Greg Ip wrote a momentous column today.
Fed Weighs Its Options in Easing CrunchBy GREG IP
April 9, 2008; Page A3
WASHINGTON — The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.
Among the options: Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed’s name rather than the Treasury’s; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.
No moves are imminent because the Fed still has plenty of balance sheet room for additional lending now. The internal discussions are part of a continuing effort at the Fed, similar to what is under way at foreign central banks, to determine its options if the credit crunch becomes even more severe. Fed officials believe the availability of such options largely eliminates the risk of exhausting its stockpile of Treasury bonds and thus losing its ability to backstop the financial system, as some on Wall Street fear.
British and Swiss central banks also are contemplating contingency plans. For now, the European Central Bank is reluctant to consider options that require substantial modifications of its standard tools.
The Fed, like any central bank, could print unlimited amounts of money, but that would push short-term interest rates lower than it believes would be wise. [LOL–ed] The contingency planning seeks ways to relieve strains in credit markets and restore liquidity without pushing down rates.
The Fed is reluctant to heed calls from some Wall Street participants and foreign officials for the Fed to directly purchase mortgage-backed securities to help a market that still is not functioning normally.
Before the credit crunch began in August, the Fed had $790 billion in Treasury securities on its balance sheet, about 87% of its total assets. Since then, it has sold or lent about $300 billion. In their place, the Fed has made loans to banks and securities firms to assist them in financing holdings of mortgage-backed and other securities. Some on Wall Street say the potential for further declines in Fed treasury holdings could leave it out of ammunition.
The Fed holds assets to manage the nation’s money supply and influence the federal-funds rate, which banks charge each other on overnight loans. When the Fed buys Treasurys or makes loans directly to banks, it supplies financial institutions with cash; in effect, it prints money. The cash ends up as currency in circulation or in banks’ reserve accounts at the Fed.
Since reserves earn no interest, banks lend cash that exceeds their required minimum. That puts downward pressure on the federal funds rate, currently targeted by the Fed at 2.25%. The Fed could purchase securities and make loans almost without limit, expanding its balance sheet. That would cause excess reserves to skyrocket and the federal funds rate to fall to zero. The Fed would contemplate such “quantitative easing” only in dire circumstances. The Bank of Japan took this step this decade after years of economic stagnation.
Weighing the Possibilities
So the Fed is seeking ways to expand its balance sheet without causing the federal funds rate to drop. The likeliest option, one the Fed and Treasury have discussed, is for the Treasury to issue more debt than it needs to fund government operations. The extra cash would be left on deposit at the Fed, where it would be separate from bank reserves on deposit and thus would have no impact on interest rates. The Fed would use the cash to purchase an offsetting amount of Treasurys in the open market; for legal reasons, it generally cannot buy them directly from Treasury.
Treasury’s principal constraint is the statutory limit debt. Treasury debt was $453 billion below the limit Monday. In the past, Congress always has responded to administration requests to raise the limit, sometimes only after political theatrics.
Fed officials also are investigating the feasibility of the Fed issuing its own debt and using the proceeds to purchase other assets or make loans. It has never done so; the legality is unclear. Some foreign central banks, such as the Bank of Japan, do so.
Another possibility is seeking congressional approval to pay interest on banks’ reserves immediately instead of waiting until a 2006 law permits that in 2011. If the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.
Congress put off the effective date because paying interest on reserves reduces the Fed profits that are turned over to the Treasury each year, widening the budget deficit. Although preliminary explorations suggest Congress would be open to accelerating the date, the Fed is leery of depending on action by Congress.
The Fed is inclined to use any additional maneuvering room to lend through its existing and recently expanded avenues. Officials are reluctant to buy mortgage-backed securities directly. They worry that such purchases would hurt the market for MBS that the Fed is not permitted to buy: those backed by jumbo and subprime and alt-A mortgages, which are under the greatest strain.
Moreover, the Fed is not operationally equipped to hold MBS and would probably have to outsource their management. Such holdings wouldn’t help avert foreclosures much, since the Fed would have little control over the mortgages that comprise MBS.
Scratch everything I’ve said about the euro having run its course …