Wednesday, December 17, 2008

The Fed's laundry list on one page

The meaty December 16, 2008 FOMC statement compared to the previous October 29, 2008 statement on one page (click to enlarge):
Yesterday's statement was quite unconventional: the body of the statement was five paragraphs compared to four in the October statement; the Fed shortened it's downside risks to growth paragraph (second paragraph); the Fed added a sentence to the inflation paragraph that indicates angst regarding price instability (in blue); a new paragraph detailed the Fed's promise to use "all available tools", and that the fed funds rate will be "low for some time"; and finally, the fifth paragraph - which last time highlighted how the FOMC believed that its actions "should help over time to improve credit conditions and promote a return to moderate economic growth" - lists the Board of Governors' promised policy measures. These measures include the following:
  • "sustain a balance sheet at a high level "- quantitative easing.
  • purchase MBS and agency debt in "large quantities" - change the composition of its balance sheet.
  • possible purchase of long-term Treasuries - change the composition of its balance sheet
  • TALF, or buying asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA) - change the composition of its balance sheet.
And here is the part that I like, "using its balance sheet to further support credit markets and economic activity". This could mean anything under the sun: CMBS (commercial mortgage-backed securities), swap obligations, corporate debt (high yield or investment grade), larger quantities of commercial paper, etc., etc.

The Fed in concerned that the financial crisis - if left untreated - will seriously injure the real economy. In some sense, the Fed's measures are working: commercial paper - propped up by the Fed's $309 billion net-holdings (as of 12/16/08) - is still functioning, the money supply is still growing (including institutional money funds in November), and the Fed-regulated banking system is still lending.

Some of my readers have expressed their strong disapproval of the Fed's policy measures, and clearly the Fed's exit strategy will be crucial. I am skeptical of the Fed's ability prevent added inflationary pressures down the road, but given the extreme downside risks to growth, I believe that the Fed is doing the right thing here. The Fed is feeding off of a credible monetary system (and rightly so, according to the TIC flows) to stave off a deflationary spiral. Barring significant inflation down the road, that is the right choice.

But with Congress' pledge to increase the size of its stimulus package with each week that passes (see this post and this post), I am re-evaluating my stance on fiscal policy, but I need to be convinced. Feel free to send me any intelligent economic material on the subject of expansionary fiscal policy, either by emailing me or by linking directly from the comment section.

One thing is certain, though: textbooks teach us that when the central bank is faced with a liquidity trap (no more stimulus left in monetary policy, i.e., reducing rates), fiscal policy must complement monetary policy. But there is still some stimulus out there -many long-term rates that matter to consumers are still elevated relative to short-term rates: mortgages, auto loan, etc. If those rates fall - 30-year mortgage down 0.06% to 5.47% on December 12, 2008 - then some economic activity may emerge.

Rebecca Wilder


  1. Welcome to planet ZIRP. Unfortunately, we do not have a handbook, or fully understand the terrain. Our process of quantative easing, the plan to helicopter money may work but as a fire fighting option, it may be like dropping water into a desert.

    The many fissures in the financial system may just continue to absorb liquidity.

  2. ...especially when AIG and Goldman are sending out billions of it in bonus $$$.

  3. What a disaster.

    Americans lack seeing what is happening.

    This is a totalitarian, Communization, a Collectivization of credit risk decision-making and the economic results from such acts.

    Bernanke and the Fed have become the Central Planners for credit, deciding WHERE CREDIT should flow for a $13 TRILLION economy.

    Before, in spite of the chartered monopoly in the manufacture and distribution of money and credit, the Fed Reserve could only dictate HOW MUCH CREDIT should flow.

    Now, Bernanke and his gang decide what kinds of credit (loans) should get made in the USA and thus who should become the winners -- mortgages and house builders, home goods suppliers, student loans and universities.

    And with winners, losers must exist as cash from credit shall not flow to them.

    Through his acts, Bernanke has set the stage for a new round of capital allocation mistakes as money rented as cash shall flow to unneeded things in the marketplaces.

    The day Bernanke decrees that Reserve Requirements for banks can drop coupled with growing spreads on rented cash is the day a Tsunami of Inflation gets unleashed upon Americans.

    If production of stuff in the USA does not follow or if the buying power of the US dollar falls thus stemming the flow imports, massive increases of prices for everything sold in the USA shall happen.

    Those cheerleaders yelling raw-raw praises for Bernanke hold intense false beliefs about money and credit, central banking and systems designs.

  4. Budget deficit financing is fast losing its validity as a fiscal device to rescue the economy from a depression, or even to prevent recessions.

    The rising yield curve and the abnormally low-level-yielding, short-term, riskless, government securities, suggests that the long-term trend of short-term rates will also be up.

    Further adding to our deficit financing woes is the volume of foreign financing, now (07) about 46 percent of total net debt (2.4 trillion).

    Further declines of the dollar may precipitate a shift by foreigners into domestic currencies.

    Both cases would tend to push interest rates up, and the latter will add to the downward pressure on the dollar.

    If the Fed follows a tight money policy, the long-term effects of which are to push interest rates down, that will also contribute to the decline of the dollar, and an adverse effect on the willingness of foreigners to invest in dollar creditorship obligations.

    And if the FED follows an easy money policy, the long-term effects of which are inflationary, the investing public will immediately respond by refusing to invest in bonds except at rates that offset the prospective increase in the price level.

    Furthermore, the higher interest rates will put a damper on the economy, which may be sufficient to significantly lower government revenue and add to the deficits.

    We are in a “Catch 22” situation; THERE IS NO RIGHT POLICY.

    The “expectation” response of the public relative to higher rates of inflation, and therefore higher interest rates, which dates back to the 50,’s, has made the Fed’s monetary management responsibilities much more difficult.

    This prevailing attitude by investors, that inflation will now be a chronic phenomenon in the U.S. economy, has also invalided the thesis of some economists that we can inflate the burden of the debt away.

    Any attempt to do so will result in sharp increases in long-term interest rates, and even larger deficits.

    Only direct controls can cope with this problem.

  5. It would seem that somewhere, somehow, if total net debt (not just Federal Debt) keeps rising faster than production (Real-GDP), the burden of interest charges at some point now indefinite and unknown, but nevertheless real, will become too great to carry.

  6. Once again: Any deficit, by definition, creates a demand for loan-funds. The larger the deficit, the higher interest rates will be, or the less they will fall.

    Any given deficit should be evaluated in terms of:

    (1) the size of the deficit in the context of the size of future deficits, and the accumulated debt relative to the means and costs of financing the whole:

    (2) how the deficit is financed: (a) from savings or (b) commercial bank credit, i.e., newly created money; and

    (3) the purpose for which the deficits are incurred.

    Prorating the federal deficits over the entire spectrum of federal expenditures, it can be said that virtually all of the current deficits are attributable to defense spending, military and civil service pensions, interest on the debt, and welfare and unemployment benefits. Social security for now is not include in the above list since only a very small proportion of social security benefits are financed from non-social security taxes.


    If current projections of Federal Deficits materialize in this, and the next few years, interest rates (both long and short-term) will be driven up sharply by the increased demand for loan funds. I.e., any recovery in the economy will present a “Catch 22” situation.

    An upturn in the economy will add increased private demand for loan funds to the insatiable demands of the Federal Government. The consequent rise in interest rates will effectively abort any recovery.

    Raising taxes to accomplish a reduction in the deficit would be counter-productive.

    Most of this debt is short-term. Combine this with the factor with the constant roll-over of some of the long-term debt and it becomes obvious that the burden of higher interest rates will be compounded.

    The burden becomes a function of the major portion of the debt, not just the current deficits.

    The burden, in fact, becomes exponential. In other words, if the trend is not stopped, the debt inevitably has to be REPUDIATED.

  7. The Social Security Trust Fund is not a fund; money is not deposited in the fund, nor are drafts drawn against it.

    The “Fund” consists of records kept by the U.S. Treasury, which reflect the net differences in Social Security receipts and expenditures, plus accrued interest on the accumulated balance.

    Although the “baby boomers” begin to come “on stream” around the year 2010, deficits in the Fund will not occur until a few years later.

    Subsequent deficits in the SSTF are expected to largely consume the Fund since the Fund is not a fund, how will the baby boomers get bank their contributions, plus accrued tax-free interest? The answer: by higher non-Social Security taxes and/or borrowing.

    Social Security is a “transfer” not an “accumulation” system. The capacity of the Social Security System or any other agency of the U.S. government, to meet its obligations is, and will remain, dependent on the TAXING AND BORROWING capacity of the U.S. Government.

  8. Again: It should be recalled that the charges on debt are related to a CUMULATIVE figure; and since the multiplier effects of debt expansion on income, the ingredient from which the charges must inevitably be paid, is a NON-CUMULATIVE figure, it would seem that the time will inevitably arrive when further debt expansion is no longer a practical or possible expedient, either to provide full employment or to keep debt charges with tolerable limits.

  9. The significant economic purposes for which a debt was contracted, or the manner in which it was financed, is of inestimatable value in evaluating it's impact.

    For example if the debt was acquired to finance the acquisition of a (new-security), the proceeds of which are used to finance plant and equipment expansion, rather than the purchase of an (existing-security) to finance the construction of a new house, rather than to finance the purchase of an existing one (bailout), or to finance (inventory-expansion), rather than refinance (existing-inventories).

    The former types of investment are designated as "real" as contrasted to the latter, which constitute "financial" investment (existing homes).

    Financial investment provides a relatively insignificant demand for labor and materials and in some instances the over-all effects may actually be retarding to the economy.

    Compared to real investment,it is rather inconsequential as a contributor to employment and production.

    Only debt growing out of real investment or consumption makes an actual direct demand for labor and materials.

  10. The extent to which an expanding debt is stimulating factor also depends on the manner in which the debt is financed.

    Debt financed from voluntary savings, which is all debt except that held by the commercial and the Reserve banks, provides an outlet for savings. In so far as the money supply is concerned, it is a velocity factor. The stimulating effect of this type of debt expansion arise entirely out of the fact that it is the catalyst which changes idle into active funds.

    Debt financed by the commercial and the Reserve banks has a much more stimulating effect because it involves and enlargement of the money supply, and the dynamics created in the economy is the process of bank credit creation tend to cause an increase in the velocity of money.

    Reserve bank financed debt not only enlarges the money supply, but by causing the excess reserves in the commercial banks to expand lays the basis for a multiple expansion of bank credit and the money supply.

    Other things being equal, bank financed debt has a much more expansive effect on production, employment and prices, than does non-bank financed debt.

  11. Again: Those who are wont to minimize the ill effects of the deficit are prone to compare the size of the deficit with nominal GDP, as if the volume of nominal GDP were independent of the size of the deficit.

    Unprecedentedly large deficits “absorb” a disproportionately large share of nominal GDP.

    Present deficits are unprecedented no matter how measured, and the past gives us no reliable guide to the future effects of deficit financing, beneficial or otherwise.

    To appraise the effect of the federal budget deficit on interest rates, it is necessary to compare the deficit, not to GDP, but to the VOLUME OF CURRENT SAVINGS MADE AVAILABLE TO THE CREDIT MARKETS.

    The current deficit is absorbing about ??% of gross savings (SEE .

    The more alarming aspect of the deficits is not the effect on interest rates but the effect of high interest rates on the level of taxable income and the volume of taxes required to serve a cumulative debt now exceeding $10+ trillion.

    Both high interest rates and high taxes induce stagflation, thus eroding the tax base and increasing the volume of futures deficits.

  12. Taylor's scrutiny of the Fed's monetary policy blunder

    Why is it said that LEGAL RESERVES aren't "binding" when it is INTEREST RATES that aren't "binding".