low.  (Please see my December 4, 2009 article: The Repo Time Bomb Redux)
Aside from the uncertainty of potential regulatory, the repo market faces new challenges.
Before the financial crisis, US investment banks ended their financial years in November. That meant that the big repo dealers were divided into two groups, with primary dealers reporting quarterly results one month behind the big US investment banks. This split in reporting periods meant that quarterly window dressing by financial institutions, whereby banks cut borrowings and often buy Treasury bills and notes to shore up their balance sheets, was spread out over several weeks.
Now, with all banks reporting on the same quarterly schedule, uniform window dressing by financial institutions has led to a pronounced and coordinated drop in the use of repo during these periods.
This potentially has big implications for financial markets and institutions in the future as the financial crisis subsides. As all large banks now operate on the same reporting schedule, it could leave investors withholding funds and institutions scrambling for funds, as liquidity declines at the end of each quarter. This may result in a mini liquidity crunch every three months.
The Fed’s other tools
The Fed also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Fed’s balance sheet. But that would reduce the money supply through quantitative tightening and drain liquidity.
Bernanke admitted that the sequencing of steps and the combination of tools that the Fed uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. One possible sequence would involve the Fed continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments, such as rising inflation expectation, were to require a more rapid exit from the current highly accommodative policy, however, the Fed could increase the interest rate paid on reserves at about the same time it commences significant draining operations. But Bernanke did not sketch out to Congress a scenario that covered how the Fed would handle stagflation, a very likely prospect in a jobless recovery.
Bernanke told Congress he currently did not anticipate that the Fed will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and he claimed optimistically that the economy is clearly in a sustainable recovery. However, to help reduce the size of the Fed’s balance sheet and the quantity of reserves, Bernanke said the Fed is allowing agency debt and MBS to run off as these instruments mature or are prepaid over time. The Fed is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. Left unsaid is that while this policy will reduce the Fed’s balance sheet, it does this by adding to the national debt.
Bernanke said in the long run, the Fed anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities. Although passively redeeming agency debt and MBS as they mature or are prepaid will move the Fed in that direction, Bernanke said he may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions. All things considered, the fragile economy is expected to be under the intensive care of the Fed for a long time.
Bernanke reported to Congress that as a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets.
Accordingly, the Fed is reported to be considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates.
The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. But such a step would have to be approved by Congress, which traditionally has been opposed to the idea because of the revenue loss that would result to the US Treasury. Each year the Treasury receives the Fed’s revenue that is in excess of its expenses. The payment of interest on bank reserves would, of course, be an additional expense to the Fed and less revenue for the Treasury.
No decision has been made on this issue; the Fed says it will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Fed anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.
Yet the structural echo of a long duration of high reserve balance coupled with zero interest rate will so conditioned the dependency of the economy on monetary accommodation that real recovery may not emerge for decades.
Bernanke told Congress that the authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Fed to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements.
Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Fed has ample time to consider the best long-run framework for policy implementation. The Fed believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.
As market conditions and the economic outlook improve, the series of special lending facilities to stabilize the financial system and encourage the resumption of private credit flows have been terminated or are being phased out. The Fed also aimed to promote economic recovery through sharp reductions in its target for the federal funds rate and through purchases of distressed securities. Yet the economy continues to require the support of accommodative monetary policies after 30 months of recession. The Fed claims it has the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus. Sounds a bit like Samuel Beckett’s Waiting for Godot.
April 14, 2010  

Next: The Fed’s Extraordinary Section 13(3) Programs