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.