FED PONDERS ISSUING DEBT TO FINANCE ITS MUSHROOMING BALANCE SHEET
By Yves Smith
December 10, 2008
The Wall Street Journal, in a typically anodyne bit of reporting, tells us that the Fed is considering selling its own debt to finance its balance sheet. Its good old buddy, the Treasury Department, which heretofore has been selling bills in part on behalf of the Fed, now has a big enough financing calendar in the offing that it no longer can lend a helping hand.
Now, the significance of the recent arrangement has largely been ignored. How independent can our central bank be if it depends on the Treasury for dough? With the media regularly making approving noises about how Paulson and Bernanke work together, the idea that the Fed is supposed to be something other than an extension of the Executive Branch seems to have been lost (but then again, maybe we all kidded ourselves about Fed independence. Willem Buiter, even before the Paulson-Bernanke comradeship, said the Fed was one of the least independent central banks, second only to the Bank of Japan).
After months of serial bailouts, proliferating new programs, and soaring and swooning markets, the notion of the Fed selling its own debt no doubt sounds like a mere footnote to recent events. But back in April, it floated various ideas for how to circumvent its balance sheet constraints via its preferred outlet, Greg Ip of the Wall Street Journal. Let's look at how this option was regarded back then.
Yves here. We are already at that point, and quantitative easing is now argued to be good and necessary to combat acute deleveraging and avert deflation. Back to the post, which next enumerates the Fed's options for getting around its balance sheet constraints. "Have Treasury borrow more than it needs and lend some to the Fed," which as we noted, has already taken place, was mentioned first, and item 3, also already being done, is "Have the Fed pay interest on reserves." Number two was: "The Fed could issue its own debt or short-term paper. The debt would be an increase in liabilities and it could presumably buy whatever it wanted with the proceeds. Whether the Fed can do so legally is less clear. It previously used the 'incidental powers' given it under the Federal Reserve Act to issue options on federal funds around the turn-of-the century date change, and issuing its own debt would likely require invoking the same thing. As one Fed study has noted, use of such power must be 'necessary to carry on the business of banking within the limitations prescribed by [the Federal Reserve] Act.'"
A contemporaneous piece by John Dizard of the Financial Times gives a better sense of the practical implications: "At the moment, for example, the Washington policy people and the Wall Streeters buzzing around them are trying to figure out how to get yet more liquidity for housing-related paper. The Wall Streeters seem to assume that the next step will be the creation of something like the Resolution Trust Corporation..... Or, as David Rosenberg of Merrill Lynch told the firm’s clients last week, “ . . . the outright purchase (by government agencies) of illiquid mortgage-backed securities is probably required, and could employ government-backed fiscal action . . . The Federal Reserve itself could buy some of those securities, but the Fed alone cannot unclog the congestion in the capital markets, in our opinion.
"That is not what the Fed, or the Feds, want to hear. The Fed is already uneasy about the scale of its on-balance-sheet exposure to mortgage-backed paper....
"Here is where the ancient bureaucratic trick of three choices comes into play. The 'policy options' presented by the stone-faced civil servant-expert to the political master are always, respectively: 1) one that will cause the end of life on earth as we know it; 2) an alternative that will mean the end of your political career; or 3) another possibility that we could “staff out” if you’re interested.
"In the case of illiquid housing assets, the End Of Life On Earth is an inflationary expansion of the Fed’s balance sheet. The career-ender is the direct use of taxpayer money. The third way is the use of government guarantees to induce the investment of private capital."
The unthinkable as of April, expansion of the balance sheet, has taken place, as has the use of taxpayer funds. But just because the then-implausible has now occurred does not remove the attendant risks. Bernanke is hell bent to stoke inflation as a remedy to disinflation that may tip into deflation. But the assumption is that once the repeated adreanaline shots finally start to work, the Fed will mop up the excess liquidity.
I sincerely doubt it. First, the Fed was consistently behind the curve as the crisis progressed. Second, Bernanke as a student of the Japanese lost decade will recall all too well that the Japanese increased the consumption tax in 1997 to help whittle down the very large amount of government debt created to fund various stimulus packages, mostly focused on infrastructure. That led to a swift return to deflationary conditions. Even though Bernanke and the Treasury are entering into far more aggressive programs than the Japanese took, the Fed chair will err on the side of letting inflation take hold rather than risk a restoking of deflationary forces.
From the Wall Street Journal: "The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets...
"Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.
"It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency....
"At the core of the deliberations is the Fed's balance sheet, which has grown from less than $900 billion to more than $2 trillion since August... In the early stages of the crisis, officials funded their programs by drawing down on holdings of Treasury bonds...
"The Fed also has turned to the Treasury Department for cash . . . More recently, the Fed has funded programs by flooding the financial system with money it created itself -- known in central-banking circles as bank reserves -- and has used the money to make loans and purchase assets.
"Some economists worry about the consequences of this approach. Fed officials could find it challenging to remove the cash from the system once markets stabilize and the economy improves. It's not a problem now, but if they're too slow to act later it can cause inflation.
"Moreover, the flood of additional cash makes it harder for Fed officials to maintain interest rates at their desired level...
"Louis Crandall, an economist with Wrightson ICAP LLC, a Wall Street money-market broker, says the Fed's interventions also have the potential to clog up the balance sheets of banks, its main intermediaries...
"Some private economists worry that Fed-issued bonds could create new problems. Marvin Goodfriend, an economist at Carnegie Mellon University's Tepper School of Business and a former senior staffer at the Federal Reserve Bank of Richmond, said that issuing debt could put the Fed at odds with the Treasury at a time when it is already issuing mountains of debt itself.
"'It creates problems in coordinating the issuance of government debt,' Mr. Goodfriend said. 'These would be very close cousins to existing Treasury bills. They would be competing in the same market to federal debt.'"
--[Author's note] Although I believe ideas should stand on their own merit, rather than on their author's credentials, I also recognize that readers want some assurance that they are not quoting a 13 year old or a dog. I have undergraduate and graduate degrees from Harvard. I have been working in and around the financial services industry since 1980 and have had over 40 articles published in venues such as the New York Times, Institutional Investor, the Daily Deal, U.S. Banker, Bank Mergers & Acquisitions, the Conference Board Magazine, BRW Magazine (Australia), and Boss Magazine (Australian Financial Review).
Financial Times (London)
December 10, 2008
These are extraordinary times at the Fed. Looking back, the years under Alan Greenspan now seem almost quaint. Fulfilling the Federal Reserve’s dual mandate of full employment and low inflation was relatively easy. There were a couple of scares, but for the most part Mr. Greenspan’s job involved the odd 25-point move followed by a speech, or perhaps lunch.
Today, however, the Fed is up to its neck in the nastiest economic crisis since the Great Depression. Its role of maintaining financial stability has brought its balance sheet to bare underpinning a range of asset markets as well as bailing out the odd mortgage company. For an institution that is technically private (its shares are owned by member banks), the Fed’s lengthening tentacles are already alarming some on Capitol Hill. But the mooted idea of the Fed issuing its own bonds for the first time may well prove an initiative too far.
It is not a stupid plan. One way for the Fed to raise money is for the Treasury to hand it the proceeds of bonds sales. Another way is for the Fed to increase bank reserves. The trouble with this second approach is that only banks can participate and they are saturated with deposits to the point of preferring Treasury bills yielding nothing to earning 50 basis points at the Fed. By issuing its own debt, the Fed could theoretically target lenders beyond the banking sector, while at the same time reducing excess reserves. This would also help bring the overnight rate and the Fed’s target rate back into line.
But under current laws the Fed cannot issue its own bonds. And an independent central bank borrowing on behalf of the government would muddy the waters. This is not about the money -- the Fed’s balance sheet is already limitless -- but about monetary fine tuning. It is strange, though, that a measure that would suck funds from the system is being proposed just at a time when the rest of government is pumping as hard as it can.