"Fed to Bare Tightening Plan"

I would recommend reading the article by Jon Hilsenrath with the title “Fed to Bare Tightening Plan” which appeared on the front page of the Wall Street Journal February 8. (http://online.wsj.com/article/SB10001424052748703427704575051442884515742.html) In this article Hilsenrath discusses the issues and possible actions the Fed may face in “credit tightening…once the Fed decides the economy has recovered sufficiently.” This is a good follow-up piece to my post of February 7 titled, “Everything is in Place: Federal Reserve Exit Watch Part 7.” (http://seekingalpha.com/article/187265-federal-reserve-exit-watch-part-7)

The problem facing the Fed?

Hilsenrath lays it out: in the financial crisis “the Fed took extraordinary action to prevent an even deeper recession— pushing short-term interest rates to zero and printing trillions of dollars to lower long-term rates. Extricating itself from these actions will require both skill and luck: If the Fed moves too fast, it could provoke a new economic downturn; if it waits too long, it could unleash inflation, and if it moves clumsily it could unsettle markets in ways that disrupt the nascent economic recovery.”

This week in testimony before the House Financial Services Committee, Chairman Bernanke is expected to begin laying out a blueprint of how the Fed expects to undo this “extraordinary action.”

The Fed has a major new tool to use in this “undoing”. This tool is something called “interest on excess reserves” which the Congress gave the central bank in October 2008. In essence, this is interest paid for doing nothing! Right now, just for holding the $1.1 trillion in excess reserves the Federal Reserve has freely given the banking system, the banks receive the interest rate of 0.25%, which is above the effective Federal Funds rate that has been around 12 basis points for a very long time.

The Federal Reserve doesn’t want the banking system to lend out this $1.1 trillion so the idea is, when the Fed is ready to start its “undoing”, it will raise the interest rate paid on excess reserves. This would, hopefully, make it more desirable for the banks to retain the excess reserves than to lend them out to businesses or consumers, thereby inflating credit and the various measures of the money stock.

In essence, the Fed has printed $1.1 trillion in bank reserves and it will subsidize the banking system whatever it takes to keep them from becoming too aggressive in their lending.

Let’s see…the government wants the banks to begin lending again…but, the Fed doesn’t want them to be lending.

Makes a lot of sense!

As Randy Quaid stated in “National Lampoon’s Christmas Vacation,” this is “the gift that keeps on giving.” Suppose I give you $1.1 trillion dollars and then let me pay you 25 basis points, 50 basis points, or whatever it takes for you not to go out and use that $1.1 trillion in any other way. Sounds like a pretty good deal. But, as we know, the Fed has lots and lots of profits from which it can pay this interest.

What is it we are doing for Main Street amongst all the deals we are giving Wall Street?

What about the Fed’s portfolio of securities purchased outright? As of Wednesday, February 3 the total portfolio amounted to $1,912 billion. Of this total, $777 billion were in U. S. Treasury securities. In the near future, this account will bear the burden of asset sales to reduce bank liquidity. Initially, the proposed methodology to achieve these sales is through “reverse repurchase agreements” or “reverse repos.” This is discussed in my post mentioned above.

But, the Fed hopes to have$1.25 trillion in mortgage-backed securities on its balance sheet by March 2010. Last Wednesday, it held $970 billion in its portfolio. It seems as if these securities are NOT going to be available for sale for a while because of the precariousness of the mortgage market and the housing market. The Fed certainly doesn’t want to do anything either in terms of dramatically higher interest rates or lack of liquidity in the mortgage market to disturb a recovery in housing. Don’t count on these securities being used to reduce the $1.1 trillion in excess reserves in the early stages of Fed tightening.

The Fed also has $165 billion in Federal Agency debt securities. Don’t expect these securities to be an active part in the Fed’s “undoing.”

Thus, it seems as if the prescription for the “undoing” is to sell U. S. Treasury securities, first through “reverse repos” and then through outright sales if the banks are congenial with a reduction in reserves and to pay interest on excess reserves to keep banks from lending out their “excess reserves” should loan demand increase or if the banks are not congenial with a reduction in reserves.

How much comfort does this “blueprint” give me?

Not a whole lot!

The Greenspan/Bernanke Fed gave us excessively low interest rates from late 2001 into 2005 (the effective Federal Funds rate was below 2.00% for all of this time period); “measured” rate increases ran into 2006 (Hilsenrath introduces one of the problems with this approach in his article. Rate increases that are “too” predictable can “fuel a borrowing boom” because of the predictability of the rises.); Bernanke publically claimed that there were no problems in the housing market and in subprime mortgage lending during this time period; the Bernanke Fed failed to foresee the economic downturn which began in 2007, but also had no clue to its potential severity; and, to combat the financial crisis, the Bernanke Fed followed one rule and that was to throw everything it could into the financial markets so as to err on the side of providing too much liquidity.

I see very little understanding of financial markets in this performance and no exhibition of “touch” in these actions. It does not leave me with a great deal of confidence that the “undoing” will proceed smoothly. My guess right now is that the Fed will wait too long to begin the “tightening” and that will put them into a world in which none of the actions that are available to them are desirable…much like the fiscal policy stance of the U. S. government right now. This is a problem, however, that one experiences because of the excesses in the past.

The Federal Reserve Exit Watch--Number One

There is great concern about the “Exit Strategy” the Federal Reserve might follow to reduce its balance sheet back to the levels that existed before the “Big Explosion” in the Fall of 2008. I plan to keep an eye on the Fed’s balance sheet over the next 12 months or so to try and keep abreast of what the Fed is doing to return to a more normal operating procedure. I discussed the prospects for a reduction in the Fed’s balance sheet in three posts on June 25, June 29, and July 2. This is just a checkup to see how things have progressed.

Over the past 13 weeks (a calendar quarter) from May 20, 2009 to August 19, 2009, the Federal Reserve allowed the total factors supplying reserve funds to decline by $128 billion. This helped to account for the major part in the decline of Reserve Balances with Federal Reserve Banks which fell by $146 billion. These are the deposits commercial banks maintain at the central bank. Other factors absorbing reserves accounted for the small difference ($18 billion) between these two figures.

The crucial contributors to this decline were all new programs that the Federal Reserve had instituted going back to December 2007 when the first innovations were introduced to relieve the liquidity crisis that was occurring in both the United States and in financial institutions all over the world. For example the amount of funds outstanding connected with the Term Auction Facility (TAF) declined by $208 billion in the May 20 to August 19 quarter. This account reached a peak amount of $493 billion in early March 2009. Currently it stands at $221 billion. This innovation was put into place to get reserves to the banks that needed them as quickly as possible. It looks as if this facility is winding down as the financial markets seem to be operating in a more normal fashion.

Another innovative response to the crisis was the Central Bank liquidity swaps in which the Federal Reserve was able to get dollars out to the rest of the world so as to avoid the problems of resolving pressures that were being felt around the world in converting financial assets into dollars. Over the past 13 weeks, the accounts related to foreign central banks and currency holdings dropped by $166 billion, another massive movement. These accounts had gotten up to around $390 billion in February of this year and on Wednesday August 19 totaled around $70 billion: another facility that seems to be winding down.

Another line item that seems to be going out of business is the Commercial Paper Funding Facility. This account dropped by $103 billion in the last quarter. This facility supported the commercial paper market and its dealers.

So, these three line items, created under the pressure of the financial crisis beginning in December 2007, have accounted for a reduction of about $477 billion of assets on the Federal Reserve’s balance sheet in the last 13 weeks. And, the declines were still continuing in the past 4 weeks so the runoff has not stopped. The figures here show that the TAF declined about $17 billion in the last 4 weeks while the Commercial Paper Funding Facility dropped $56 billion and the Central Bank facility dropped about $29 billion during the same period.

What has changed because the Total Factors Supplying Reserves only fell by $128 billion?

Well, the Federal Reserve is conducting open market operations again, seemingly to keep longer term interest rates from rising and to provide liquidity support to the mortgage backed securities markets. Securities held outright by the Federal Reserve rose $366 billion in the 13 weeks ending August 19! The biggest increase came in the Fed’s holdings of Mortgage Backed Securities, an increase that totaled $178 billion. The Fed also added $153 billion to its holdings of U. S. Treasury securities and $35 billion to its holdings of Federal Agency securities.

Over the last four weeks the Fed increased its holdings of Mortgage Backed securities by $64 billion, its holdings of U. S. Treasury’s by $43 billion and its holdings of Federal Agency securities by $9 billion.

The bottom line is that the Federal Reserve is allowing the special facilities created during the height of the financial crisis to run off but is substituting purchases of open market securities to keep bank reserves at high levels. Reserve balances with Federal Reserve Banks stood at $805 billion on Wednesday August 19, the vast majority of the reserves being just “Excess Reserves” in the banking system.

The philosophy behind this? The Federal Reserve is “exiting” the special facilities it has created to get the financial system through the crisis. However, it cannot “exit” the banking system by allowing those reserves to leave the banks.

An error was made in 1937. Commercial banks were maintaining large amounts of excess reserves at that time. As at the present time, banks were attempting to get their balance sheets in order, were not lending, and were trying to work off bad loans. The Federal Reserve, seeing all of the excess reserves, RAISED reserve requirements. This resulted in another collapse of the banking system, a collapse in the money stock, and a second period of economic disaster for the U. S. economy to follow the 1929-1933 depression.

The Federal Reserve does not want to create another crisis as it did in the 1937-1938 period. My guess is that the Fed will continue to support the large quantity of excess reserves that exists within the banking system until the commercial banks to start lending again.

Thus, it appears that the concern about an “exit” strategy is not going to be about the shrinking of all the innovative lending facilities that the Fed created to combat the liquidity crisis of the recent financial collapse. It appears as if the Fed is going to substitute open market operations to replace the decline in reserves resulting from the working off of these facilities in order to maintain the high level of excess reserves that currently exist in the banking system. Therefore, the concern about “exit” strategy is going to be connected with the removal of bank reserves from the banking system when the commercial banks begin lending again.

It is going to be interesting to see how the Fed will reduce its securities portfolio by $700 to $800 billion at that time!