Marshall Auerback here:
I am somewhat simplistic about this, but if the issue is one of a drive for dollar liquidity, the Fed should be able to address that problem. Before the week ending September 17th, the Fed was not, in fact, flooding the system with liquidity. The Fed was instead swapping their holdings of liquid assets for less liquid assets held by eligible counterparties – and the list for the latter two items having been generously expanded as the year went on. By last Friday, the Fed’s balance sheet (with total assets of the Fed carrying the name “reserve bank credit outstanding) was 1.6 times its size in mid September. This doesn’t happen very often, so how do we make sense of the Fed’s balance sheet going supernova like this.
A central bank with a sovereign currency (that is, not convertible on demand into anything other than itself, which also means no fixed exchange rate regime as well) has no technical limits on the size of its balance sheet. Politically, and practically, there may be limits, especially for central banks of countries with large external debts, as a flight from the currency can result. In any case, when a central bank with a sovereign currency acquires assets, it credits the seller’s bank accounts, and money is created. This comes as a shock to some professional investors, but future Chairman Bernanke referred to this capability in his famous Nov. 2002 printing press speech about electronic printing presses. If I were the Fed, I would be inclined to call that bluff because I see no interest in the country’s foreign credits playing the economic equivalent of the nuclear option.
Much of the Fed’s balance sheet expansion occurred in the category of the primary dealer credit facility, and then in primary credit to depository institutions, which is piped through the discount window. Late in September, it was plausible to explain some of this away as an exaggerated version of the quarter end surge in liquidity demands of banks, but the scale of the demand, and its spillover into October, suggests otherwise. Banks appear to be demonstrating what Keynes referred to as absolute liquidity preference, based on the unsettled state of the interbank lending market specifically, and the uncertainty of bank solvency more generally. In addition, banks may be expressing a precautionary surge for liquidity, in the face of large but uncertain CDS settlements coming up for several failed institutions (Lehman, AIG, and now Icelandic banks as well).
In addition, for all the media hype about flights from money market mutual funds, ICI weekly data no such thing developed amongst retail investors. Institutional holders (such as CFO’s parking cash assets from corporate balance sheets) did pull back, but again, to describe this as a collapse in the money market fund complex is surely incorrect. If anything, the swarm of retail redemption of equity mutual funds by retail investors will tend to partially replace the defection by institutions from this market.
If we follow the story told by the data, rather than CNBC hysteria, we also find no collapse in the nonfinancial commercial paper market, while there was a nearly $250b contraction in total CP in recent weeks. As during the summer of 2007, financial CP is not getting rolled, and this may further explain the cash hoards showing up on bank balance sheets, which are a part of the Fed’s explosive balance sheet growth. If a bank or other financial institution cannot count on rolling its CP, it better have a larger precautionary cash balance on hand. What comes through in this analysis is that while some channels of short term credit are constricted, the whole short term credit market has not ground to a halt, bank balance sheets are not collapsing, and the Fed, for the first time in this whole rescue effort, is exploding the size of its balance sheet.
The issue then appears more one of the price of credit, rather than the supply of credit per se. Given the surge in the Fed’s balance sheet, we can only conclude that private sector – especially financial sector – liquidity preferences have gone through the roof: and that is the essence of a financial panic.Professional investors are used to reading monetary policy by observing the level of the Fed Funds rate – sometimes from the Fed Funds futures, and sometimes inflation adjusted. ML produces a composite of private market interest rates. While the Fed has been cutting its policy rate, private market rates have surged higher 160 bps. The reality is that the Fed’s easing has been vetoed by private investors as perceived risk and uncertainty has risen while the New Financial Architecture (NFA) has been slowly but surely imploding.
Now that the Fed is paying interest on reserves, an effective floor for the policy rate can be kept in place while the Fed tries to lower longer rates, like those on MBS, which could bring mortgage rates down enough to set off another refinancing wave. Until mortgages are made more affordable, mortgage loan defaults and delinquencies will merely mount on bank balance sheets. In addition, by adopting a clearinghouse role in the CP market, there is a fighting chance that the Fed can help banks get some relief as well on the cost of funds side.
Without an aggressive, surgical strike on both these private market interest rates, I doubt the Fed will ever get ahead of the curve. Otherwise, they will simply keep shoveling newly created money into a financial system that appears to be demonstrating an insatiable liquidity preference. The Fed pegged long rates near 2% during WWII. A similar effort may be required in the face of a massive financial panic. As for clearing the CDS market, at $60 trillion, it probably got too big to settle.
While the CDS market is ostensibly a zero sum game, if settling $60 trillion in directional bets deeply impairs the financial system, perhaps the counterparties should declare force majeure rather than wait for the Fed to force the setting up of a clearinghouse, after the fact. These were, after all, deregulated markets. The participants in them viciously defended that status, and Chairman Greenspan ran interference for them whenever they were challenged. These were markets made up of consenting adults who knew they were buying the equivalent of insurance policies, except with no reserves set aside to cover policy claims. The Great Unwind in OTC markets cannot, under any circumstances, be allowed to usher in the next Great Depression.