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Nov 2, 2008 11:10 pm


Recent Fed Machinations



Recent Federal Reserve activity is unprecedented. For a dramatic visual, go to Greg Mankiw's blog.

Many believed that Ben Bernanke had begun pumping up the money supply as early as the end of last year in response to the financial situation. But in fact, the Fed did not actually open the monetary spigots until a little over a month ago. Up until then, Bernanke effectively sterilized all his monetary injections, either by directly trading Treasuries from the Fed's portfolio for riskier financial securities, or by indirectly loaning to financial institutions with money recouped by selling Fed-held Treasuries on the open market. Either way, there was no major impact on the monetary base. As a result, the annual rate of growth of the monetary base remained in the neighborhood of 2 percent through August 2008, whereas total bank reserves remained virtually constant.

Indeed, one of the problems with the Fed's early response may have been Bernanke's fear of potential inflation, as the RELATIVE prices of oil and other commodities headed upward. He therefore tried to do the impossible: simultaneously avoid inflation by holding the line on monetary growth, while warding off a potential deflationary bank panic by injecting liquidity into selected institutions. The market's confusion over these cross purposes seems to have actually prolonged and deepened financial difficulties. In fact, a desire to achieve both goals simultaneously was a primary motive behind the dreadful Treasury Bailout. At least Bernanke didn't make the mistake of the European Central Bank, which with its rigid inflation targeting, tightened monetary growth in response to rising commodity prices, exacerbating the supply-side shock (and incidentally helping the Euro to remain temporarily strong against the dollar).

But now, all that has changed. After September 17, when the interest on T-bills briefly went negative, Bernanke opened the monetary floodgates. The reversal of commodity prices probably made him more comfortable about doing so. In any case, back in August the monetary base was $847 billion with total reserves constituting $72 billion of that (all figures are not seasonally adjusted and not adjusted for changes in reserve requirements). The Fed's latest H.3 Release (October 22, 2008) puts the base at $1,149 billion, a 40 percent jump over a year ago. What has exploded even more is total bank reserves, where the base increase is concentrated. Reserves have increased by an astonishing factor of about FIVE over the last month, and are now somewhere between $343 and $358 billion.

And that is not all! Federal Reserve Bank Credit (as reported in the weekly H.4.1 release) has doubled in the last month to around $1.8 trillion. Although Federal Reserve Bank Credit used to mirror the monetary base closely, that is true no longer--not since the Fed activated its U.S. Treasury supplementary financing account, which you can find reported in the same release. These are additional Treasury deposits at the Fed, which have gone from zero to approximately $560 billion.

These new deposits result from what the Treasury calls its Supplementary Financing Program, initiated a month ago to try to staunch the growing demand for Treasury securities manifested in falling T-bill rates. What essentially has been going on is that the Treasury is now issuing extra securities to borrow money from the economy, then loaning the money to the Fed in these special deposits so that Bernanke can re-inject it to make his bail out purchases of various securities, all without increasing the base. In other words, what the infamous Bailout Act permitted the Treasury to do directly is something it had already started doing indirectly through the Fed to the tune of half a trillion. And all in the name of easing a tight Treasury market. This partly explains why Treasuries fell in price after the Bailout passed, along with stocks, contrary to what usually happens.

It also means that the total bailout is not the $700 billion that Congress appropriated but at least $1.2 trillion. Nor does this count the Fed's recently promised $540 billion bailout of money market funds, which if not covered by the Fed's sale of other assets, will require either further monetary increases or further Treasury borrowing. Thus we now have the worst of both worlds: a massive bailout financed BOTH by Treasury borrowing, in order to avoid inflationary pressures, and a monetary base increase, heralding future inflation anyway.

There will be a lag before the explosion of the base works its way fully into the broader monetary aggregates. The year-to-year annual growth rate of M1 has already risen from 0 to over 7 percent, whereas that of M2 is up slightly from 6 to 7 percent. Bernanke's plan is undoubtedly to pull liquidity back out before this process heats up. But that will entail dumping around $300 billion of Fed-held securities back on the market (or still more if base expansion continues). Now that the Fed is paying interest on bank deposits at the Fed, it can also induce banks to hold more reserves, dampening the money multiplier. It has already jacked up the interest it pays, not on required reserves, but on excess reserves.

Notice further that when you combine the Treasury's Supplementary Financing Program with the Bailout, you have a $1.2 trillion increase in federal government borrowing, at least half of which has already taken place within the space of a month. This sudden 25 percent increase in the outstanding national debt qualifies as the most dramatic peacetime experiment in fiscal stimulus the U.S. government has ever implemented. If Keynesian theory were correct, we should already be well beyond any potential recession. But how many economists are going to acknowledge this striking empirical refutation of fiscal policy's efficacy?

Indeed, I suspect that this enormous increase in government debt at least partly explains the sudden stock market collapse after the Bailout passed. Government borrowing represents a future tax liability, and expected future taxes affect the value of equities. Some argue that this new borrowing may not increase taxes at all because it merely finances the purchase of earning assets that the government can later resell. While certainly possible in the long run, no one knows the true value of those assets in the short run. After all, the market's anxiety about their worth was the justification for the Bailout in the first place. So now the government transfers that uncertainty from private financial institutions to the general taxpayer. Just in case markets failed to notice, Bernanke--rather than calming them as you might expect the Fed to do--combined forces with Treasury Secretary Henry Paulson and President George W. Bush to scare hell out of the American people in order to ram their ill-advised Bailout through Congress. Is it any wonder that stock prices took a nosedive? In short, current events seem to have not only refuted Keynesian theory but also dramatically demonstrated the validity of the approximate Ricardian Equivalence between government expenditures financed with present taxes and those financed with future taxes.

And as icing on the national debt cake, the Bailout Act, by allowing the Fed to pay interest on bank reserves, has in effect converted that portion of the monetary base into still more Treasury securities. Reserves held as vault cash obviously cannot earn interest, but this change still adds another $325 billion to the growth of federal debt over the last month. Future historians may someday refer to this sad episode as the Bernanke-Paulson Recession, concluding that it was the policies of those two individuals, more than any other factors, that turned what was not even a mild recession into a major economic downturn.

A CORRECTION FOR PERFECTIONISTS (added Oct 27): I realize now that my claim above, in the last paragraph, that interest on reserves increases the national debt by $325 billion is not completely accurate. Here is the reason. Unless it sells goods and services on the market like a private firm, the government has only three ways of financing its expenditures: (1) current taxes, (2) borrowing (i.e., future taxes), or (3) printing money (a.k.a seigniorage). With a central bank, Treasury borrowing is divided between (2) and (3), with the amount borrowed from (that is, monetized by) the Federal Reserve generating seigniorage. Before the Fed paid any interest on reserves, the recent $300 billion increase in the monetary base would have constituted seigniorage. So the future taxes required by the new $1.2 trillion Treasury debt would have been REDUCED by $300 billion. Instead, by simultaneously paying interest on reserves, the Fed completely eliminated this seigniorage deduction, requiring future taxes for the entire sum of $1.2 trillion. Not only that, the Fed began paying interest on reserves the banks were already holding, adding merely about $25 billion (not $325 billion) to the $1.2 trillion. (This may seem complicated enough, but I haven't adjusted for the interest differential between what the Fed pays on reserves and what the Treasury pays on its securities. That differential represents a smidgen of lingering seigniorage that reduces the $25 billion somewhat.) Of course, to the extent that the banks or public convert reserves into currency, Treasury debt will be converted into seigniorage.

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Hans L. Eicholz - 10/30/2008

One other point...You may be correct that bubbles will happen with or without a Fed. But the point of moral hazard is to account for an accumulation of bad moral capital so-to-speak. The greater the accumulation based on each episode of intervention, reinforces and extends the degree of bad practices, bad investments. So perhaps bubbles might not go away, but perhaps their management by a central authority encourages their systemic character?


Hans L. Eicholz - 10/30/2008

Very good points and its always harder to argue for what someone else would say, but I'll give it a go.

As a central bank skeptic, you seem to agree that the policy of "ignoring bubbles" is a very problematic undertaking. Now add what O'Driscoll appears to be saying about ignoring them UNLESS their collapse is thought to be "systemic." What he seems to be saying is that there is a fundamental incoherency here--one you have also picked up on. It is fraught with all sorts of contrary implications depending on what your policy goal is. The result in actual practice has not been to ignore them at all, but to intervene at every potential bursting with new liquidity. He goes back to the rate cut in 2000 and then again to the holding at 1% in 2003/4(?). One might reasonably ask then, what bubble is he not going to re-inflate, regardless of how conservative the Fed chairman might otherwise try to be between intervals? Doesn't this send a message, even if you think the Fed has no other option if price stability is its aim? It is an inherent problem of a central banking system.

You say, well, I am missing the point: "There is no effort to keep stock prices at peak, "bubble" levels. But total spending and stable prices for final goods and services are maintained." Pray tell, how do you actually disentangle them? The money is injected for all to avail themselves of, not just the provision of goods and services.

Perhaps the better way to see the distortionary effects of such a policy is to place the current "crisis" in the context of the radical restructuring of incentives brought on by Fannie and Freddie, HUD, etc.

In this context, rational expectations or not, the bubble was undeniable and given past Fed experience, each player in the market could reasonably expect to be able to borrow and borrow again to attempt to restructure his holdings. Individually this was quite rational, and the Congress and the Fed facilitated the process.

You may be correct that this is simply an inescapable aspect of central banking no matter what measure they try to take of economic performance, the money supply, prices etc, but that sounds to me like a very damning fundamental critique of the very idea of central banking itself, a knowledge problem of such insurmountable magnitude that it strikes at the entire rationale of the institution. If that is what you are saying, well, I think you are right.



Bill Woolsey - 10/30/2008

Suppose the Fed's policy is stability in the prices of final goods and services. That requires that the Federal Reserve ignore stock prices whether they believe that they are "too high" or not.

Now, if rising stock prices lead firms to float new issues and finance more real investment, this will raise the demand for final goods and services and raise prices in that sector. Other things being equal, this raises the price level. If the Fed had God-like knowledge, it would anticipate this effect, and raise its interest rate target. This higher interest rate should reduce consumption and dampen the stock financed investment, keeping saving and investment in balance. If this dampens or pops a bubble in stock prices--so be it. The Fed is maintaining price level stability and ignoring "bubbles."

If the "bubble" doesn't burst and prices continue to rise for stocks, then the Fed does nothing to stop it. In particular, it doesn't raise interest rates to a point that consumption and investment both fall to a point less than the productive capacity of the economy, creating surpluses througout the economy, and resulting in downward pressure on prices. That would lead to deflation--contrary to the Fed's goal of price level stability. It is possible that the recession and deflation would result in a bubble in stock prices popping. But, causing deflation (and recession) is inconsistent with the policy goal of price level stability.

Now, suppose a bubble pops independent of Fed activity (or the pop is caused by the side effect of the Fed maintaining price level stability.) If the pop causes excessive pessimism by households and firms, so that consumption and investment fall, the Fed would respond to the resulting imbalance between saving and investment by lowering interest rates. The purpose would be to prevent reductions in demand for final goods and services, and surpluses thoughout the economy. There is no effort to keep stock prices at peak, "bubble" levels. But total spending and stable prices for final goods and services are maintained.

I can tell the same story if the goal is to target any measure of the money supply we choose, maitaning gold convertibilty, protecting the exchange rate relative to major trading partners, keeping nominal income stable, maintaining a growth rate of nominal expenditure, and having the price level rise at some particular rate other than zero.

Similarly, the same story can be told in the context of money supply and money demand. I actually prefer that analysis, but the market interest rate-natural interest rate approach is fine.

I am a central banking skeptic. I think it is simply false to claim that speculative bubbles are impossible without a central bank. If we have some kind of privatized monetary arrangement, then there will be no monetary policy tool that could pop a bubble. The market forces that mitigate the bubble would still exist, of course. Perhaps they would operate in slightly different ways.


Hans L. Eicholz - 10/27/2008

I suppose O'Driscoll would say that much hinges on how one interprets a bursting of the bubble. At what point do you inject more liquidity?

In his essay, he cites statements that sound fairly strong about preventing the deflationary effects of declining asset prices. This could well be taken as more money to play with, by those involved, especially if one believes that earlier Fed policy may have, at least in part, helped to fuel the bubble to begin with, so I think my question still holds up.


Robert Higgs - 10/26/2008

Splendid post, Jeff. I've just drafted a commentary on a related topic, but with considerable overlap with your post, which will probably be posted tomorrow or the next day. Like you, I was astonished when I checked the data on the monetary base and saw the huge spike for the most recent month. Ominous, indeed.


Bill Woolsey - 10/26/2008

I disagree that a policy of ignoring bubbles creates a moral hazard.

Apparently, you are assuming that the Federal Reserve promised to prevent the bubble from bursting.

The promise is to make sure that the drop in asset prices doesn't lead to a drop off in aggregate expenditure.

If the "bubble" in asset prices leads to excessive increases in production in some areas of the economy, and bursting the bubble causes those sectors shrink though reduced demand, maintain growing expenditure just means that there are other sectors in the economy with shortages to match those surpluses.

I will grant, however, that existing policy is aimed at bailing out people who invested heavily into the the housing bubble. This does create a moral hazard.

The policies described by Hummel seem to be aimed at keeping the market from reallocating types of credit finance. (Yes, we must make sure that we continue to have people hold money market mutual funds that invest in commerical paper.)

I can't imagine that they really want to keep production levels in housing at boom levels.

Any, I don't agree that keeping the Fed away from trying to regulate asset prices necessarily creates a moral hazard.

If the Federal reserve has any other policy goal, from maintaining gold convertbility to maintaining steady growth in aggregate expenditures, it has to leave asset bubbles alone.

If buyers and sellers in the open market determine the proper values of houses or equities, then bubbles are possible. (Prices are "too high" in hindsite.) Having a central bank determine the proper level of prices and then cause recession and deflation of forces if they are too high requires is bad. The opposite, of course, is to cause inflation if asset prices are too low. Surely, the nominal value of future profits will rise if we cause enough inflation. We can raise stock prices easily...






Hans L. Eicholz - 10/26/2008

Dear Jeff,

Very interesting piece. I think you are right about the train wreck on the horizon, but I am still interested in the origins of this and wonder about the causal role of the Fed in this latest crisis, especially given your opening paragraph respecting a fairly conservative monetary policy. It strikes me that this would still be fairly consistent with what O'Driscoll notes in his article on the moral hazard of Fed policy.

According to him, Greenspan and Bernanke explicitly said they would do nothing in anticipation of bubbles, but would respond to their aftermath. This would seem to go along with that pattern and now as you point out, with a vengence!

If in fact that is the case, this would clearly be a moral hazard of some consequence, would it not? O'Driscoll sees this policy as operative in 2002, when "the Fed was worried about the possibility of price deflation and introduced a strong anti-deflationary bias." Retrenching later, would do nothing to alter the basic signal to asset markets: "We'll step in when you need us."

So, rather than recounting the last few quarters of Fed policy as conservative, it might be best to note that they had altered its character fundamentally by changing the nature of the Fed's relationship to asset bubbles. What think ye?

Best,
Hans

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