"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.

Is Treasury's TARP Debt Already Monetized?--Part Two

My post from Friday June 26 contained the first part of this discussion. Today I would like to continue the discussion and there are two reasons for doing so. The first reason is to understand just what the Federal Reserve has been doing over these last nine months. The second is to understand how likely it might be for the Federal Reserve to “unwind” what it has done over the past nine months and reduce a part of the fear of future inflation. Note, I am not including any discussion of future government deficits and the probability that they will be “monetized.”

There is no doubt in my mind that the Federal Reserve has “printed” a lot of money since early September 2008, most of it before January 2009. The Monetary Base (Non-seasonally adjusted, NSA) rose from $847 billion in August 2008 to $1,712 billion in January 2009, an increase of $865 billion. Between January and May 2009, the Monetary Base only rose $63 billion.

Total Reserves (NSA) in the banking system increased by $817 billion from September 2008 to January 2009, but only increased by $42 billion since January. The most interesting thing is that Excess Reserves (NSA) in the banking system rose by almost $800 billion in the earlier period and increased by $46 billion in the January to May period.

The Federal Reserve put a lot on money into the banking system over the last nine months and the VAST MAJORITY of the funds went into Excess Reserves. The Fed “printed” a lot of money (or, created a lot of deposits at the Fed) but these monies did not find their way into the economy!

These two periods need to be separated in order to get a better picture of what the Fed has done and for some implications about what might occur in the future. My basic argument is that the Fed has put a tremendous amount of money into the world banking system and has ultimately underwritten the Treasury’s TARP program and provided much more money to the banking system than Congress authorized.

The underlying effort has two goals: first, to keep financial markets liquid; and second, to protect against the insolvency of the banking system. The first goal has basically been accomplished. The second is still playing itself out. The crucial thing to understand is that the way the Fed has acted has given the system a chance to get healthy and yet provide a net to catch insolvent banks so as to avoid a precipitous collapse of the banking system.

In the September 2008 to January 2009, the crisis period, the Fed basically ceased using the normal tools of monetary policy: open market operations consisting of outright purchases of government securities and repurchase agreements. In the fall, the Federal Reserve basically picked and choose what parts of the financial markets needed liquidity and created facilities to support these ill-liquid sub-markets. The major ways that it supplied funds or saw funds withdrawn in the September 2008 through January 2009 period and in the January 2009 through May 2009 period.

Change (billions) from Sept/08 to Jan/09: Term Auction Credit $257; Other Loans $166; Commercial Paper LLC $334; Other Fed Reserve Assets $506; for a total of $1,263. The change (billions) from Jan/09 through May 2009: Term Auction Credit (-$124); Other Loans (-$62); Commercial Paper LLC (-$206); Other Fed Reserve Assets (-$411); for a total of minus $803.

The Term Auction Credit Facility (TAF) helped to get reserves to the commercial banks that needed reserves, an effort the Fed believed was more efficient than open market operations. TAF peaked at $300 billion increase on 12/31/08. Other loans include increased borrowings from the Fed’s discount window, a facility for asset-backed commercial paper (which reached a peak increase of $152 billion on 10/8/08), a facility for primary government security dealers (which reached a peak increase of $147 billion on 10/1/08), and a facility for AIG. The commercial paper LLC was a limited liability facility that bought 3-month paper from eligible issuers (which reached its peak of $334 billion on 12/31/08). The increase in Other Fed Reserve assets was primarily Central Bank Liquidity swaps (which reached a peak of $682 billion on 12/17/08).

However, the Fed’s efforts reported here resulted in almost a $1.3 trillion increase in its assets and an $865 billion increase in the Monetary Base. Thus, almost the entire monetization ended up as excess reserves held at Federal Reserve Banks. Bank reserves at Federal Reserve Banks increased steadily throughout the fall, peaking at $856 million on December 31, 2008. Whew! The Federal Reserve had made it through this period of financial market illiquidity which accompanied the entire Thanksgiving/Christmas seasonal need for cash.

What happened in 2009? As mentioned above, the needs of specific market makers retreated, but now the solvency of the banking system came to the fore. In terms of the special facilities, as can be seen from the figures given above, a total of $803 billion was removed during the first five months of the year. Then the Fed began to conduct open market operations again. Throughout this time, securities bought outright by the Fed increased by $712 bullion. This included a program to buy government securities on a regular basis which contributed $177 billion to the Fed’s portfolio. It also added $70 billion of Federal Agency issues. Furthermore, the Fed initiated a very important program in 2009 and bought $465 billion of Mortgage-backed securities.

In essence, Total Federal Reserve Bank credit declined by about $200 billion during the first five months of the year but, as was reported earlier, the monetary base increased by $63 billion and total reserves and excess reserves in the banking system increase by more than $40 billion. In essence, the Fed operated in 2009 to keep the banking system very liquid and replaced the reserves that had been supplied to different parts of the financial markets in 2008 by interjecting funds directly into the banking system. The new twist? Directly helping banks sell their mortgage-backed securities, thereby reducing pressure on the banks to clean up their balance sheets. This was the original purpose of the Treasury’s TARP program.

The banking system faces three problems going forward: existing bad assets; bad assets that will appear over the next 18 months or so; and refinancing needs as the banks may not always be able to roll over existing liabilities.(See my post of June 15, “What Banks Aren’t Telling Us”, http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us, for more on these factors.) The huge amount of excess reserves will help the banks face these problems. In terms of financing needs, the banks have the cash to pay off maturing liabilities without needing to roll the debt over. In terms of bad debts, this is where the TARP program comes in because the Treasury has provided preferred stock to banks with warrants attached. Charge offs can go against existing capital and the preferred stock and warrants can be transformed into new capital owned by the government to keep these banks afloat until something can be done with them.

Some banks have repaid the TARP funds that they had received. Several well-known large banks returned $68.25 billion this month to reduce Federal Government oversight. Still there have been 633 banks that have directly received about $200 billion in TARP funds and a total of 32 banks have now repaid about $70 billion. (On this see “Small Banks Not Shying From TARP” in June 27 Wall Street Journal, http://online.wsj.com/article/SB124606040026463617.html.) So, of the roughly $800 billion that banks are now holding in excess reserves, one could argue that approximately $130 billion of them have been supplied through the Treasury program and are held, mostly, by smaller banks and $670 billion of them has been supplied by the Federal Reserve, the total of the two being the money “printed “ to get us out of the current financial crisis.

The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!