The Fed Giveth, and The Fed Taketh Away

The Fed Giveth, and The Fed Taketh Away

March 17, 2008 0 Comments

(March 17, 2008) – The Fed almost got it right.

I have been whining for some time about the need to use asset market policies, rather than giving people checks so they can buy another iPod, to fix the current blackout in the credit markets. Friday’s run on the bank at Bear Stearns has apparently gotten somebody’s attention.

The Fed cannot ease the credit crisis until they increase the Monetary Base and grow bank reserves. It’s as simple as that. They must stop giving with one hand and taking away with the other. Until they do, we are doomed to more crises and more alphabet soup rescue measures.

The Fed has been nibbling at the problem for some time. On January 22, they lowered their fed funds target by 0.75%, the biggest one-time drop in 2 decades. Then, on March 7, the Fed acknowledged that the Fed funds market was not performing its function by increasing the size of the temporary Term Auction Facility (TAF) they use to mainline reserves directly to banks with liquidity issues to a whopping $100 billion, doubled the length of the loans to 28 days and announced that banks would be able to use mortgage-backed and asset-backed securities as collateral to secure the transactions.

On March 11, the Fed announced a $200 billion Term Securities Lending Facility that would allow financial institutions, including the big investment banks, to borrow cash or Treasury securities using mortgage-backed securities as collateral. But last Friday, things hit the fan at Bear Stearns and the Fed stepped in to provide a non-recourse 4 week loan to Bear Stearns, through JPMorgan Chase (JPM).

Finally, on Sunday, the Fed agreed to fund $30 billion of Bear Stearns’ less liquid assets, on a non-recourse basis, to facilitate the JPM purchase of Bear Stearns. At the same time, the Fed announced a 0.25% cut in the discount rate and created yet another alphabet program–this time the Prime Dealer Credit Facility (PDCF) that will provide overnight funding to primary dealers in exchange for a wide range of collateral including “investment-grade corporate, securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.” The one day loans can be rolled over each day. The interest rate is the discount rate, currently 0.25% above the Fed funds rate. The Fed has full recourse to the borrowers capital.

Tomorrow, when the Open Market Committee meets, everyone expects them to reduce the Fed funds by another full point, with a corresponding further cut in the discount rate.

So why isn’t it working? The answer is in the fine print. When the Fed announced the new PFCF (you have to use acronyms in this business) they also issued a press release, a Terms and Conditions statement and a statement on Frequently Asked Questions (although they had never done this before so I am a little skeptical about how many times it had come up in conversation).

Near the end there are 2 questions we should pay attention to.:

Will the PDCF operations have a reserve impact?

Yes, the credit advanced to the primary dealers under the PDCF will increase the amount of bank reserves.

How will we offset the reserve impact of PDCF loans?

PDCF loans made to primary dealers increase the total supply of reserves in the banking system, in much the same way that Discount Window loans do. To offset this increase, the Federal Reserve Open Market Trading Desk (the “Desk”) will utilize a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements, redemptions of Treasury securities, and changes in the sizes of conventional RP transactions.

In other words, in conjunction with their Fed funds targeting operation, the Fed will siphon off every dollar of reserves created by the new facility–thereby, negating all of the stimulative impact of the policy! Or, another way of saying the same thing, the Fed will reduce reserves at healthy banks–thereby worsening their liquidity–dollar for dollar with the loans they are making to the investment banks.

As an example, on Monday, March 7, the same day they unveiled the $100 billion facility, the Fed announced they would sell $10 billion of Treasury bills from its portfolio on Monday, March 10 (thereby reducing reserves by the same amount), the first outright sale of securities since 1991.

This is a problem on many levels. Leave aside the obvious moral hazard problem of taking money away from careful people to give it to people who are not so careful. It also reduces the amount of bank reserves in commercial banks–as opposed to investment banks who do not hold deposits. This will further contract lending and worsen the credit crunch.

The chart above, showing bank reserves, is the picture worth 1000 words. In spite of all the Fed’s huffing and puffing, the total stock of bank reserves today stands at $94.7 billion, lower than it was ($97.1 billion) on January 16 before they started inventing the alphabet facilities, roughly 0.7% lower than it was on May 23, before wither the leveraged loan crisis or the mortgage crisis reared their ugly heads.

If you prefer to think in terms of the Monetary Base, the aggregate that the Fed actually controls made up of bank reserves plus outstanding currency, you reach the same conclusion. The Monetary Base on March 12 (the most recent figure) stood at $857.6 billion. That’s less than it was at the end of January ($860.7 billion), and almost exactly equal to its level on August 15, 2007 when the mortgage crisis first hit the headlines. In other words, all the Fed’s stimulus since then amounts to a 0% growth in the Monetary Base.

The Fed cannot ease the credit crisis until they increase the Monetary Base and grow bank reserves. It’s as simple as that. They must stop giving with one hand and taking away with the other. Until they do, we are doomed to more crises and more alphabet soup rescue measures.

What’s at stake? So far, we have been extraordinarily lucky. Because the crisis first showed up in large leveraged loans last June, then in mortgages, it was not closely tied to commercial credit risk. As a result, banks continued to make working capital loans available for their business customers. Bank commercial and industrial loans–generally working capital loans to companies too small to raise capital on the public markets–the same ones that provide 100% of all new jobs for the economy. Bank C&I loans have grown from $1200 billion in January, 2007 to $1456 billion on February 27, the most recent figure available. C&I Loans are up $150 billion since last August, when we first heard about the mortgage crisis. C&I loans are the reason the GDP has continued to grow and jobs have continued to increase.

We should not take this for granted. Last time we got into a banking mess, in the fall of 2000, unwise actions by the Treasury Department shut down business lending and drove the economy into a recession. Loans fell from $1100 billion in November, 2000 to $870 billion in early 2004 causing tremendous loss of jobs. If the Fed does not stop siphoning off the reserves they are creating it can happen again.


John Rutledge


  1. Peter Collins

    March 18, 2008

    Dr. Rutledge, although the Fed is neutralizing the effects of the PDCF on the monetary base, there is a definite effect on the money supply. Banks, having had significant amounts of lower quality, illiquid assets removed from their balance sheets will have capital freed up to support new lending and growth in the money supply.

    Not actually true Peter. The money supply (actually the deposit component of the money supply) cannot increase unless there is an increase in 1) reserves, or 2) the money multiplier, which is constrained by the reserve deposit ratio. It is possible for the banks to increase deposits somewhat by committing previously excess reserves to new loans, but this is a one-time effect and rather small. To get a meaningful increase in deposits it requires an increase in reserves.

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