Where Will the Federal Reserve Go?

The Federal Reserve evolved over the years to perform three major tasks: to supply liquidity to commercial banks and the financial markets (specifically as the “lender of last resort”); to manage the monetary system so as to encourage economic growth, yet contain inflation; and to oversee the health of the banks who were members of the Federal Reserve System through regulation, examination, and supervision.

Whereas the Federal Reserve System is supposed to fight a liquidity crisis, a very short term phenomenon, it was not set up to resolve a solvency crisis, a longer term situation. The problem faced in a liquidity crisis is that, for one reason or another, an institution or a few institutions want to sell quickly some kind of a financial asset but there are few, if any, buyers. The responsibility of the Federal Reserve is to supply liquidity to the market on a short term basis so that the market will stabilize and buyers of these financial assets will return to the market.

We have gone through our liquidity crises this time around. Liquidity crises are surprises…we are not prepared for them…and this is why the response has to be quick and decisive. I say that we have gone through our liquidity crises this time around because investors are very wary about ALL asset classes now and the surprises that come to light on a regular basis are how deep the losses on assets continue to be…not that there are losses.

The Federal Reserve is not set up to solve a solvency crisis. The solvency crisis is a capital adequacy problem. It is a problem related to how large the losses are related to the book value of the assets. Yes, there are liquidity issues related to these troubled assets…they may not be able to be sold…or they cannot be sold. If this is the case the question becomes whether or not the problems related to these assets can be worked out and if so how much of the asset value will be retained…if any of it can be retained. And, the solvency crisis is of a longer term nature than the liquidity crisis.

The Federal Reserve, over the past 13 months has drastically changed the way it operates in an effort to provide liquidity to financial markets. Attention has been directed to the expansion of the asset portfolio of the Federal Reserve System. In the last 13 months, the line item labeled “Total Factors Supplying Reserve Funds” that appears on the Federal Reserve Statistical Release, H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has increased by approximately $1.2 trillion. The increase is from $0.9 trillion on Wednesday November 28, 2007 to $2.1 trillion on Wednesday January 14, 2009. All of this increase has come since Wednesday September 3, 2008 when the balance totaled $0.94 trillion.

I include December 2007 in this calculation for it was in this month that we first got the innovation called the Term Auction Credit Facility introduced to the Fed’s tools of operation. And, as they say, the rest is history.

The major changes include a decline in the “Securities Held Outright” of $275 billion, the account that includes Treasury securities the instrument that the Federal Reserve has traditionally used to conduct monetary policy. But even this figure is misleading because this category now includes “Federal Agency Debt Securities” and “Mortgage-backed Securities”. These two accounts have gone up by about $23 billion over the past 13 months, so that the decline in Treasury securities held by the Fed has actually declined by about $300 billion.

What has accounted, therefore, for the $1.5 trillion increase? (The $1.5 trillion comes from the $1.2 trillion increase in Factors Supplying Reserves and the decline of $0.3 trillion of Treasury Securities held.) “Term Auction Credit” injections accounted for almost $0.4 trillion, “Other Federal Reserve Assets” rose by almost $0.6 trillion and “Net portfolio holdings of Commercial Paper Funding Facility LLC” rose by a little over $0.3 trillion. The other roughly $0.2 trillion came from minor accounts like the increase in primary borrowings from the discount window, primary dealer and other broker-dealer credit, credit extended to AIG, the assets connected with the Bear Stearns bailout, and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility.

And, what is the point of listing all of these different sources of funds? The point is to highlight that most of the funds were injected into the market in order to provide liquidity to different sectors of the financial markets in an effort to “unfreeze” lending. The securities provided to the Federal Reserve to serve as collateral for these “loans” are supposedly of the highest credit quality. The rest of the funds…really a minor part of them…only about $113 billion…is to hold assets connected with the bailouts of AIG and Bear Stearns. That is, almost all of the funds were supplied to the market for liquidity reasons…not for solvency reasons. Thus, the Fed is sticking to one of its primary functions and not entering into the area of “capital adequacy” problems.

The capital adequacy problem should not be an issue that the Federal Reserve takes up. To do so would cause a major conflict with its primary responsibility…to conduct monetary policy.

To me, this is an issue primarily for the Treasury Department because it is very closely related to ownership...and when we start talking about ownership we start thinking of “nationalization”…and I believe that a lot of people have trouble walking down this road. However, given the depth of the problems of the banking industry, the issue of nationalization is going to come up and must be thoroughly discussed and debated. This is a major step for any nation to take…and most nations around the world that are looking at this problem in the face are treating the issue very gently. Even those nations who have governments that look to more governmental involvement in the economy at being very careful.

Fed Chairman Bernanke has stated that the United States cannot just rely on the Obama stimulus plan to get the economy going…and he is right. But, the Federal Reserve has supplied a lot of liquidity to financial markets…and, they will stand ready to supply more liquidity if it is needed. However, the Fed cannot do much more at this time. I hope it does not have many more tricks up its sleeve to surprise us with as it did this past year. In this respect, I think the Fed needs to be careful going forward and not get impatient and do something way off the wall.

As you may remember, I am not a great fan of Bernanke and I had hoped that he would offer to step down so that President Obama could select a Chairman of the Fed that would be more capable. I believe that Bernanke panicked last September (See “The ‘Bailout Plan: Did Bernanke Panic?” on Seeking Alpha, http://seekingalpha.com/author/john-m-mason/articles/latest, November 16, 2008.) Paulson was over whelmed, Bush 43 was absent without leave, and there was no one else in the administration with the intellectual quality to counter Bernanke’s arguments. As a result we got the mess labeled TARP…which was ill-planned, ill-debated, and mismanaged from the start…which has turned into its own source of disaster.

Frankly, I am concerned about where the Fed is headed. There are certainly stronger intellects around in the Obama administration…Larry Summers particularly comes to mind. However, the Fed has a certain independence that forces one to worry when you do not have confidence in its leadership.

Where will the Fed go? One should not be surprised by the central bank. A central bank needs to be steady and secure at the helm. A central bank needs to provide confidence to markets and institutions. I do not sense that participants in the financial markets feel this way at this time about the current Federal Reserve System.