DeLong Smackdown Watch: Effects of Sterilized vs. Non-Sterilized Policy Moves

Paul Krugman writes:

Why sterilization matters: Brad DeLong, commenting on my last post, misses the point, I think:

Foreign exchange markets are so large that even big exchange intervention efforts look like a drop in the bucket. But domestic financial markets are even larger--so that even big open-market operations not just look like but they are a drop in the bucket. Yet open-market operations are highly effective in changing interest rates.

The reason open-market operations are highly effective is that they change the monetary base -- and the monetary base is only $822 billion (yes, "only" -- we are in the land of Very Big Numbers here). Whatis more, there are no close substitutes for monetary base. So there, an intervention of a few tens of billions of dollars has a big effect.

But a sterilized intervention means an intervention that doesn%u2019t affect the monetary base %u2014 swapping dollar t-bills for euro T-bills, or T-bills for mortgage-backed securities. And here the numbers are much bigger: $11 trillion in home mortgages, for example. And home mortgages are a better substitute for, say, long-term government debt than either is for green paper bearing portraits of dead presidents.

The point is that the effectiveness of conventional open-market operations offers very little reason to be optimistic about the super-TAF, or whatever they are calling the Fed's new role as pawnbroker of last resort.

I think a better guide is the failure of sterilized intervention in, say, the 1992 sterling crisis: $40 billion in intervention -- about 4 percent of GDP -- blown away by the markets in a couple of weeks. That's why I'm not optimistic about the Fed's plan.

I parry in sixte with the response that while there are no close substitutes for monetary base (in a world with no excess reserves) there are very close substitutes for the liquid bank deposits those reserves enable: drop my checking balance and raise my VISA limit by $1000 and my liquidity position is unchanged.

But Paul's point that it is harder to see how sterilized interventions matter is correct.

Touche...

Comments

[anne]

Well done, all through.

[knzn]

The conclusion that sterilized intervention doesn't work was based on the premise that the volume of sterilized intervention necessary to have substantive and persistent effects on the exchange rate was so high as to be inconceivable in the real world. But then Mr. Inconceivable was introduced to the People's Bank of China, and I think he dissolved rather like the Wicked Witch of the West.

The Fed does have limited assets (in contrast to the PBoC's theoretically unlimited ability to buy dollars while issuing sterilization bonds), but I would venture to say that what we have seen so far is a tiny fraction of what the Fed could theoretically do if it wanted to swap assets on a truly grand scale. And the Fed can increase its assets while effectively sterilizing associated increase in liabilities by raising reserve requirements. I don't think there's any theoretical limit to that avenue, which would potentially (theoretically) enable the Fed to accept the entire outstanding stock of MBS as collateral.

[Joe S.]

"drop my checking balance and raise my VISA limit by $1000 and my liquidity position is unchanged"

Yah. But there is a riposte. Your liquidity position has not changed; it is true. But your VISA issuing bank now has a contingent liability on its balance sheet, which translates to an asset, which means that a constant-leverage bank will not make a loan to somebody else, which decreases somebody else's liquidity.

Touche?

[christofay]

there's a big explanation of this at Seeking Alpha,

http://seekingalpha.com/article/67767-repurchase-agreements-and-covert-nationalization

"But accountability has gone out of style. The Federal Reserve is injecting equity into failing banks while calling it debt."

It gets into details of why the writer thinks that TAF actions amount to buying equity rather than debt. It also states that we have essentially already nationalized 10% of bank equity and most of that will be centered in the money center big name brand and overly compensated executives banks.

Socialism is fun.

[Neal]

The rest of the world has placed the US fiancials in the plague ward.

There is speculation related to rate cuts before the next meeting.

Triple pimp slap by the Fed didn't do the trick.

Time to bring out the dead.

Hope is not a plan.

Panic is not a plan.

Wait, hasn't this already happened before with this administation, a screw-up of massive proportions that must be hidden because the truth would be too scary?

[Winslow R.]

"But Paul's point that it is harder to see how sterilized interventions matter is correct."

What is so hard to see?

Big banks with direct access to the OMD can't financially strangle small banks by cutting off interbank lending if those small banks have direct access to the TAF.

Big banks lose with the TAF, making them less valuable. Though BofA was able to strangle Countrywide, small banks on balance win if they are experiencing market meltdown.

A point that is not being addressed:

Big banks would have a much harder time financially strangling U.S. citizens if those citizens had direct access to the TAF. I'd be willing to allow citizens to refinance existing bank mortgages at the Fed, as the cost of moving the financial system to firmer footing as long as the new access was made permanent.

[Winslow R.]

As a non-depository institution, with no access to the Fed, Carlyle Capital can be strangled by its liquidity problem. I'm all for banks being able to strangle other corporations, but I'm against them being able to strangle U.S. citizens while receiving government bailouts.

Carlyle Capital Says Lenders May Force Further Sales -

http://www.bloomberg.com/apps/news?pid=20601103&sid=aI0wKOr_pTeA&refer=us

Do we forget that 'property management' really got going during the Great Depression as the big, surviving banks expropriated existing American wealth by cutting off liquidity?

[anne]

http://krugman.blogs.nytimes.com/2008/03/10/in-praise-of-expected-inflation/

March 10, 2008

In Praise of Expected Inflation
By Paul Krugman

Real rates go negative [Chart]

There has been a lot of hand-wringing over the fact that interest rates on some TIPS — Treasury Inflation Protected Securities, which are indexed to consumer prices — have gone negative. It’s said to be a sign that inflation expectations are getting out of control. And it’s true that the implied 5-year rate of inflation has risen a fraction of a percentage point over the past few months.

But I think these worriers are missing the main point: mainly, what we’re seeing is an economic environment so weak that real interest rates need to be negative for a while. Why “need”? Well, the decline in medium-term interest rates could be pronounced excessive if anyone expected lower rates to produce a runaway boom — but nobody expects that. In fact, the question is whether falling rates will even be enough to offset the effects of slumping investment demand and consumer spending.

And given that a negative real interest rate is necessary, we should be thankful that it’s possible. If we had come into this slump with zero expected inflation, we’d be up against the zero lower bound right now. It’s only because we had an inflation buffer that the Fed even has a chance of avoiding a Japan-type trap.

So let us all praise expected inflation. Without it, we’d already be in deep sushi.

[anne]

http://www.nytimes.com/2008/03/10/opinion/10krugman.html?ref=opinion

March 10, 2008

The Face-Slap Theory
By PAUL KRUGMAN

Friday's employment report — which was so weak that it had many economists declaring that we're already in a recession — was bad news. But it was actually less disturbing than what's going on in the financial markets.

The scariest thing I've read recently is a speech given last week by Tim Geithner, the president of the Federal Reserve Bank of New York. Mr. Geithner came as close as a Fed official can to saying that we're in the midst of a financial meltdown.

To understand the gravity of the situation, you have to know what the Fed did last summer, and again last fall.

As late as August the favorite buzzword of financial officials was "contained": problems in subprime mortgages, we were assured, wouldn't spread to other financial markets or to the economy as a whole.

Soon afterward, however, a full-fledged financial panic began. Investors pulled hundreds of billions of dollars out of asset-backed commercial paper, a little-known but important market that has taken over a lot of the work banks used to do. This de facto bank run sent shock waves through the financial system.

The Fed responded by rushing money to banks, and markets partially calmed down, for a little while. But by December the panic was back.

Again, the Fed responded by rushing money to banks, this time via a new arrangement called the Term Auction Facility. Again the markets calmed down, for a while.

But again, the respite was only temporary. Last month another market you've never heard of, the $300 billion market for auction-rate securities (don't ask), suffered the equivalent of a bank run. Last week two big financial companies announced that they had been unable to raise the cash demanded by their lenders. Even Fannie Mae and Freddie Mac, the giant government-sponsored mortgage agencies long regarded as safe places to put your money, are now having trouble attracting funds.

One consequence of the crisis is that while the Fed has been cutting the interest rate it controls — the so-called Fed funds rate — the rates that matter most directly to the economy, including rates on mortgages and corporate bonds, have been rising. And that's sure to worsen the economic downturn.

What's going on? Mr. Geithner described a vicious circle in which banks and other market players who took on too much risk are all trying to get out of unsafe investments at the same time, causing "significant collateral damage to market functioning."

A report released last Friday by JPMorgan Chase was even blunter. It described what's happening as a "systemic margin call," in which the whole financial system is facing demands to come up with cash it doesn't have. (A financial joke making the rounds, via the blog Calculated Risk: "Who is this guy Margin that keeps calling me?")

The Fed's latest plan to break this vicious circle is — as the financial Web site interfluidity.com cruelly but accurately describes it — to turn itself into Wall Street's pawnbroker. Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.

Some observers worry that the Fed is taking over the banks' financial risk. But what worries me more is that the move seems trivial compared with the size of the problem: $200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it's a drop in the bucket....

[Winslow R.]

PK wrote:"In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities."

...and the American public ends up with nothing in return except a continually faulty financial system.

Fine, let banks go to the Fed with worthless MBS, but at the same time allow American citizens with these worthless existing mortgages go refinance at the Fed at the current variable FF rate (3%). Let Fannie and Freddie approve any new mortgages for citizens that would like to borrow direct from the Fed.

Now is the time to 'ask' the banks for something in return for the bailout we are giving them.