"Small" Financial Market Interventions and Asset Prices

Paul Krugman writes:

Whats Ben doing? (Very wonkish) - Paul Krugman - Op-Ed Columnist - New York Times Blog: The financial crisis seems to have entered its third wave. Panic in August, then partial recovery thanks to lots of money thrown at the system by the Fed. Renewed panic late fall, then partial recovery thanks to even more money thrown in, especially the Temporary Auction Facility. And panic has set in yet again.

So the Fed is throwing another wave of money in, via the TAF and also additional loans to banks. All this lending is backed by collateral: the banks are setting aside various stuff, but probably mainly mortgage-backed securities.

How do we think about all this?... [T]he old framework I learned back in grad school for thinking about sterilized intervention in the foreign exchange market applies pretty well....

Normally, the Fed engages in open-market operations: it buys T-bills with freshly printed money. This shifts the market-clearing conditions for T-bills and money, but not securities.... But now the Fed faces a new problem: the private sector is fleeing from private securities that are seen as risky/illiquid, and seeking safe haven in T-bills. Hence rising interest rates on securities even as T-bill rates fall.... [T]he Fed is afraid that this will lead to a vicious spiral of financial collapse.... As Jim Hamilton says, the Fed is conducting monetary policy on the asset side of its balance sheet -- shifting from T-bills to less liquid, and arguably riskier assets... the reverse of the flight to safety by private investors.

OK, this is just like the way you analyze sterilized intervention in currencies. And the usual problem with such intervention applies: the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it's usually because... the markets are getting hysterical, and intervention gives them a chance to come to their senses. And the problem now becomes obvious. This is now the third time...

Paul is, as usual, smart. But I think this argument proves to much. 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. (Or so we believe--the late Fischer Black, Robert Rubin, and some others think that Fed open-market operations are more often a reaction to than a driver of consensus shifts in interest rates.) If most of the market is "inert"--at least in the short run--relatively small exchange rate interventions, open-market operations, and asset swaps could matter a lot--at least in the short run.

Or so Ben Bernanke, Tim Geithner, and company hope.

Comments

[Bruce Wilder]

Fed lending to depository institutions is approaching $50 billion.

JP Morgan Chase estimated on Friday that the effect of margin calls, triggered by the falling value of mortgage-backed securities, would be realized losses of $350 billion.

So, Fed efforts, at this point, remain fractional, but they've moved out of "drop-in-the-bucket" open market operations territory.

[gorobei]

I found the most interesting part of PK's post to be this:

"And the problem now becomes obvious. This is now the third time Ben & co. have tried slapping the market in the face — and panic keeps coming back. So maybe the markets aren’t hysterical — maybe they’re just facing reality"

For the last six years, Alan, Ben & Co have been pushing short-term rates around, and their minions have been writing papers expressing confusion about the lack of movement in long-term rates (everyone seems to have forgotten the 2002-2003 soul-searching when cheap money didn't translate to cheap bonds.)

PK hits the nail on the head: nothing Ben can do will affect the global situation - he's got a blunt axe in a big forest. We've got a global, near perfect-information economy: USD is an asset class, not a benchmark, at this point.

Changes in USD and T-Bills are now looked on more as market manipulation than intervention: reality hasn't changed (oil imports, housing, etc,) but the value of short-term USD has been merely pushed around. No trading desk looks at these changes as policy shifts, they see them as short-term opportunities at this point.

[jim]

I don't think the Fed is trying to move the market any more. It's trying desperately to keep the lid on through the panic. The Times reported last week that the increase in TAF was to prevent the collapse of "a major bank." Not hard to guess which one. Early Friday, Schwab was offering Citigroup notes due April 09 at a price which would yield just under 9.9% to maturity (13 months away!). They apparently had no takers. By the end of the trading day they were offering the same security to yield 10.11%. There's massive doubt out there as to whether Citigroup will still be there in April 09 to pay off its notes. We have never had a bank the size of Citibank fail. Hell, until recently we never had a bank the size of Citibank. Such a bank failure would be game changing. One can interpret everything Bernanke's done simply as trying to prevent it. Apply Occam's razor.

[Colin Danby]

Thanks Jim. Any analysis out there on what has made Citigroup especially vulnerable?

--

Do central bank operations in a wider range of securities create some sort of implicit floor under their price, that is an implicit gov't guarantee? Seems like there have been several ad hoc moves here and abroad to make certain kinds of assets more liquid, and I wonder if anyone has stepped back and surveyed the whole picture.

I also wonder how far we are from having to bail out Fannie Mae and Freddie Mac. Has anyone run scenarios?

[Dave]

These open market operations are quite large--if they weren't, they wouldn't be having such a big impact on inflation.

(When I saw that Ben's response was to stop worrying about inflation to try to re-inflate the bubble which will cause more long-term pain, rather than taking a smaller amount of pain in the short term, I bought some gold. Too bad I didn't shift more of my assets to gold. We need another Volcker. I don't know enough about Ben to be sure, but it doesn't seem like he'd be willing to stand up to one i-banker complaining about his bonus, much less farmers rolling their tractors onto C St. to solve the problem.)

[Randolph Fritz]

"Any analysis out there on what has made Citigroup especially vulnerable?"

Surely it's partly that how Citi has got so big is by making many deals at bubble prices? Assets in dollars, and wars probably don't help a lot, either. They were just banking, but without regulation, banking is prone to boom and bust. I think that, until we see world financial market regulation, this is going to keep happening.

[General Glut]

The Fed has indeed become a pawnbroker, but is only taking rather high quality collateral at this point via the TAF. But what is to stop the Fed from agreeing to take worthless garbage as "collateral" in order to save Citibank? Or to demand no collateral at all (e.g. a set unsecured personal loans to the members of the Citibank Management Committee)? Section 13 of the Federal Reserve Act appears to grant the Fed Board of Governors wide latitude to do whatever they deem necessary.

Hold on to your hats!

General Glut