FEDERAL Reserve officials are throwing everything they have into the fight to stabilise financial markets and restore economic growth. In the process, the Fed balance sheet is ballooning to US$3 trillion, if not more.
It’s a risky approach because all the cash piling up in the banking system might spark rising inflation down the road. The alternative – just relying on traditional interest-rate cuts – might leave markets and the economy mired in the mud for years.
Fed chairman Ben S. Bernanke and his colleagues know that when the markets stabilise and the economy turns around, they will have to move fast to take back the extra cash and shrink the central bank’s balance sheet.
A second risk – that the Fed ends up losing billions on some of the assets accepted as collateral for loans – is of small importance compared with what’s at stake.
All the Fed’s work hasn’t prevented a deepening of the recession.
Bernanke made it plain in a Dec 1 speech that the Fed will expand efforts to deal with the crisis while waiting for the big dose of fiscal stimulus promised early next year by president-elect Barack Obama and congressional leaders.
So far this year, the Fed has aggressively reduced its overnight lending rate target to only 1%, and it probably will trim it by another 50 basis points at a Dec 15-16 Federal Open Market Committee meeting.
It has also pumped unprecedented amounts of liquidity into the banking system using loans and new auction techniques.
And recently, the central bank began providing credit directly to businesses and financial institutions by buying commercial paper and other assets.
As a result, the Fed’s balance sheet has ballooned to US$2.1 trillion from less than US$900bil a year ago. On Nov 25, it said it would buy another US$800bil worth of asset-backed securities, expanding the balance sheet to almost US$3 trillion.
The Nov 25 announcement knocked about 50 basis points off rates on conventional 30-year fixed-rate mortgages, leaving them at about 5.5%, a full percentage point lower than at the end of October. That in turn sparked a surge in mortgage applications.
Mortgage rates were affected because of the US$800bil, the Fed planned to use US$100bil to buy debt from Fannie Mae, Freddie Mac and the Federal Home Loan Bank System.
Another US$500bil would be used to purchase mortgage-backed securities from Fannie, Freddie and Ginnie Mae.
The remaining US$200bil would finance a new facility to buy assets backed by student loans, car loans and other consumer loans.
“This is an outside-the-box response to our credit problems that will eventually prove successful,’’ said a Dec 3 memo from Wells Fargo Bank economists.
The question is how many of those applications will result in offers of mortgages, given the tightening in lending standards this year.
More broadly, all the interest-rate cuts and additions of liquidity haven’t spurred a significant resumption of lending by financial institutions or new commitments by risk-averse investors.
A significant chunk of the added cash is piling up in the form of excess reserves on deposit at Federal Reserve banks.
Normally, the Fed keeps overnight rates close to its chosen target through the daily addition or subtraction of reserves. An increase in reserves gives banks the ability to increase lending, adding to the money supply and spurring economic growth. When loans are withheld, this process is truncated.
“All these reserves could stimulate the economy, but for that to happen, you have to have lending,’’ said economist Ray Stone of Stone & McCarthy Research Associates. “Right now, the Fed is taking the horse to water but can’t make him drink.’’
The Fed announced Thursday which bonds it plans to buy, beginning yesterday, as part of the US$100bil in debt it will acquire. Those purchases, and the mortgage-backed securities it will also buy, likely will further increase the amount of excess reserves.
The key point, though, is to bring down longer-term interest rates, which the Fed can’t control as closely as overnight rates.
In his Dec 1 speech, Bernanke said the Fed could also influence financial conditions by purchasing “longer-term Treasury or agency securities on the open market in substantial quantities.’’
Just the hint the Fed might do that drove yields on 30-year Treasury bonds down to a record low of 3.17%.
While the Fed can’t lower its overnight lending target much more, there’s hardly any limit to the amount of liquidity it can add to the market.
As Peter Fisher of BlackRock Inc, who for several years directed the Markets Group at the New York Federal Reserve Bank, said in a Dec 2 interview, when the economy begins to recover “there’s going to be an exit problem. We hope the Fed is going to be as agile when they have to shrink their balance sheets and pull back.’’
We all should be relieved when they have to try. — Bloomberg
- John M. Berry is a Bloomberg News columnist and one of the most respected economic policy writers in the United States. He has worked at the Washington Post, Time magazine and Forbes.
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