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.
From a WSJ Economics Blog post, “What Could the Fed Do?“:
Since the Federal Reserve began rolling out ever more creative steps to unfreeze credit markets, it has sold or pledged a growing portion of its portfolio of Treasurys in order to put loans on its balance sheet to banks and securities dealers backed by mortgage-backed securities and other shunned collateral. This has led some observers to worry that if the Fed continues at such a pace, it could run out of ammunition, forcing it to move to quantitative easing – in essence, buying up assets wholesale and allowing the federal funds rate to fall to zero.
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.”
Update 4:00 AM: Jesse takes a very dim view:
But as usual the Fed surprises us all with their lack of transparency. They are asking Congress about permission to issue their own debt directly, not tied to Treasuries.
This is known in central banking circles as ‘cutting out the middleman.’ Not only does the Treasury no longer issue the currency, but they also no longer have any control over how much debt backed currency the Fed can now issue directly.
If the Fed were able to issue its own debt, which is currently limited to Federal Reserve Notes backed by Treasuries under the Federal Reserve Act, it would provide Bernanke the ability to present a different class of debt to the investing public and foreign central banks.
The question is whether it would be backed with the same force as Treasuries, or is subordinated, or superior.
There will not be any lack of new Treasury debt issuance upon which to base new Fed balance sheet expansion. The notion that there might be a debt generation lag out of Washington in comparison with what the Fed issues as currency is almost frightening in its hyperinflationary implications.
This makes little sense unless the Fed wishes to be able to set different rates for their debt, and make it a different class, and whore out our currency, the Federal Reserve notes, without impacting the sovereign Treasury debt itself, leaving the door open for the issuance of a New Dollar.
What an image. The NY Fed as a GSE, the new and improved Fannie and Freddie. Zimbabwe Ben can simply print a new class of Federal Reserve Notes with no backing from Treasuries. BenBucks. Federal Reserve Thingies.
Perhaps we’re missing something, but this looks like a step in anticipation of an eventual partial default or devaluation of US debt and the dollar.
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Consolidating my thoughts from a prior thread here where they’re more appropriate, this is just like the Fed choosing to issue CD’s. The two explanations given in the article align with the ideas I listed earlier. Fortunately, I’m some random boob commenting on a blog, so I can be more blunt in my language.
The first, difficulty in draining the funds again in case of inflation, is just a narrow way of looking at the term mismatch between what the Fed is buying and the liabilities they’ve issued. The inability to control inflation well in that situation is a result of that term mismatch, because they couldn’t sell off the long-dated low-yielding assets without blowing themselves up.
The second is the ability to solidify the floor on short-term interest rates, but again, I don’t see why that’s a desirable policy goal at this point.
This will expose the lucky bailed out institution to changes in interest rates, rather than the Fed. The Fed would now only absorb the credit risk in exchange for the difference in yield between its own CD’s and the random bag’o’paper they purchased. Spreads the pain a little wider in case of the worst occurring.
It’s cute that they’re still talking about central bank independence. I still oppose these interventions, but if they’re going to happen, this is a better way to do it, so I’m in favor and hope this is granted.
Yves, you’re the berries. Great analysis, good call on Greg Ip. Thank you.
does anyone have a good/authoritative/correct link/page that talks about what is fed’s “balance sheet constraint?” and why the fed would want to pay interest on the reserves?
thank you
p.s. i am a noob thats addicted to this blog… doing my best to grasp all the goodies
I dont quite understand. Why do they need to issue debt to finance asset purschases in this day and age of quantitative easing? Whatever happened to the good old printing press.
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 deflationary forces.
I agree, Yves. But I think the inflation talk, while true, is just cover fire verbiage once you think about it.
The action itself is not at all inconsistent with the Fed continuing to keep the money flowing if they so chose. In fact, it helps make inflation a more feasible option, because it protects the Fed from the interest rate risk over the term of the garbage, and exposes the recipient of the bailout. It’s an exceedingly nice way to lay off some of the credit risk too, because some inflation would almost certainly reduce defaults.
If banks go along with this, and they probably will in this environment, I think this is great for the Fed. Clever, FRB.
“the Fed chair will err on the side of letting inflation take hold rather than risk a restoking deflationary forces.”
You keep saying this. It must mean you believe it. It also means you think that he has the will, means, and opportunity to do it. So much that is done has profound unexpected consequences, and so much that has happened has demonstrated that we are experiencing a singularity. Inflating will just expose an unknown strain of deflation. Regardless of how we reinvent money, we have too much world wide capacity and too many unproductive businesses and too much centralization of wealth. You can change where the plane lands, but you can’t leave it in the sky.
does anyone have a good/authoritative/correct link/page that talks about what is fed’s “balance sheet constraint?” and why the fed would want to pay interest on the reserves?
If you can stand getting a little technical, and you’re probably going to have to given the subject matter, Sims has a good paper.
dont quite understand. Why do they need to issue debt to finance asset purschases in this day and age of quantitative easing? Whatever happened to the good old printing press.
There is no such thing as “just” a printing press. There are assets and liabilities. The Fed is like any other bank. When it wants to create cash, it has to buy or repo something in return. Usually it did this with Treasuries, but that’s basically pointless right now and doesn’t further policy goals much. You can see the excess reserves just sitting there in the sewers of the banking system.
So, to meet their policy goals, they need to buy something else. Anything else exposes them to a variety of risks, and as Sims’ paper points out, the central bank’s balance sheet certainly does matter.
Issuing CD’s instead of dollars actually significantly reduces the Fed’s risk here. The dollars are a liability of the Fed with zero maturity and a floating interest rate. Buying back those dollars isn’t free: it has to sell off one of its own assets. Usually it sells Treasuries, but it can’t, because it doesn’t have many left. If all it holds is bad paper, it can’t get enough of those zero-maturity dollars back in an inflationary environment. The bad paper would probably be worth less than when the Fed bought it, so the Fed would show a significant capital loss.
Again, I feel Sims lays this out very well. I encourage everyone to take a look at his “Bad luck: Inflationary spiral” scenario to get a feel for the issues here. This action would make that spiral slightly less scary, because the Fed’s balance sheet would be a lot less likely to go negative, while the purchasers of the CD’s would be in more trouble.
Still think this is all madness, but this is better madness. Sorry for posting so much. It’s just really interesting.
bg,
We are likely to have a currency crisis long before we have any risk of inflation. Various academics are saber-rattling in the Chinese media that they should be getting more out of their continued support of the dollar, and suggested such goodies as unrestricted purchases of US assets (no more Unocal turn-downs) and access to US advanced technology. I doubt that we will go along, and wonder how hard China will press the issue. If our imports from China have fallen dramatically (not at all impossible) they may feel they have little to lose in playing hardball (if they believe the dollar will tank in the end regardless, they have little to lose by calling our bluff).
I was just in Europe, and the small but very plugged in group I met with is very distrustful of the dollar, but isn’t keen about any other paper currencies either. They think sentiment will switch to the Euro once we get further through the Eastern European mess (that falls in Austria’s lap, which in turn falls in Germany’s lap). They think the dollar goes to 2 or 2.5 to the euro in the next couple of years, but think the dollar will rise further before it turns.
The point is that too many non-US parties have their eyes on the exit as far as the dollar is concerned. Not a good sign.
I am not smart enough to know what the outcome of a dollar crisis would be, but I expect it to be ugly.
The Fed would use these notes to prop up BK banks and only God Knows how deep the hole is their in. This is another scam to keep the banks from going back to Congress for the 350 billion and for the other $700 billion they need because they know that they would have to pay interest on preferred and the conditions, after the auto bailout would be onerous.
They are using the good faith and credit of the American people to backstop their friends on Wall Street.
Yves, I’m not feeling good at all about the dollar, but I don’t know whether this particular action is positive or negative for the dollar. It unpins the Fed, making inflation a much more credible threat, but it reduces odds that the Fed will be/is insolvent. What’s priced in? Who knows.
If our imports from China have fallen dramatically (not at all impossible) they may feel they have little to lose in playing hardball
That would suck, of course.
They are using the good faith and credit of the American people to backstop their friends on Wall Street.
I share your anger here, mmckinl, but urge you to look again at this particular action. It’s much the opposite, for once.
ndk,
I am looking at this from a very simpleminded supply and demand standpoint. Right now, we have massive demand for the dollar, which is more due to technical factors (deleveraging, nasty long bond short covering due to derivatives sold a long time ago to make various fancy financial products “work”. I am sure you are aware of this, From what I can tell anecdotally, this is a much stronger impetus than flight to liquidity/safety.
At some point, the technically driven buying will peter off, and we have a burgeoning Treasury calendar plus the Fed also competing for funds.
We are pretty much dependent on the kindness of foreign central banks. How much will they stump up when the Treasury funding calendar increases big time next year? Just on a mechanical level, I have trouble seeing how the works. The Bundesbank already had a bond auction failure.
Just on a mechanical level, I have trouble seeing how the works.
Well, Anonymous, on a purely mechanical level, it would work. The point you’re getting at, I think, is what the collateral damage will be from success. In terms of inflation, the health and happiness of Fed CD purchasers, and the dollar, it could be quite ugly. But that amount of damage, and what it would look like, is unknowable.
I also can’t say for sure whether as ugly as the two bad luck alternatives in Sims’ paper, but I suspect not by a long shot. This would make his bad luck, good policy ending more plausible, and I thought it pretty outlandish originally. I can’t really think of a good alternative without invoking a parting of the red ink sea and walking to safety on the other side.
This is the first time in a long time that something smells like exit strategy. It’s still pretty fetid.
“I share your anger here, mmckinl, but urge you to look again at this particular action. It’s much the opposite, for once.”
Again, this tactic is avoid Congressional scrutiny over getting more funds. It won’t be so easy next time as the auto bailout showed.
The banks will have to show their books, just as the automakers. That alone is enough to scare the bejeezus out of banks that are for all intents and purposes bankrupt.
No, what this measure is, is a circumvention of Congress pure and simple. The banks books can’t stand the scrutiny and don’t want the dilution and the oversight that would be demanded.
This tactic is avoid Congressional scrutiny over getting more funds…. no, what this measure is, is a circumvention of Congress pure and simple.
You’re precisely right on all counts, mmckinl. The other way to accomplish this is to include Treasury and explicitly recapitalize the Fed by taxing people. As you ably demonstrate, it’s impractical politically, which would lead to disaster #A if the Fed didn’t monetize a bunch of stuff, and disaster #B if it did.
I really wish we’d never dirtied the government’s hands in this morass and just allowed the culling to happen, with all its implications good and bad, but it’s likely too late now.
Sending out those pre-paid WalMart gift cards directly to the consumers is looking better all the time.
That idea about bulldozing excess housing doesn’t sound so insane now either.
The Federal Reserve Act doesn’t allow competition from the Treasury….that’s about funniest thing I’ve read all week.
Trying to defibrillate the consumer morphs into using a cattle prod, next moving the paddles to the area for shock treatment.
Hyper-inflation, here we come.
Yves, ndk and any other gurus; Question of topic, but not unrelated, to this and previous posts; What the hell is driving the stock market at the moment? Futures indicate a 103 point gain yet we read that the Fed wants to flood the market with cash (longer term interest rate issues) AIG still haemorrhaging, auto makers in strife regardless of how big the bail out is – the news aint good anywhere. Is the market so hammered that any good news is treated thus or are the shorters waiting in prey regardless of the illegalities?
PS: ndk – We like cold beer in this part of the Commonwealth not tea and scones…
I’m either the world’s worst trader, or God’s gift to other traders, depending on your perspective. Don’t ask me for any insights there.
That’s why I’m paying so much attention to the negative reaction from traders and voters. They hold all the power. Looking at the issue academically, this is basically the most elegant path to relatively controlled inflation, with unknown resultant explosions. If the Fed’s idea is rejected, the situation gets vastly more political than it already is, with more important explosions.
While Jesse’s concerns are valid, what’s a better option here? Sims lays it out pretty bluntly: barring good luck, we have to do something, or none of these FRB notes we all carry around matters at all, as the Fed is likely to go under in some form. I always try to include suggested alternatives when I criticize an idea.
PS: ndk – We like cold beer in this part of the Commonwealth not tea and scones…
After thinking about it for awhile, that only rules out a surprisingly small number of countries… :D
If the Treasury’s and Federal Reserve’s new logic functions as planned even for more than a couple of hours forestalling riotous mobs with pitchforks and torches, I’m all for it.
Herding the cattle to invest in stocks via negative gains (cough) from government paper and with the liquidity injections, don’t be surprised if the markets run up while stock prices try to stay ahead of the loss of value in the dollar.
So Yves at 2:44, the scenario of your contacts in Europe is exactly what has been on my mind since long. I though the $ would level out around two to the euro, but that was on the assumption that we would show a modicum of restraint in attempting reflation. Given that we are being most immodest in promising billions to all, 2.5 to the euro sounds much more probable. I also concur with your usage in the post that our present conditions are _disinflationary_ rather than actually deflationary—to this point. Deflation is implied in demand contraction, and the Powers That Be are determined to avoid that. Oddly enough, I doubt that we will hit a truly hyperinflationary scenario on the arc back: Our currency will blow up first, with so many sideways consequences its hard to know where all the pieces will land.
Should the Fed push FedDebt to ostensibly back its dough? Does it matter? So long as the Treasury and our Bailout Czar keep issuing colossal guarantees and debt levels of their own, the Fed is doomed no matter what it does. The total issuance matters more than who pushes what, and the total issuance is on a parabolic rise.
I have never for a second envisioned the Fed an an independent agency. The full faith and credit of the sovereign is behind everything they do; therefore . . . . Just like the GSEs, the _notion_ of independence was useful in many ways, but it was a useful fiction. When the Fed had a strong Chair, the Fed would be expected to lead on the bailout strategy. Bernanke was appointed to be the opposite of a strong Chair, and such he has proved.
The central bank failure that Jim Rogers predicted after the Bear Stearns failure is coming along nicely. The question is, will we learn never to trust another central bank again, or just think we need to “do it better next time”?
Why now must be the question? Is it the prospect of Tim taking over from Hank at the Treasury that prompts some independence? Somehow I doubt it. Perhaps the FED is beginning to realise just how bad some of that stuff is that it has got on its books and wants to shift the risk. Again somehow this although true does not seem to be a deciding factor. The only reason I can think of for having FED Bills is that they represent a very different risk profile to Agency or Treasury debt. We do know that Ben is particularly keen on tackling foreclosures and I would wager that this is an attempt to deal with this issue. The answer to the original question could be that the FED thinks the treasury and congress are not tackling the problem and wants independence to do what it thinks is best.
By arguing that it shifts risks away from the taxpayer I think the FED may get what it wants, not that anyone will buy the stuff if it is based on stuff that is too toxic. The end game could be precipitated by the FED Bills failing to sell like treasuries.
Yves,
Eastern Europe: Your take is basically right; the biggest case, Bank Austria, it is much more colorful though: Eastern Europe debt owned by an Austrian bank, which is owned by an (anyway) undercapitalised Italian Bank whose management carries no favor with Berlusconi. Fortunately they have a German sub, HVB, which might take on the BA exposure (they have owned the bank before) and maybe some other stuff the Italian bought even further East. Thank God for the German taxpayer.
This also opens the door to the FED borrowing in non-US Currencies or in a basket of currencies. With that you have “US” debt but a differentiation between Treasury Debt (dollars) and Fed debt (basket). Benefit to this is capturing those dollars looking to flee the US. Also provides a benchmark to which to devalue the dollar into a new basket currenty. Smart really but still sound like in my lifetime we’ll be throwing dollars “into the basket” if you will, or burning them for heating fuel.
“The Fed is considering issuing its own debts”.
ummmmmmmm……. excuse me.
Isn’t that what the FED does every minute of every day of every week of every month of every year?
The FED – and as we all know the FED includes all of the FED branch banks and all of the member banks of those branches under the Federal Reserve System, does NOTHING but create new debt with every tansaction that it makes.
So, big deal.
Now it is going to create new debt by borrowing from the Treasury who does not have it in the first place and who usually goes to the FED for its monies in what my friends all call ‘the great charade’.
Don’t be too surprised to see even more acts added to this play.
For a capitalistic system to work, capital has to be allocated to capitalistic purposes.
That’s not happening. Bennie can print, borrow, issue, create… whatever, but the problem seems to lie elsewhere.
Yves, I don’t understand how people can be sanguine about the Euro. Their exposure to emerging market defaults is colossal and their demographic decline has already started. In short, they’ve got humungous bills to pay and a shrinking workforce to pay them. How they’re going to keep from overheating their printing presses worse than we are is beyond me.
Add to that decades of ossification in European industries and you get … a strong Euro?
Bernanke would you just hurry up and make the dollar worthless so we can move on to the next stage. quit screwing around.
but it reduces odds that the Fed will be/is insolvent.
How would you know this yet? Seems more likely the Fed is insolvent if they have to try this.
And would you buy what the Fed is selling? I sure wouldn’t unless the yield was higher than I could get elsewhere.
doubt that we will hit a truly hyperinflationary scenario on the arc back: Our currency will blow up first, with so many sideways consequences its hard to know where all the pieces will land.
Semantics.
Regardless of how the pieces land, loss of individual purchasing power is the end result.
anon @ 7:18
Great insight. This opens the door for the “major” countries to established diversified baskets and then globalize currency. Remember Summers suggestion that China diversify its basket (and look who’s advising Obama). I thought the Fed would push a North American currency first but this will not solve the global debt/derivatives unwind. A global currency with the major trading partners working through the details over the next decade seems a likely outcome to keep the game going for one more round.
Aren’t you all missing something? And Jesse as well?
If the Fed issues debt, it does so in exchange for currency. This contracts the money supply. The Fed sterilizes this contraction by buying mortgages. In effect, this makes the Fed a giant bank. Unfortunately, this “bank” has no impact on the money supply.
Its possible that in the future the Fed will choose to repay its debt with printed money. But why not just print the money NOW. Why not adopt an inflation target as Krugman, Rogoff, Hamilton and others have suggested?
It seems the Fed cannot make up its mind about Quantitative Easing. The balance sheet has been flat for the past three weeks, and now it floats this “bank” idea. As long as there is confusion over the Fed’s inflation policy, plunging velocity puts us at risk of deflation.
How would you know this yet? Seems more likely the Fed is insolvent if they have to try this.
It’s hard for us to guess from the outside. You’d have to know what they’ve bought, what the NPV of their seigniorage will be, and how much Treasury would kick over to them. I’d agree they might be close.
And would you buy what the Fed is selling? I sure wouldn’t unless the yield was higher than I could get elsewhere.
I probably wouldn’t. A bank that has to choose between that and no more life preservers might.
If the Fed issues debt, it does so in exchange for currency. This contracts the money supply. The Fed sterilizes this contraction by buying mortgages. In effect, this makes the Fed a giant bank. Unfortunately, this “bank” has no impact on the money supply.
David, currency is the Fed’s debt. You could think of this like buying mortgages in exchange for dollars that say, “Yields 3% interest. Only valid after 2018.”
Its possible that in the future the Fed will choose to repay its debt with printed money. But why not just print the money NOW. Why not adopt an inflation target as Krugman, Rogoff, Hamilton and others have suggested?
Because it’s not remotely believable that they could meet such a target with their balance sheet and the economy in this condition. This kind of move makes a target much more credible, because it helps protect the Fed from bankrupting themselves or causing a hyperinflationary spiral, through more even distribution of pain.
the Fed chair will err on the side of letting inflation take hold rather than risk a restoking of deflationary forces
I don’t know about that. Bernanke has been very slow about starting to inflate. The temporary liquidity trap in March was a clear signal some inflation was needed, because that’s the only way out once the trap closes (which it now has). But Benanke waited until last month to actually start increasing the money supply – from March to October growth was actually below trend.
So, is Benanke a slacker or is the “Helicopter Ben” persona a sham? I certainly don’t know. If the first, we will indeed see a big burst of inflation once we’re out of the liquidity trap because Ben will be as slow pulling the cash out as he was putting it in. If the latter, he’ll pull back prematurely and possibly even put us back into a liquidity trap. I don’t think we’ll know the outcome until it happens.
3 points.
1. If the Fed bonds are subordinate to Treasuries, other than another tool to affect rates, what’s the point. So many are already fearful of a Treasury default, being subordinate to treasuries, I sure as hell wouldn’t touch them. If they’re Superior to Treasuries, they will have immediately put the nail in the coffin in Treasuries and euthanized the Federal Government.
2. What backs them… the printing press, taxpayers dollars. Can’t be the latter for obvious reasons. So what backs them. If they’re backed by the printing press, then, again, I fail to see the point.
3. Why do they see a need for this. The post from Jesse seems to make the most sense. Funny how what seemed tinfoil back in April is coming to fruition. I have a very very bad gut feeling about 2009. I sure as hell Obama’s ready, cause we’re all going to need him to be.
“David, currency is the Fed’s debt. You could think of this like buying mortgages in exchange for dollars that say, “Yields 3% interest. Only valid after 2018.”
Exactly. The dollar is essentially a FRN of infinite duration with zero interest.
I never disagree with a faireconomist.
But, a question.
If Bernanake was slow to increase the money supply March-October, what was happening with the one to two trillion he was creating out of thin air to buy whatever collateral the banks, and corporations, and others were presenting to secure this new FED issuance?
On the banking side, this created excess reserves, no?
And excess reserves are the basis for mechanical money ‘supply’ expansion by the banks, no?
These are questions, respectfully submitted.
While I recognize that the banks have NOT in turn carried out their lending function, I think Ben has done his part to inflate.
This end run around Treasury will establish a parallel currency. Fed debt can and will be exchanged without limit for all the toxic assets the Fed deems as strategic, cutting the connection between the issuance of currency and the tax base that supports Treasury borrowing. Here we see the genesis of the next bubble, which is of the currency itself — hyper or mega or what have you inflation. The excess liquidity will be that much harder to sterilize, if in fact we can talk at all of sterilization when the economy will likely be in the tank for some time, and sterilization would make it re-tank under most scenarios. Say what you will, Fed debt would effectively be a parallel currency and as the saying goes, the bad money might tend to drive out the good.
NDK — explanation please…
1. If the fed issues in foreign currency perhaps the implications are that it would possibly absorb some dollar flight and protect the currency as those fleeing are herded back into the system to support dollar. I get that, but why would someone fleeing the US for other debt, buy Fed notes that have to be subordinated to the Treasury (or it would be unconstitutional period). Unless the money coming into the Fed overseas basket was net new money then it is simply a long cycle way of trapping $ in the system and further bankrupting the Fed
2. Why would Mr. market buy this debt? Who would buy it? Given the cap structure of the US why would anyone be enticed to buy it? Even if it gave you fx protection why not just buy the sov debt and take the fx risk without the associated political risk. If Bernenke thinks it is the fx risk people are fleeing it isn’t. It is was Jim Bunning said to him at the TARP hearing. Bunning asked him why he was coming to Senate for money to bail. Bernanke said he needed the funds to protect and fix the system. Bunning replies Sir you are the problem.
3. More a question: Not sure the mechanics you speak of work as in controlling tail risk of inflation? Back off envelope all this does is lay off sovereign risk from US Gov’t (CDS exploding on the Sovs) and shift risk of default to the Fed itself.
4. Why would anyone buy the Fed debt on faith given all that has occurred and the lack of transparency?
5. The Taxpayer is already bailing out the Fed. Isn’t the Treasury selling debt and transferring it to the Fed for loan to the banks for their bad collateral just a complicated way of saying the Gov is borrowing money to hand over to the banks with the Fed taking the loss. IE the fed is just going to require more and more money to make it whole.
6. Therefore, without knowing what is backing the printing exercise (i.e the taxpayer) it is pointless. Furthermore, why is the fed selling debt any less an evil than the government borrowing and shelling it over to the fed to perform the laundering operation?
7. Does the massive extension of the dollar swap lines have a role to play here? Just thinking out loud…
Rambling sorry, but just don’t get why laundering money through the fed does anything other than optically change the game. total dollars in and out are the same and the fed is not about to get a better rate than treasury.
While Jesse makes a very nice case that this is in preparation for a partial default on the dollar, I don’t think that’s the true purpose. While in theory Fed notes would be different from Treasury notes, in practice, they will be equal. Do you really think a fed. govt that backstopped the GSEs is going to let the Fed fail? Either the entire edifice of govt debt will default, or not. But there is no practical, politically acceptable way to allow Fed debt to default while keeping “sovereign” debt intact. It won’t happen.
I suspect the real reason to pursue this option, and why Congress may allow it, is because we will soon be facing some very unpalatable choices in how we fund our debt. While we’re currently getting a free ride thanks to this flight to treasuries, very soon, that spigot will dry up, and the sheer magnitude of our borrowing will force us to making concessions to our creditors that will be politically very unpopular. For example, the issuance of foreign currency-denominated bonds. This is politically very unpopular, and so having the Fed do it would be a great way to avoid political responsibility for it.
I think Dizard’s third option is actually the following: The Fed is the govt’s staff, pure and simple. Let the Fed staff take the heat of finding ways to fund the government when the world’s creditors start asking for big concessions on its debt.
One other possibility is that this may allow the Fed to tie some Fed bond issues to specific Fed assets (Fed-based asset backed securities). For example, issuing Fed MBS notes, which are backed by a package of MBS that the Fed currently has (perhaps along with some guarantee that the Fed will take a percentage of first losses). When the market settles in a few years, the Fed will still have several trillion dollars worth of assets on its balance sheet, and this may be a way of reducing some of the default risk of these assets if they can’t sell them on the open market.
Anyway, as the old Chinese curse goes, may we live in interesting times…
“David, currency is the Fed’s debt. You could think of this like buying mortgages in exchange for dollars that say, “Yields 3% interest. Only valid after 2018.”
Exactly. The dollar is essentially a FRN of infinite duration with zero interest.
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Don;t get this at all..this is true if the fed is printing not issuing debt…if fed issues debt it will not be a zero interest obligation..Am I to understand this as fed issues debt klets say fx demoninated and then gets say yenn and then must buy $…to then buy up tohe toxic garbage. The duration of the assets bought matters i suppose in how that inflation and eventual fed recapitalization takes place…Dollars are only zero interest (which itself is a bit of a stretch considering the yield curve, inflation constraints, societal order etc…) and infinity as long as someone wants them….
S,
My answers to 2 and 4 are the same: it’s that or the violin factory for the holders of this bad paper. There are plenty of other buyers for fully government-backed debt right now. Pension funds, annuities providers, and so forth have made promises in dollars.
The question of whether or not the U.S. banking system/government as a whole is insolvent without entering an inflationary spiral is independent and much more interesting. I’m open to the possibility, to say the least.
My answer to 1, 5, 6 is that the backing is holders of dollars rather than the taxpayer explicitly. Yous pays me through seigniorage, or yous pays me through direct taxation.
My answer to 3 is that this protects the Fed from interest rate risk over the term of the trash it bought. It certainly doesn’t protect the lucky recipient of the Fed CD; quite the opposite.
My answer to 7 is probably not.
And, your final remark is mostly right. There’s probably been a decision made that recapitalizing the Fed through taxation and a donation by the Treasury is politically untenable, even though that would probably be a better option because you could target the tax precisely. This is pretty politically untenable too, but maybe less so.
I suspect the real reason to pursue this option, and why Congress may allow it, is because we will soon be facing some very unpalatable choices in how we fund our debt.
I’m with you, Lune.
One other possibility is that this may allow the Fed to tie some Fed bond issues to specific Fed assets (Fed-based asset backed securities). For example, issuing Fed MBS notes, which are backed by a package of MBS that the Fed currently has (perhaps along with some guarantee that the Fed will take a percentage of first losses).
There’s probably a simpler way to weasel into that if it were the only goal, but it is a possibility, certainly.
this is true if the fed is printing not issuing debt
Remember, printing is issuing debt, S. It’s just zero maturity debt that currently yields 0.9% or 0%, depending on how cool you are, and can be used in some funny fractional reserve ways.
Doesn’t the Fed already issue debt in the form of little pieces of paper called “Federal Reserve Notes”, which most of us refer to as “dollar bills”?
NDK,
why not just target a bank tax at X profitability ( oh wait we are cutting taxes here) and make the uinudtsry pay it pack like any other debtor. Why does JPM need to survive or GS. They don’t is the simple answer.
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“And, your final remark is mostly right. There’s probably been a decision made that recapitalizing the Fed through taxation and a donation by the Treasury is politically untenable, even though that would probably be a better option because you could target the tax precisely. This is pretty politically untenable too, but maybe less so”
NDK,
I get the seigniorage argument, but it is so patently trasparent that a dollar rampage is almost guiaranteed regardless. I am with Yves…smoke and mirrors. This is akin to California paying in IOUs…
Thanks to all for the insights so far. I read Jesse’s post as well as Sims’s paper and have a much better understanding of the issue, but. . .
With that said, I may have lost the forest for the trees on a couple points.
Question #1: Is it possible for the Fed to go broke? Would the Congress/Treasury realistically refuse to donate another stack of T-Bills to recapitalize the Fed?
Question #2: If the Fed were to go broke, what would that mean in a practical sense? Would all the member banks’ equity get wiped out, thereby ruining their balance sheets in turn?
Yeah, I understand the worry about currency meltdown before hyper-inflation. Using the rule, you must inflate more than the previous inflation to maintain growth, would apply but debt created outside the normal banking system is massive to say the least. May not be able to cover it but doesn’t mean the government won’t try.
This lame brain idea of new issuing of debt that is somehow sterilized will work until the dollar breaks down and then any returns will be paid in inflated dollars which as we know can be less than zero returns. A not so hidden tax.
If the US consumer doesn’t start spending and injecting the world’s reserve currency in the world banking system (dollar shortage at the present time) the exchange rates will really go out of whack.
Mr. Cash Flows, thanks for following my links. :D
Question #1: Is it possible for the Fed to go broke? Would the Congress/Treasury realistically refuse to donate another stack of T-Bills to recapitalize the Fed?
Yes, it’s possible. I could envision some rare circumstances under which it would be politically necessary to cut the Fed loose.
Your question is much more interesting when it comes to the Euro and the ECB; Buiter has more. Who backs the ECB? The CD idea is much more crucial for them, and this might go so far as to provide them some cover.
Question #2: If the Fed were to go broke, what would that mean in a practical sense? Would all the member banks’ equity get wiped out, thereby ruining their balance sheets in turn?
I can’t even fathom a guess. Maybe people would just whistle Dixie as the Fed continued to “mark” its books. Maybe not, which would be a traumatic event.
A simple matter if you ignore the implications.
Technically a banking system can’t go broke because they can print currency all they want.(Zimbabwe) Even if the currency is rejected (loss of trust), in due course, they can reinvented another one.
Being the world’s reserve currency only affords some temporary advantages.
Howsabout this:
“On July 5th 1932, in the middle of the Great Depression, the Austrian town of Wörgl made economic history by introducing a remarkable complimentary currency. Wörgl was in trouble, and was prepared to try anything. Of its population of 4,500, a total of 1,500 people were without a job, and 200 families were penniless.
The mayor, Michael Unterguggenberger, had a long list of projects he wanted to accomplish, but there was hardly any money with which to carry them out. These included repaving the roads, streetlighting, extending water distribution across the whole town, and planting trees along the streets.
Rather than spending the 40,000 Austrian schillings in the town’s coffers to start these projects off, he deposited them in a local savings bank as a guarantee to back the issue of a type of complimentary currency known as ‘stamp scrip’. This requires a monthly stamp to be stuck on all the circulating notes for them to remain valid, and in Wörgl, the stamp amounted 1% of the each note’s value. The money raised was used to run a soup kitchen that fed 220 families.
Because nobody wanted to pay what was effectively a hoarding fee [technically known as ‘demurrage’ and often referred to as “negative interest”], everyone receiving the notes would spend them as fast as possible. The 40,000 schilling deposit allowed anyone to exchange scrip for 98 per cent of its value in schillings. This offer was rarely taken up though.”
http://anz.theoildrum.com/node/4633#more
Although, in a way, if treasuries are trading negative, it’s almost the same thing only at the commercial level. I say, why not let the Fed offer a second currency along the lines described above. Bring back liquidity! Value be damned.
I vote for “The End Of The Earth As We Know It” because this is fear mongering and any economists on this forum know and have said that the bailouts are bad and are making things worse.
This direction at least returns some semblance of integrity to the financial world. It sure as hell doesn’t have any now.
Let me take a wild guess at the coming credit rating of the Fed debt – “AAA”.
Of course the FED is independent of the Government. Read the Federal Reserve Act. The banks are the legal owners of the Fed Banks, all 12 of which are corporations. The employees at the Board of Governors in D.C. are not Federal Employees or Civil Servants. It says so on the FED website. If FED banks issue debt it is not backed by the Government. Just like Fannie and Freddie debt is not backed by the Government. If the FED issues debt it will be to the benefit of their stockholders, which are the big banks. Glen
KT CAT “Yves, I don’t understand how people can be sanguine about the Euro. Their exposure to emerging market defaults is colossal and their demographic decline has already started. In short, they’ve got humungous bills to pay and a shrinking workforce to pay them. How they’re going to keep from overheating their printing presses worse than we are is beyond me.”
What you are describing is the valley that Europe and its currency must descend to. The sanguine outlook Yves and her contacts was the horizon beyond the valley. They acknowledged the descent into the valley and were looking out over the valley and beyond. They were discussing “Then What” scenarios. And that is what is sanguine as you put it. But we must attend to the valley first….
Again, I must be painfully ignorant.
Comment is made that the FED’s employees ARE the government.
Excuse me?
Since when?
The FED is a private banking institution.
It’s employees are NOT government employees.
This is WHY the FED refuses to allow a view of the collateral tahat it is holding for creatingnew money and lending it to the holders of this collateral.
There’s a lot more to this story than even meets the watchful eye of NC.
The Treasury Department’s use of TARP and the Federal Reserve have one real goal, shovel as much money as possible to the financial ruling class with few strings attached, the taxpayers be damned. The system is rigged in favor of the plutocracy, the US is corrupt and has no moral compass.
If Bernanake was slow to increase the money supply March-October, what was happening with the one to two trillion he was creating out of thin air to buy whatever collateral the banks, and corporations, and others were presenting to secure this new FED issuance?
They were borrowing it. 1 trillion was with treasuries they already owned because they’d bought it with the currency they’d already issued. Another few hundred billion the Treasury issued bonds for. Some is not yet spent, but promised.
Money supply is actually relatively technical – things aren’t *really* bought with money; you can’t really save money on an economy-wide basis. It’s a medium of exchange. People *think* you buy stuff with money because it works so well you don’t have to think about the fact that what people are really taking is goods they can buy with the money, not the money itself.
The Fed can actually buy some with newly issued money – but not very much. Nothing like what they’re trying to buy now.
The problem with deflation is that once deflation starts money doesn’t work right anymore. There are similar problems with highly variable inflation or hyperinflation. Money is a tremendous convenience – it effectively represents properly discounted goods from all over the planet. When you lose that efficiency you have a terrible efficiency loss and enormous real economic declines.
Ben’s behavior is a puzzlement. The “Helicopter Ben” persona is psycho hyperinflationary. He promised to guarantee low long-term rates to “solve” deflation. That would create hyperinflation – once inflation goes above those guaranteed rates the presses will have to go nuts to keep the nominal rates down. Yet, when we were facing serious deflation risk, as of March, he actually cut the money supply growth back below trend. It just doesn’t make sense.
What difference is there really between Treasury debt and hypothetical Federal Reserve debt (assuming it is backed by the full faith and credit of the federal government via an upcoming bit of legislation)? The answer is none.
Selling new Fed bonds (think of it as exchanging reserves for bonds) would actually be deflationary, correct? It almost seems as if what the Fed needs is for these Fed bonds to somehow already exist, and then buy these Fed bonds on the open market to provide further monetary stimulus. Then if the tide turns inflationary, they could sell them back to the market to mop up the excess liquidity. But selling them now doesn’t seem to be the right approach (maybe they could just give them away just to get them out there?) without some sort of anti-sterilization mechanism.
Bigger picture, what is the end game here? The federal gov’t ends up holding all private sector debt and the private sector ends up holding all Fed/Treasury debt?
Isn’t Jesse a bit of a goldbug?
The difference between the two is: One is demanded as payment for your taxes and happens to be the reserve currency of the world.
Federal Reserve with be powerless and up shit creek if Congress decided to only demand some other currency as payment for taxes.
Joebhed:
I agree with what you said in respone to Lune. FRB are NOT employees of the government. In fact, I would strongly argue it the other way around – politicians (particularly President, VP, and Senators) are largely the employees of the FRB.
Someone else mentioned a currency crisis before hyperinflation. Ummm, how are these not two sides of the same coin? They are the same thing, as long as currencies are fiat debt mechanisms.
gamma
Bigger picture, what is the end game here? The federal gov’t ends up holding all private sector debt and the private sector ends up holding all Fed/Treasury debt?
More or less. Nobody trusts the banks anymore and so they want to “deposit” money with the Fed/Treasury by buying T-bills. If the Treasury accomodates that craving by issuing vast amounts of debt they’ll hoover all those savings from the real economy. The only way they can avoid unimaginable deflation is to loan/spend all that money. End result, the Fed becomes the banking system, holding most deposits and making most loans.
If the Fed/Treasury doesn’t accommodate by issuing debt we remain in a liquidity trap and credit stops anyway. At this point crowding out is no longer an issue. The savings aren’t going into the private banking market anyway. It’s the Fed or the mattress until the Fed can get inflation going again.
The big banks are insolvent. The Fed is literally owned by the big banks. We must expect that the Fed will pursue strategy and tactics which are designed to (1) postpone the inevitable bankruptcies of the insolvent big banks, and (2) shift the burden of such insolvency from the shareholders and creditors of the big banks to the taxpayers. There is no solution to the crisis that does not require bankruptcy reorganization of the big banks, and elimination of the CDO’s and other derivatives that can never be repaid. Hyperinflation is the necessary consequence of the Fed’s (and Congress, and Treasury’s) refusal to recognize this and undertake the necessary bankruptcy reorganizations.
Are there convenient ways for an unsophisticated investor to hold some portion of her portfolio in yen-denominated securities? Or even just a yen-denominated bank account?
Are there convenient ways for an unsophisticated investor to hold some portion of her portfolio in yen-denominated securities? Or even just a yen-denominated bank account?
Dear Ms. Unsophisticated,
We try to avoid specific investments here, I think, but since this thread’s dead and it’s a small question I don’t see the harm in helping out. The easiest and cheapest way would be to buy FXY, the CurrencyShares Japanese Yen Trust. It holds yen in exchange for your dollars, but it trades like a stock.
You can convert directly to yen and bank them, but it’s a lot of hassle and you’d generally lose a lot on an unfavorable exchange rate.
FairEconomist, you said
“Ben’s behavior is a puzzlement. The “Helicopter Ben” persona is psycho hyperinflationary. He promised to guarantee low long-term rates to “solve” deflation. That would create hyperinflation – once inflation goes above those guaranteed rates the presses will have to go nuts to keep the nominal rates down. Yet, when we were facing serious deflation risk, as of March, he actually cut the money supply growth back below trend. It just doesn’t make sense.”
This reminds me of the “What on earth is the Bush/Cheney administration up to?” question, which goes back and forth between malevolence and stupidity. We can all see that it’s bad for nearly everybody, but seems to benefit some of them and their friends.
If we want to say its not a matter of stupidity or randomness, we’re left with deliberate sabotage.
Right now, there’s that lawsuit against JP Morgan, claiming that it deliberately sunk Lehman Brothers.
( http://www.cnbc.com/id/27040603 “JP Morgan Chase stands accused of allegedly precipitating the collapse Lehman Brothers by freezing Lehman assets days before it filed for bankruptcy protection. Lehman creditors have accused JPMorgan of freezing $17 billion in cash and securities on Friday, Sept. 12, according to a published report. Lehman filed for bankruptcy the following Monday. “)
Sounds like what you said “we were facing serious deflation risk, as of March, he actually cut the money supply growth back below trend.”
It may have been to someone’s benefit to sink Lehman Bro’s, and perhaps the sinking of the US economy is also benefiting a few people. Maybe someone had too much derivatives exposure. If you burn down the bank, do you have to pay what you owe?
Maybe this situation, as wasteful as war — no, make that more so, in economic terms — creates the same kind of horrible profit opportunities that war does for those poised to profit.
What if this is simply a “harvest” of the global economy?
My goodness, never has so much ink been spilled
without reason as on discussing the effects of the latest “avoid liquidation at all costs” Fed gambit.
The dollar is almost certainly going to be trashed the most, but I dare any of you to be long the Euro, because whether one Euro will fetch 2.50 (or more) dollars or not will be meaningless because the purchasing power of all fiat compared to gold will in due course take your breath away. You may think you have, but you haven’t seen a Black Swan event yet. Bank on it.
GMAC “in a fascinating game of chicken” by Reuters.
“Analysts said the company’s survival is at stake. If the company does not become a bank, it risks violating the terms of its lending agreements, or covenants.
“If they don’t get a waiver on those covenants, they probably don’t have any alternative to filing for bankruptcy protection,” said Sean Egan, managing director at ratings agency Egan-Jones Ratings Co.”
http://www.reuters.com/article/newsOne/idUSTRE4B94GV20081210
Sy Krass said…
I’ve stated on previous threads that hyperinflationary pressures mean the stock market goes up when it should be going down. Why? If the dollar devalues that means everything it purchases will be more expensive including assests that should be going down like real estate, cars, and stocks. This is the “implicit” default, rather than the explicit default of non-payment of debt. That’s why IMHO if the FED issues a “new dollar” it won’t matter, it trades on par with the already falling old dollar or it becomes more valuable, Either way it will lead to HYPERINFLATION. Yves, isn’t this waht happened in the Weimar republic, A stock market that went to the stratosphere with hyperinflation?
ndk,
Thanks!
The Fed should not be allowed to issue debt. If they want more flexibility on their balance sheet then start by realizing the losses on the crap you purchased from Bear Stearns. It is time for Fed officials from Bernanke and Geithner on down to tell us why they have been warehousing toxic waste at or near par value. Just how long do they propose to keep this stuff? The hit to the taxpayer in the form of lost income and even perhaps the need for the Treasury to recapitalize the Fed banks is huge. Instead of issuing debt, the Fed should be selling non-Treasury paper to help the markets finally start to clear. Put the assets on the curb and sell them now.
Excellent news. Instead of issuing non-interest bearing paper money, the Fed will now pay a little more for its privilege as the monopoly provider of currency.