The Wall Street Journal tonight, in “As It Starts Programs, Fed Weighs How to Stop Them,” broaches the touchy subject of how Federal Reserve unwinds all the “support lending” initiatives it has underway and is on the verge of launching.
In general, this piece is more wary of party line than the typical WSJ offering, but it does miss a couple of very big issues, which we will get to in due course.
While the Journal does not tease this out, the Fed’s readiness on this issue is a worrisome echo of Timothy Geither: the Fed plans to have a plan:
Fed Chairman Ben Bernanke told community bankers in Phoenix Friday…”We are very much aware that we don’t want to be in the credit markets forever,” he said. “We need to help them now, but we want to have an exit strategy, and allow those markets to recover and become again fully private sector.”
Yves here. Wanting to have an exit strategy and actually having an exit strategy are two different states of affairs. Back to the article:
Part of the Fed’s exit should take care of itself by design. More than $1 trillion of the central bank’s loans are for three months or less, such as liquidity programs and currency swaps with other central banks. The Fed also established rates for many programs that wouldn’t be attractive to markets in normal times, forcing the programs to unwind on their own. When markets pull back from the programs, that would be a signal for the Fed to shrink other elements of its balance sheet, before turning to raising interest rates from their current level near zero.
Yves here. This is all a bit misleading, or more accurately, wishful. The part that is 100% correct is that the currency swap lines are seeing much less usage, although that could reverse if Eastern Europe were to slip into crisis. Some of the facilities, such as the Primary Dealer Credit Facility, have seen a great variation in use of available support over time.
But even looking at the original emergency bank backstop, the Term Auction Facility, whose size per twice-monthly auction has increased from $20 billion to $150 billion, still has bids not that much lower than the levels seen last November, which was considered a crisis month (although the Fed did have more frequent auctions then, two of the four had very low take-up).
The idea that the programs can or will simply roll off is also, shall we say politely, a bit naive. For instance, the FDIC just extended its supposedly temporary Temporary Liquidity Guarantee Program. These programs will continue until banks are ready to wean themselves off them.
And that could be quite some time in coming. The problem is analogous to welfare programs. Any reduction in subsidy is a disincentive. A classic was benefits like food stamps or housing vouchers that were not available to recipients when they crossed a certain income threshold. The net effect was that even if the recipient wanted to get off the dole, there was an income range, often quite considerable, in which he would be much worse off than if he earned less than the ceiling due to the loss of benefits.
The argument, the programs become unattractive “in normal times” which one presumes is when rates are higher, is spurious. The rates and terms will be adjusted if the Fed believes (based on gnashing of teeth and tearing of hair) that banks still need the programs even though circumstances have changed. If we are lucky, the goodies might be skinned down, but don’t get your hopes up that subsidies will end in a mere couple of years. And the story, to its credit, points out that
welfare queens participants will fight to keep their lucre:
Each of the portfolios will have its own constituencies — in markets and governments across the country — that could pressure the Fed not to pull back too quickly, or ever. With each of those programs, the Fed faces the risk of becoming more entangled with political authorities — undermining its role in setting interest rates.
And now we get to the part the Journal missed. what happens when the Fed loses money when it sells the stuff it owns, or holds it to maturity and suffers a shortfall? It’s a given the Fed will take hits.
First, it is lending against crappy credit, and the risk of Fed insolvency from them is real, and raises a host of other thorny issues. As Willem Buiter points out:
The Federal Reserve System is not owned by anyone (conspiracy freaks need not bother writing comments to deny this and to attribute ownership of the Fed to the Queen of England, the Vatican, the Rockefeller family or the Elders of Zion). Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. Ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, fixed at 6 percent per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks)….
Behind every viable and credible central bank with a price stability mandate stands a fiscal authority – the only economic entity with non-inflationary long-term deep pockets….
The Fed does not have a full indemnity from the US Treasury even for its outright purchases of private securities. It has no guarantee or indemnity for private credit risk assumed as a result of its repo operations and collateralised lending.
For the Fed’s up to one trillion dollar potential exposure to private credit risk through the TALF, for instance, the Treasury only guarantees $100bn. They call it 10 times leverage. I call it the Fed being potentially in the hole for $900 bn . Similar credit risk exposures have been assumed by the Fed in the commercial paper market, in its purchases of Fannie and Freddie mortgages, in the rescue of AIG and in a host of other quasi-fiscal rescue operations mounted by the Fed and by the Fed, the FDIC and the US Treasury jointly.
I consider this use of the Fed as an active (quasi-) fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US.
There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – tax payers’ money.
As regards the threat to the independence of the Fed (whatever is left of it), first, even if the central bank prices the private securities it purchases appropriately (that is, there is no ex-ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large, that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.
As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player, nor a debt collector. The ex-post transfers or subsidies involved in writing down or writing off private assets are (quasi-) fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework.
The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withold . The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around$170 bn with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns balance sheet has been hidden in some SPV in Delaware.
The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of tax payers’ resources that it entails, threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.
Yves again. Now if the dubious risks being assumed wasn’t a big enough source of possible trouble, we also have a second source of trouble: certain losses on the Fed’s quantitative easing (an aside, Bernanke keeps dancing around that notion. The FOMC statement clearly said inflation was suboptimal, but the buying firepower is directly primarily at Agency paper. In addition, Bernanke in his speech Friday talked about managing spreads, not fighting deflationary pressures. So are there multiple objectives or is this a pump up asset prices program in another guise?).
Consider: The Fed is buying Agencies and Treasuries to keep yields down, which means keep their prices up (for bonds, prices and yields move in inverse directions). At some point, the assumption is economic growth will take hold, inflation will rise, the yield curve will steepen (remember, this operation is flattening the yield curve, meaning lowering the normal difference between short term rates and long term rates).
Higher inflation means higher interest rates. The Fed will want to allow interest rates to rise, because once the economy starts moving, the cumulative effect of all of its interventions will mean inflation is likely to accelerate fast. So it not only stops buying all that paper, it starts selling its holding, which will contract money supply (when buyers pay the Fed for the purchases, it takes money out of circulation).
So let’s see, we have the Fed going from being a big buyer, which means higher prices for bonds. Then inflation starts to rise, which lowers bond prices. Then the Fed starts selling bonds, which means even lower prices.
The whole QE program is buy high, sell low. That is the inherent profile of this operation. So its unwind will also lead losses, hence a need for a capital infusion from the Treasury.
Ah, but someone at the Fed is a step ahead on this one. Back to the Journal:
In a recent speech, Federal Reserve Bank of Philadelphia President Charles Plosser proposed eventually handing over the central bank’s assets from targeted credit programs to the Treasury Department to separate itself from fiscal policy. The Fed would get liquid government securities, and officials in the Treasury and Congress would be left to make political decisions. That would allow the Fed to maintain independence in monetary policy as it raises rates.
What a clever way to finesse at least a part of the loss problem (the drecky asset one). Just dump the bad portfolio on the Treasury (presumably for the fictive prices at which it was sourced) and let the Treasury realize the losses. A cute way of trying to bury the problem.
But with the Fed in charge of monetary policy, it will have to reverse QE, and I don’t see as easy a way to hide those losses and the associated recapitalization from the public. We have some interesting politics in the offing about the role of the Fed. I wonder if this is part of the push to make it stability regulator, rather than going the more obvious (given the Fed’s complete lack of appetite for regulation) of creating a separate financial uber regulator. If the Fed has a bigger mandate, it may be harder for Congress to mess with it when it inevitably needs more dough.