Federal Reserve Power Unsupported by Credibility

[SinoIndusFriendship]

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 investments 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

Next: Facing a Lost Decade Ahead

 

[SinoIndusFriendship]

Federal Reserve Power Unsupported by Credibility

By
Henry C.K. Liu

Part I: No Exit

Part II: Facing a Lost Decade Ahead



Ben S. Bernanke, who has just been reappointed a second term as Chairman of the Federal Reserve by President Obama, has announced repeatedly his decision to turn the traditionally secretive Fed into a more open institution, saying his unusually large number of recent public appearances is the result of the “extraordinary” times the economy faces. It appears that the extraordinary times that both Chairman Bernanke and President Obama concede as likely to last a long time may well turn into a lost decade for the US economy while waiting for an anemic jobless recovery.

Troubling Economic Projections

White House Budget Director Peter R. Orszag predicts that US unemployment will surge past 10% in 2009 and the fiscal budget for 2010 will reach $3.7 trillion while the fiscal deficit will reach $1.5 trillion, some 40% over revenue. The figures are higher than previous administration forecasts because of a recession that was deeper and longer than expected by administration economists. The White House Office of Management and Budget (OMB) Mid-year Economic Review forecasts a weaker economic recovery than it saw in May, as the gross domestic product is expected to shrink 2.8% in 2009 before expanding 2% in 2010 from a lower base. The Congressional Budget Office (CBO), in a separate assessment, forecasts the economy will grow 2.8% in 2010 from a low base. Both see the GDP expanding 3.8% in 2011, an optimistic forecast likely to be revised downward by actual events.

“While the danger of the economy immediately falling into a deep recession has receded, the American economy is still in the midst of a serious economic downturn,” the White House OMB report said, adding: “The long-term deficit outlook remains daunting.” What the Administration and the Fed have done is to halt the sharp downdraft in the economy with measures that will guarantee a protracted lackluster recovery when it comes.

Budget Shortfall Projections

The Obama budget shortfall for 2010 would mark the second consecutive year of trillion-dollar fiscal deficits. Along with the unemployment numbers, the fiscal deficit may weigh heavily on Obama’s faltering drive for his top domestic priority, reforming the US health care system, a long overdue urgent task. Obama’s hope for change cannot be fulfilled without a vibrant economy. It cannot be financed with fiscal deficits.

Administration and congressional budget officials expect the unemployment rate, which was 9.4% in July, 2009 to keep rising even with recovery. White House officials at the OMB said the unemployment rate likely will rise past 10% by the end of 2009, averaging 9.3% for the entire year. A 7.9% estimate released in May 2009 by the White House was revised up to a 9.8% for 2010, no small revision.

The CBO report also estimates the 2009 jobless rate at 9.3% but a 2010 average of 10.2%. These estimates are predicated on the prospect that Fed policies work as hoped. There is no official data on underemployment which has become a serious problem in the economic meltdown when layoff workers have to settle for jobs below their qualification that pay less than their previous jobs. Moreover, the unemployment problem is hitting the service sector, traditionally the sector responsible for growth in recent decades.

Unprecedented Fiscal Deficit Projections

The OMB raised its deficit projection for fiscal 2010, which begins on Oct. 1, 2009 from the $1.26 trillion forecast in May, to $1.5 billion, reflecting slower economic growth in 2009 and 2010 because of “the severity of the crisis in the US and in our trading partners.” The OMB added almost $2 trillion to the 10-year fiscal deficit from its May forecast, to $9.05 trillion. The nonpartisan CBO lowered its long-range projection to $7.14 trillion for the decade in anticipation of Congress cutting the administration’s budget requests.

White House Budget Director Orszag defended the trillion-dollar deficits during a recession, saying they should not be used to block the administration’s long-term health-care reform initiative. Revising the way the nation pays for medical care will help save money in the long run, he asserts. The cruel fact is that there is no way to reduce health care cost absolutely without affecting quality. Systemic efficiency improvement can only come from spreading rising medical spending towards the needy rather than limiting it to the privileged rich, thus producing a healthier population. The correct way to look at medical expenses is to see it as investment rather than consumption. The same principle applies to education. Cutting cost is a dead-end solution for these sectors.

Even with economic conditions turning out worse than originally forecast, Christina Romer, highly respected economist on leave as Garff B. Wilson Professor of Economics at the University of California at Berkley, now Chair of the White House Council of Economic Advisors, expects “positive GDP growth” by the end of Q4 2009 as the economy reaches “a turning point”, albeit from a much reduced base. Still, she admits that “a return to employment growth will take longer.” So at best, it will be another jobless anemic recovery even if there is a recovery.

Romer predicts that the economic stimulus package probably is adding “between 2 and 3 percentage points” to economic growth in the second quarter of 2009, helping to cushion conditions that would have been worse, previewing a report on the effect of the stimulus program due to Congress in September. That means GDP growth would have been negative without the economic package. The wild card is what happens when the stimulus package is spent and the massive debt, which would take a decade to fully unwound, is still hanging over the economy.

Looming Inflation and Interest Rate Hikes

Romer thinks inflation will remain subdued. Projections for the consumer price index show a contraction to 0.7% in 2009, rising to 1.4% in 2010 and 1.5% in 2011. The good news is that deflation has been at least stopped temporarily, thanks to the stimulus money without which there might have been sharp deflation and sharp negative GDP growth for all three years. The economic assumptions were compiled jointly by the Council of Economic Advisers, Treasury Department and the Office of Management and Budget. The estimates reflect conditions as of early June 2009. This means the Fed Funds rate target should rise from its current low of 0-0.25% even in 2009 and rise to 2% in 2011 to support a neutral monetary stance on inflation. Any rise in interest rate will torpedo tenuous recovery.

Fed Openness in Response to Loss of Credibility

The Fed’s new openness is in response to the mounting public debate over the central bank’s ineffective role and poor performance so far in the current financial crisis in relation to the proposal to expand its regulatory powers going forward. A July 2009 Gallup Poll shows the Fed being held in lowest esteem by the US population among all government agencies, lower even than the Internal Revenue Service. The Centers for Disease Control (CDC) got the highest approval rating, with 61% of Americans saying it was doing a good job. The Fed has failed to impress the public as a Center for Financial Disease Control.

Notwithstanding Bernanke’s hero image on Wall Street and a 75% approval rating from international investors in a Bloomberg poll, only 30% of the US public thinks the Federal Reserve is doing a good job despite the central bank’s unprecedented heroic efforts to save the economy from the financial crisis and a crippling recession. The US public, parting company with Wall Street globalists, do not see the Fed as the people’s trusted friend and protector. In 2003, the last time Gallup polled the Americans on their view of the Fed, 53% said the Fed was doing a good job even when wealth and income disparity was already on the rise.

Bernanke is increasingly going public with a defense of the Federal Reserve’s handling of the crisis in an effort to ward off a populist headwind in Congress among some lawmakers, in the form of a bill introduced by Republican Representative Ron Paul of Texas with 250 co-sponsors, who want to cut down the Fed’s monetary independence from the will of the people.

The Threat on the Dollar

Bernanke in his April 3, 2009 speech described the ominous international situation of the dollar. Like depository institutions in the US, foreign banks with large dollar funding positions were also experiencing heavy liquidity pressures. Bernanke saw it as another temporary liquidity problem rather than a structural insolvency predicament. Money disintegrated from the financial system as the value of financial assets denominated in dollars dropped precipitately globally, and transnational banks need new dollars from the Fed to slow down the fall of prices because foreign central banks cannot issue dollars. To call this situation a liquidity problem is to confuse the issue. It is an insolvency problem with a liquidity dimension. The money did not just fail to circulate; wealth measured in money had vanished as prices fell while the monetary liability in debt remained unchanged. The debt/equity ratio has turned below zero into negative territory and leverage has risen to infinity.

Bernanke characterized the shortage of money caused by the bursting of the financial bubble as a temporary unmet foreign demand for dollars that spilled over into US markets, including the federal funds market. To address this issue, the Federal Reserve cooperated with foreign central banks in establishing reciprocal currency arrangements, or liquidity swap lines. In these arrangements, the Federal Reserve provides dollars to foreign central banks in hope that they in turn would lend to banks in their jurisdictions, even though the foreign banks could not find many credit-worthy borrowers. Thus the Fed dollars went into foreign bank reserves to write off nonperforming loans and toxic assets. Left unspoken is the problem that an unmet demand for dollars in Europe will upset the exchange rate market which is dominated by the dollar, the euro and the yen, the world’s three major freely exchangeable currencies.

The Fed views credit risk as minimal in these swap arrangements, as the foreign central bank is responsible for repayment, rather than the institutions that ultimately receive the dollar funds. Further, the Fed receives foreign currency from its foreign central bank partners of equal value to the dollars lent, albeit that exchange rate risk can be a problem. Liquidity provided through such arrangements peaked ahead of year-end 2008 but has since declined as pressures in short-term dollar funding markets have eased. The outstanding amount of currency swaps currently stands at about $310 billion. This was because several European central banks, led by the United Kingdom, took decisive steps to nationalize banks in severe distress. In contrast, the Fed went through torturous financial acrobatics to mask the “N” word in its rescue efforts.

Fed Emergency Lending

Following the sharp deterioration in market conditions in March 2008, the Federal Reserve used its emergency lending authority to provide primary dealers access to central bank credit. Primary dealers can now obtain short-term collateralized loans from the Fed through the Primary Dealer Credit Facility (PDCF). The PDCF, which is closely analogous to the discount window for commercial banks, currently has about $20 billion in borrowings outstanding. Another program for primary dealers, called the Term Securities Lending Facility (TSLF), lends Treasury securities to dealers, taking investment-grade securities as collateral. The primary dealers then use the more-liquid Treasury securities to obtain private-sector funding. Extensions of credit under this program, which currently total about $85 billion, do not appear as distinct assets on the Fed’s balance sheet, because the Federal Reserve continues to own the Treasury securities that it lends, unless the Fed suffers a massive counterparty default and could not get its Treasuries back.

Lender of Last Resort or Market Maker of Last Resort

Bernanke reminds his audience that the provision of liquidity on a collateralized basis to sound financial institutions is a traditional central bank function. This so-called lender-of-last-resort activity is particularly useful during a financial crisis, as it reduces the need for fire sales of assets and reassures financial institutions and their counterparties that those institutions will have access to liquidity as needed.

Bernanke glosses over the fact that the central bank’s role in current circumstances is that of a market maker for overextended illiquid markets, a role much different in both nature and operation than a neutral lender of last resort in brief temporary liquidity crunches. The Fed then becomes a market participant of last resort to buy not just top-rated assets, but toxic assets that cannot find private sector buyers not merely in a fire storm, but for extended periods with no fixable exit date. In fact, the Fed has become a market maker in failed markets for assets of little worth, paying bubble prices that can recover only with the devaluation of money.

Bernanke concedes that to be sure, the provision of liquidity alone cannot address solvency problems or erase the large losses that financial institutions have suffered during this crisis. Yet both the Fed’s internal analysis and external market reports suggest to him that the Fed’s “damned the torpedo” approach of providing ample supply of liquidity, along with liquidity provided by other major central banks, has significantly reduced funding pressures for financial institutions, helped to reduce rates in bank funding markets, and increased overall financial stability. But this stability is not support by new wealth creation, but by asset reflation.

Bernanke noted that for example, despite ongoing financial stresses, funding pressures around year-end 2008 and the second quarter-end in 2009 appear to have moderated significantly. Ironically, the example that Bernanke gave supports critical allegation that the Fed has confused funding pressures with financial stresses. The Fed has managed to moderate funding pressure for the financial sector with free money, but it has not relieved financial stress in the economy. The excess debt remains in the financial system to drag down the economy, possibly for a decade or more, as Japan has experienced.

Bernanke defended the Fed’s actions to ensure liquidity to another category of financial institution: money market mutual funds. In September 2008, a prominent money market mutual fund “broke the buck” -- that is, was unable to maintain a required net asset value of $1 per share. This event led to a run on other funds, which saw very sharp withdrawals. These withdrawals in turn threatened the stability of the commercial paper market, which depends heavily on money market mutual funds as investors.

Money market funds are not federally insured like bank deposits. Therefore, fund assets have an implied promise to preserve capital at all costs and preserve the $1 floor on share prices. These funds are regulated by the Securities and Exchange Commission and Rule 2a-7 restricts what they can invest in regarding credit quality and maturities with the hope of ensuring principal stability.

For 37 years no retail money market fund had broken the buck. In 2008, however, the day after Lehman Brothers Holdings Inc. filed bankruptcy on September 15, Reserve Primary Fund’s net asset value fell to 97 cents after writing off the debt owed to it by Lehman. The $64.8 billion fund held $785 million in commercial paper issued by Lehman which filed for bankruptcy protection that might eventually repay debt at cents on a dollar. This created the potential for a bank run in money markets as there was fear that more funds would break the buck.

Shortly thereafter, another large fund announced that it was liquidating, due to redemptions. The next day the US Treasury announced a program to insure the holdings of publicly offered money market funds so that should a covered fund break the buck, investors would be protected to $1 NAV.

Surely any economist as astute and experienced as Bernanke would understand that money of constant value allows its owners, or banks that did not pay interest for it, to hold it idle without penalty. The positive effect would be that the value of money might not fall. Money would, in market parlance, be "well held". The holders would be under no pressure to employ all of it, waiting instead to employ part at a higher rate later.

The negative effect is that money will be underemployed and cause to economy to stagnate. Thus the three conditions that compel money to be constantly fully employed are taxes, interest payments and mild inflation which forces holders of money to seek returns above inflation rate. Tax reduction, low interest rates and deflation are conditions that destabilized money markets by retarding money circulation.

In the current financial crisis, tax reduction had been implemented by the previous Republican administration, low interest rate had been implemented by the Bernanke Fed and mild inflation has been banished by the recession. No wonder that the economy is facing a liquidity crisis in the midst of an abundance of idle funds. The safe path to capital preservation is to withdraw funds from the falling market.

Bernanke must also know that money is economically productive only if it is not free. In the money market, money is normally held by those who must pay interest on it, such as money-market fund managers, and such entities must employ all the money in its care productively to avoid insolvency. Such entities do not so much care at what rate of interest they employ the money they manage: they can reduce the interest dividend they pay investors in proportion to that which they can make from lending, but they must pay something. They must also always avoid losing capital, known as breaking the buck, as each unit of investment is generally structured as $1.00. Yet if Fed funds rate stays near zero for long periods, the interest rate spread may not be sufficient to pay the fees of fund managers and may cause funds to fail.

Following the long-standing principle that the central bank should lend into a panic, the Federal Reserve established two programs to backstop money market mutual funds and to help those funds avoid fire sales of their assets to meet withdrawals. Together with an insurance program offered by the Treasury, the Fed’s programs helped end the run on mutual funds; the sharp withdrawals from the funds have been replaced by moderate inflows. Although credit extended to support money funds was high during the intense phase of the crisis in the fall, borrowings have since declined substantially, to about $6 billion.

On March 17, 2009 a proposal drafted by an industry group whose work began in late 2007 but became far more urgent in September2008 when a run on a giant money fund forced the Treasury Department to set up an ad hoc insurance program to stem a panic in the nearly $4 trillion money fund market.

That crisis underscored how vital money market funds have become as sources of short-term credit to American businesses and local governments, and prompted calls for changes in how they are regulated. The industry’s plan, endorsed by the board of the Investment Compnay Institutue seems aimed at heading off more sweeping and more damaging revisions to a product that has become a mainstay of household finances since its inception almost 40 ceades ago.

Under the industry proposal, money funds would be required to keep minimum levels of cash on hand, reduce the risks in their portfolios and increase the amount of information provided to investors and regulators. The plan also calls for regulators to pre-emptively question any money market fund that offers yields that are significantly above its peers, to determine whether the fund is taking undisclosed or unacceptable risks. These steps would lower most fund yields, but the industry is betting that lower risks will reassure most mainstream investors.

To protect funds from runs like the one that started the September 2008 crisis, the industry will ask regulators to give money funds greater leeway to halt redemptions temporarily or liquidate entirely if they are hit by a flood of redemptions. That would reassure investors that all shareholders would be treated equally if disaster struck
These proposals differ sharply from those offered in January by the Group of 30, an international forum of senior public and private sector representatives whose chairman is Paul Volcker, an top adviser to the Obama administration on recovery. The Volcker panel recommended that money funds be stripped of their check-writing feature and their fixed dollar-a-share pricing unless they submitted to regulations similar to those that govern banks — steps that would eliminate the defining features of the modern money fund.
The first-ever panic in the money fund industry came after Lehman Brothers filed for bankruptcy protection on September 15, 2008. That prompted an avalanche of redemptions from the Reserve Primary Fund, a multibillion-dollar money fund with a big stack of Lehman notes in its portfolio.

The next day, the fund reported it had “broken the buck,” reporting a share value below a dollar. That spurred widespread concern among money fund investors who have long trusted that they could always redeem a money fund share for a dollar without the risk of losses.
As hundreds of billions of dollars were withdrawn from money funds, the Treasury rushed to create a temporary money-fund insurance program, which would expire no later than September 2008. Critics ask: Given public skepticism about financial self-regulation, why should the fund industry be trusted to write its own prescription for reform?

The nature of financial panics

A panic is a species of neuralgia. A financial panic is cured by having it starved, stopping the drain of confidence from a market that runs on confidence. To cure a financial panic, the holders of cash reserves must, in contrast to natural instinct, be ready not only to keep the reserves for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to all market participants in need of liquidity whenever credit is otherwise good in normal situations. The problem with toxic assets in the current financial crisis is that they are worth the value in normal times and the credit of many holders of such assets is not good in normal, non-bubble times.

The hesitance is related to the unhappy prospect of unnecessary larger loss in the event the cure fails to stem the panic, resulting in throwing good money after bad. And the cure will fail if any entity in the chain of credit should decide to bail itself out at the expense of the system. In wild periods of alarm, one failure will generate many others in a falling domino effect, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

This was easier to do when the number of counterparties in the distressed contract was relatively small, as in the case of the 1998 crisis involving Long Term Capital Management (LTCM), a large hedge fund, where they could all be gathered in one room is the New York Fed Building to work out a rescue deal. But in the case of the Refco collapse in 2005, where counterparties were spread over 240,000 customer accounts in 14 countries, it became a different problem. The identities of counterparties for over-the-counter derivative contracts were unknown as risks were unbundled and sold off to a variety of investors with varying appetite for risk. In 2007, the problem of the credit crunch was even more widespread.

The management of a panic is mainly a confidence restoring problem. It is primarily a trading problem. All traders are under liabilities; they have obligations to meet that are time-sensitive and unconditional, and they can only meet those obligations by discounting obligations from other traders. In other words, all traders are dependent on borrowing money as bridge loans until settlement of their trades, and large traders are dependent on borrowing much money. At the slightest symptom of panic, traders want to borrow more than usual; they think they will supply themselves with the means of meeting their obligations while those means are still forthcoming. If the bankers gratify the traders, they must lend largely just when they like it least; if they do not gratify them, there is a panic. Fear generates more fear in a vortex toward an abyss.

There is a great structural inconsistency of logic in this. First, bank reserves are established where the last dollar in the economy is deposited and kept in a central bank. This final depository is also to be the lender of last resort; that out of it unbounded, or at any rate immense, advances are to be made when no one else can lend. Thus central banks posit themselves both as depositories of reserves and as lenders of last resort to the banking system. This seems like saying, first, that a bank reserve should be kept, and then that it need not be kept because in a real panic, the central bank will lend where bank reserve is insufficient.

What is more problematic is that banks now constitute only a small part of the credit market. The lion’s share is in the non-bank derivatives market. Granted, notional values in derivative contracts are not true risk exposures, but a swing of 1% in interest rate on a notional value of $220 trillion in the current derivative market is $2.2 trillion, approximately 20% of US gross domestic product.

When reduced to abstract principles, a financial panic is caused by a collective realization that the money in a system will not pay all creditors when those creditors all want to be paid at once. A panic can be starved out of existence by enabling those alarmed creditors who wish to be paid to get paid immediately. For this purpose, only relatively little money is needed. If the alarmed creditors are not satisfied, the alarm aggravates into a panic, which is a collective realization that all debtors, even highly creditworthy ones, cannot pay their creditors. A panic can only be cured by enabling all debtors to pay their creditors, which takes a great deal of money. No one has that much money, or anything like enough, but the lender of last resort - the central bank. And injecting that amount of money suddenly after a panic has begun will alter the financial system beyond recognition, and produce hyperinflation instantly, because the extinguishment of all credit with cash creates an astronomical increase in the money supply.

David Ricardo (1772-1823), brilliant British classical economist and a bullionist along the line of Henry Thornton (1760-1815), wrote: “On extraordinary occasions, a general panic may seize the country, when everyone becomes desirous of possessing himself of the precious metals as the most convenient mode of realizing or concealing his property against such panic, banks have no security on any system.”

Thornton in his classic The Paper Credit of Great Britain (1802) provided the first description of the indirect mechanism by observing that new money created by banks enters the financial markets initially via an expansion of bank loans, through increasing the supply of lendable funds, temporarily reducing the loan rate of interest below the rate of return on new capital, thus stimulating additional investment and loan demand. This in turn pushes prices up, including capital good prices, drives up loan demands and eventually interest rates, bringing the system back into equilibrium indirectly.

The Bullionist Controversy emerged in the early 1800s regarding whether or not paper notes should be made convertible to gold on demand. But today, no central bank has enough precious metal (gold) to back its currency because the global currency system is based on fiat money. The use of credit enables debtors to use a large part of the money their creditors have lent them. If all those creditors were to demand all that money at once, their demands could not be met, for that which their debtors have used is for the time being employed, and not to be obtained for payment to the creditors. Moreover, every debtor is also a creditor in trade who can demand funds from other debtors. With the advantages of credit come disadvantages of illiquidity that require a store of ready reserve money, and advance out of it very freely in periods of panic, and in times of incipient alarm.

Notwithstanding the fact that the global money market has already run away from the control of every central bank, the management of the global money market is much more difficult than managing banking reserves in any particular country by its central bank, because periods of internal panic and external virtual demand for gold bullion commonly occur together. The virtual demand for gold bullion in today's fiat-currency world is expressed in the exchange rates of currencies. A falling exchange rate drains the global purchasing power of a currency and the resulting rise in the rate of discount, as expressed in a change in the exchange rate, tends to frighten the market. The holders of bank reserves have, therefore, to treat two opposite maladies at once: one requiring punitive remedies such as a rapid rise in the market rates of interest; and the other, an alleviative treatment with large and ready loans to combat illiquidity.

Experience suggests that the foreign drain must be counteracted by raising the rate of interest. Otherwise, the falling exchange rate will protract or exacerbate the alarm, generally known as a loss of confidence in the currency and the banking system and the functioning of the market. And at the rate of interest so raised, the holders of the final bank reserve must lend freely. Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not available, or that it may not be available at any price, only raises alarm to panic and enhances panic to madness, with a total loss of confidence. Yet the acceptance of loans at abnormally high interest rates is itself a sign of panic. This is the fate that awaits the dollar going forward. Against such contradictions, no central bank has found the appropriate wisdom. Former US Federal Reserve chairman Alan Greenspan’s formula had always been more liquidity at low interest rates, which pushes the monetary system into what John Maynard Keynes called the liquidity trap. This transformed Greenspan from a wise central banker to a wizard of bubbleland.

And great as the delicacy of such a problem in all countries, it is far greater in the US now than it was or is elsewhere because of dollar hegemony. The strain thrown by a panic on the final bank reserve is proportional to the magnitude of a country's trade, and to the number and size of the dependent banks and financial institutions holding no cash reserve that is grouped around the Federal Reserve. There are very many more entities under great liabilities than there are, or ever were, anywhere else because of the emergence of the debt-driven US economy.

At the commencement of every panic, all entities under such liabilities try to supply themselves with the means of meeting those liabilities while they can. This causes a great demand for new loans while loans are still available. And so far from being able to meet it, the bankers who do not keep extra reserve at that time borrow largely, or do not renew large loans, or very likely do both.

The repo (repurchase agreement) market relieves the need of any bank or institutions to hold extra reserves, as new loans are supposed to be always available. (Please see my February 16, 2006 AToL article: The Global Money and Currency Markets – The Nature of Financial Panics)

Direct Lending to Borrowers and Investors

A second set of programs initiated by the Federal Reserve -- including the Commercial Paper Funding Facility (CPFF) on October 27, 2008 and the Term Asset-Backed Securities Loan Facility (TALF) on November 25, 2008 -- aims to improve the functioning of key credit markets by lending directly to market participants, including ultimate borrowers and major investors. The lending associated with these facilities is currently about $255 billion, corresponding to roughly one-eighth of the assets on the Fed's balance sheet. The sizes of these programs, notably the TALF, are expected to grow in the months ahead.

The commercial paper market is a key source of the short-term credit that US businesses use to meet payrolls and finance inventories. Following the intensification of the financial crisis in the fall of 2008, commercial paper rates spiked, even for the highest-quality firms. Moreover, most firms were unable to borrow for periods longer than a few days, exposing both firms and lenders to significant rollover risk. By serving as a backstop for commercial paper issuers, the CPFF was intended to address rollover risk and to improve the functioning of this market. Under this facility, the Fed stands ready to lend to the highest-rated financial and nonfinancial commercial paper issuers for a term of three months.

As additional protection against loss, and to make the facility the last rather than the first resort, the CPFF charges borrowers upfront fees in addition to interest. Borrowing from this facility peaked at about $350 billion and has since declined to about $250 billion as more firms have been able to issue commercial paper to private lenders or have found alternative sources of finance. Conditions in the market have improved markedly since the introduction of this program, with spreads declining sharply and with more funding available at longer maturities. Market participants are of the opinion that the CPFF contributed to these improvements.

TALF is aimed at restoring securitization markets, now virtually shut down. The closing of securitization markets, until recently an important source of credit for the economy, has added considerably to the stress in credit markets and financial institutions generally. Under the TALF, eligible investors may borrow to finance their holdings of the AAA-rated tranches of selected asset-backed securities. The program is currently focused on securities backed by newly and recently originated auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. The first TALF subscription attracted about $8 billion in total asset-backed securities deals and used about $4.7 billion in Federal Reserve financing. Over time, the list of securities eligible for the TALF is expected to expand to include additional securities, such as commercial mortgages, as well as securities that are not newly issued.

Relative to the Fed’s short-term lending to financial institutions, the CPFF and the TALF are rather unconventional programs for a central bank to undertake. Bernanke sees them as justified by the extraordinary circumstances in which the Fed finds itself and by the need for central bank lending practices to reflect the evolution of financial markets, After all, a few decades ago securitization markets barely existed. Notably, other central banks around the world have shown increasing interest in similar programs as they address the credit strains in their own countries. These programs also meet the criteria I stated at the beginning of my remarks regarding credit risk and credit allocation. Credit risk is very low in both programs; in particular, the TALF program requires that loans be over-collateralized and is further protected by capital provided by the Treasury. Both programs are directed at broad markets whose dysfunction impedes the flow of numerous types of credit to ultimate borrowers; consequently, I do not see these programs as engaging in credit allocation--the favoring of a particular sector or a narrow class of borrowers over others. (Please see my August 20, 2009 AToL article: Integrity Deficit has its Price)

In the US, the money market is a subsection of the fixed-income market. A bond is one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term high-grade debt securities (debt that matures in less than one year). Money-market investments are also called cash investments because of their short maturities and low risk. Money-market securities are in essence IOUs issued by governments, financial institutions and large corporations of top credit ratings. These instruments are very liquid and considered extraordinarily safe. Because they are extremely secured, money-market securities offer significantly lower return than most other securities that are more risky.

One other main difference between the money market and the stock market is that most money-market securities trade in very high denominations. This limits the access of the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this with the stock market, where a broker receives a commission to act as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems. Individuals gain access to the money market through money-market mutual funds, or sometimes through money-market bank accounts. These accounts and funds pool together the assets of hundreds of thousands of investors to buy the money-market securities on their behalf. However, some money-market instruments, such as Treasury bills, may be purchased directly from the Treasury in denominations of $10,000 or larger. Alternatively, they can be acquired through other large financial institutions with direct access to these markets.

There are different instruments in the money market, offering different returns and different risks. The desire of major corporations to avoid costly banks borrowing as much as possible has led to the widespread popularity of commercial paper. Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivables and inventories. It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than nine months, with maturities of one to two months being the average.

Commercial Paper Market

For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and creditworthiness issue commercial paper. Over the past four decades, there have only been a handful of cases where corporations have defaulted on their commercial-paper repayment. Commercial paper is usually issued with denominations of $100,000 or multiples thereof. Therefore, small investors can only invest in commercial paper indirectly through money market funds.

On December 23, 2005, commercial paper placed directly by GE Capital Corp (GECC) was 4.26% on 30-44 days and 4.56% on 266-270 days, while the Fed Funds rate target was 4.25% and the discount rate was 5.25%, both effective since December 13. On August 14, 2009, commercial paper was 0.21% on 30-44 days and 0.27% on 90 to 119 days, while the effective Fed Funds Rate was 0.16%. Shares of GE reached a high of $42.12 on October 12, 2007, three months after the credit crisis broke out, and fell to a low of $6.69 on March 4, 2009. It was $13.92 on August 14, 2009, still less than a third of its peak. GE market capitalization fell from $447.63 billion at its high in 2007 to $71.09 billion at it low in 2009 and bounced back to $147.93 billion on August 14, 2009. Before the collapse of the commercial-paper market, GE had become the world’s biggest non-bank finance company until the financial crisis of 2007. GE commercial paper is no longer listed in the financial press as a bench mark rate.

Rates on AA ranked financial commercial paper due in 90 days fell to a record low of 0.28% on Jan. 8, 2008, or 21 basis points more than the US borrowing rate,

The market for commercial paper backed by assets such as auto loans and credit cards was the first to seize up. It fell 37% over five months to $772.8 billion, from its peak in August 2007 of $1.22 trillion, as defaults on subprime home loans began to soar.

After Lehman Brothers Holdings Inc. filed for bankruptcy on September 15, 2008, the broader commercial paper market froze. The next day, the flagship $62.6 billion money-market fund of Reserve Management Co. became the second of its kind to “break the buck” in market history, or fell below the $1-a-share price paid by investors, triggering a run that helped freeze global credit markets and drove up borrowing costs. Returns on money-market funds have dropped 62% since then.

Meanwhile, the commercial paper market slumped 20% over six weeks as money-market investors fled for safer assets such as Treasuries. Prime money-market funds’ holdings of first-tier paper, rated at least P-1 by Moody’s Investors Service and A-1 by Standard & Poor’s, fell by 33% from September 9 to October 7, 2008.

On October 21, 2008, the Fed had set up the Money Market Investor Funding Facility (MMIFF), to provide liquidity to money-market investors. The facility buys commercial paper due in 90 days or less. The short-term debt markets had been under considerable strain in recent weeks as money market mutual funds and other investors had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. By facilitating the sales of money market instruments in the secondary market, the MMIFF is designed to improve the liquidity position of money market investors, thus increasing their ability to meet any further redemption requests and their willingness to invest in money market instruments. Improved money market conditions enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households.

A week later, on October 27, 2008, the Fed set up the Commercial Paper Funding Facility (CPFF), complementing a separate program for providing liquidity to the asset-backed debt market that had begun in September. These programs were intended to ensure companies would have access to short-term credit and to ease redemption concerns at money-market funds. The amount outstanding under the asset-backed program peaked at $152.1 billion on October 1, 2008 before plunging to a low of $14.8 billion as redemption concerns subsided.

About $220 billion to $230 billion of 90-day commercial paper was sold to the Fed above market rates in October 2008 through the CPFF matures in the first week of operation. That was as much as 66% of the $350 billion in debt that the CPFF owns. The Fed has purchased about one-fifth of the commercial paper market through the CPFF.

Fed Purchases of High-Quality Assets

The third major category of assets on the Fed's balance sheet is holdings of high-quality securities, notably Treasury securities, agency debt, and agency-backed MBS. These holdings currently total about $780 billion, or about three-eighths of Federal Reserve assets. Of this $780 billion, holdings of Treasury securities currently make up about $490 billion. Some of these Treasury securities are lent out through the Term Securities Lending Facility mentioned earlier. Obviously, these holdings are very safe from a credit perspective. Longer-term securities do pose some interest-rate risk; however, because the Federal Reserve finances its purchases with short-term liabilities, on average and over time, that risk is mitigated by the normal upward slope of the yield curve.

The Fed’s holdings of high-quality securities are set to grow considerably as the FOMC, in an attempt to improve conditions in private credit markets, has announced large-scale open-market purchases of these securities. Specifically, the Federal Reserve will purchase cumulative amounts of up to $1.25 trillion of agency MBS and up to $200 billion of agency debt by the end of 2009, and up to $300 billion of longer-term Treasury securities over the next six months. The principal goal of these programs is to lower the cost and improve the availability of credit for households and businesses.

Fed Support for Specific Institutions

In addition to those programs discussed, the Federal Reserve has provided financing directly to specific systemically important institutions. With the full support of the Treasury, the Fed used emergency lending powers to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. and also to prevent default by AIG. These extensions of credit are very different than the other liquidity programs discussed previously and were put in place to avoid major disruptions in financial markets. From a credit perspective, these support facilities carry more risk than traditional central bank liquidity support, but the Fed nevertheless expect to be fully repaid. Credit extended under these programs has varied but as of Bernanke’s April 3, 2009 speech accounted for only about 5% of Fed balance sheet. That said, these operations have been extremely uncomfortable for the Federal Reserve to undertake and were carried out only because no reasonable alternative was available. As noted in the joint Federal Reserve-Treasury statement mentioned earlier, the Fed and the Treasury are working with the Administration and the Congress to develop a formal resolution regime for systemically critical nonbank financial institutions, analogous to one already in place for banks. Such a regime should spell out as precisely as possible the role that the Congress expects the Federal Reserve to play in such resolutions.

Fed Liabilities

Having reviewed the Federal Reserve's main asset accounts, Bernanke described briefly on the liability side of the balance sheet. Historically, the largest component of the Federal Reserve's liabilities has been Federal Reserve notes--that is, US paper currency—the dollar. Currency has expanded over time in line with nominal spending in the United States and demands for US currency abroad. By some estimates, a bit over one-half of US currency is held outside the country to maintain dollar hegemony.

Other key liabilities of the Federal Reserve include the deposit accounts of the U.S. government and depository institutions. The US government maintains a “checking account” with the Federal Reserve--the so-called Treasury general account--from which most federal payments are made. More recently, the Treasury has established a special account at the Federal Reserve as part of its Supplementary Financing Program (SFP). Under this program, the Treasury issues special Treasury bills and places the proceeds in the Treasury supplementary financing account at the Federal Reserve. The net effect of these operations is to drain reserve balances from depository institutions.

Depository institutions also maintain accounts at the Federal Reserve, of course, and over recent months, as the size of the Federal Reserve's balance sheet has expanded, the balances held in these accounts have increased substantially. The large volume of reserve balances outstanding must be monitored carefully, as--if not carefully managed--they could complicate the Fed's task of raising short-term interest rates when the economy begins to recover or if inflation expectations were to begin to move higher.

The Fed has a number of tools it can use to reduce bank reserves or increase short-term interest rates when that becomes necessary.

First, many of the Fed’s lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly. In addition, since the lending rates in these programs are typically set above the rates that prevail in normal market conditions, borrower demand for these facilities should wane as conditions improve.

Second, the Federal Reserve can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC.

Third, some reserves can be soaked up by the Treasury's Supplementary Financing Program.

Fourth, in October 2008, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves. Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate.

Bernanke said the FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that--as noted in the joint Federal Reserve-Treasury statement--the Fed's efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability. As was also noted in the joint statement, to provide additional assurance on this score, the Federal Reserve and the Treasury have agreed to seek legislation to provide additional tools for managing bank reserves.

Bernanke said that in these extraordinarily challenging times for the US financial system and economy, he is confident that the Fed can meet these challenges, not least because he has “great confidence in the underlying strengths of the American economy.” He asserts the Fed will make responsible use of all its tools to stabilize financial markets and institutions, to promote the extension of credit to creditworthy borrowers, and to help build a foundation for economic recovery. Over the longer term, the Fed also look forward to working with its counterparts at other supervisory and regulatory agencies in the US and around the world to address the structural issues that have led to this crisis so as to minimize the risk of ever facing such a situation again.

The Federal Reserve operates with a sizable balance sheet that includes a large number of distinct assets and liabilities. The Federal Reserve’s balance sheet contains a great deal of information about the scale and scope of its operations. For decades, market participants have closely studied the evolution of the Federal Reserve's balance sheet to understand more clearly important details concerning the implementation of monetary policy. Over recent months since the financial crisis, the development and implementation of a number of new lending facilities to address the financial crisis have both increased complexity of the Federal Reserve’s balance sheet and has led to increased public interest in it.

Each week, the Federal Reserve publishes its balance sheet, typically on Thursday afternoon around 4:30 p.m. The balance sheet is included in the Federal Reserve's H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," available on this website. The various tables in the statistical release are described below, an explanation of the important elements in each table is given, and a link to each table in the current release is provided.
Factors Affecting Reserve Balances

The Fed’s balance sheet, a broad gauge of its lending to the financial system, grew in the week previous to its data release on August 20, expanding to $2.037 trillion from $2 trillion in the previous week. It is composed of holdings of Treasuries and mortgage-backed securities. It was only $941 billion in the week ending July 17, 2007 before the start of the credit crunch. In the week of September 11, 2008, it was still $940 billion.

On September 16, 2008, the Federal Reserve announced that it would extend credit to the American International Group (AIG) under the authority of section 13(3) of the Federal Reserve Act. This secured lending will assist AIG in meeting its obligations as they come due and facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

On September 19, the Federal Reserve announced a new lending facility to extend non-recourse loans to US depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money market mutual funds.

On September 21, the Board of Governors authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch against all types of collateral that may be pledged at the Federal Reserve’s primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility. In addition, the Board authorized the Federal Reserve Bank of New York to extend credit to the London-based broker-dealer subsidiaries of
Goldman Sachs, Morgan Stanley, and Merrill Lynch against the types of collateral that would be eligible to be pledged at the Primary Dealer Credit Facility. Credit extended under these authorizations will be included, along with credit extended under the Primary Dealer Credit Facility under the entry “Primary dealer and other broker-dealer credit.”

By week ending November 5, 2008, the Fed balance sheet has risen to $2.11 trillion.

The Fed’s holding of mortgage-backed securities increased to $609.53 billion on August 19, 2009 from $542.89 billion a week earlier, while its Treasuries ownership rose to $736.09 billion from $728.97 billion a week earlier.

Along with holding down the Fed Funds rate target, which controls short-term interest rate, the Fed’s purchases of U.S. government and mortgage debt have been critical components of loose monetary policy intended to bring down long-term interest rates and to end the worst economic downturn since the Great Depression.

The Fed has pledged to buy $300 billion in Treasuries and $1.25 trillion in mortgage-backed securities. This increase in the Fed’s Treasuries and MBS holdings in August 2009 was mitigated somewhat by ongoing decreases in loans to banks, commercial paper holdings and overseas lending of dollars.

The Fed’s backstop for commercial paper created in reaction to the credit crunch in September 2008. It fell to $53.74 billion on August 19, 2009 from $58.05 billion a week ago.

The Fed’s inter-central bank liquidity swap lines, which make dollars available overseas via other central banks, averaged $69.14 billion per day in the week ended August 19, 2009, below the average daily rate of $76.28 billion in the previous week. The Fed’s direct overnight lending to the most creditworthy US banks slowed to a daily rate of $30.71 billion from $33.93 billion in the previous week. But overall discount window borrowings averaged $107.14 billion a day in the latest week, up from the daily rate of $105.98 billion in prior week. The latest credit picture is far from positive. The economy faces the prospect of a lost decade from massive debt overhang.

Next: Unemployment and Loss of Household Wealth