Commentary by John M. Berry
Dec. 5 (Bloomberg) -- Federal Reserve officials are throwing everything they have into the fight to stabilize financial markets and restore economic growth. In the process, the Fed balance sheet is ballooning to $3 trillion, if not more.
It's a risky approach because all the cash piling up in the banking system might spark rising inflation down the road. The alternative -- just relying on traditional interest-rate cuts -- might leave markets and the economy mired in the mud for years.
Fed Chairman Ben S. Bernanke and his colleagues know that when the markets stabilize and the economy turns around, they will have to move fast to take back the extra cash and shrink the central bank's balance sheet.
A second risk -- that the Fed ends up losing billions on some of the assets accepted as collateral for loans -- is of small importance compared with what's at stake.
All the Fed's work hasn't prevented a deepening of the recession. Bernanke made it plain in a Dec. 1 speech that the Fed will expand efforts to deal with the crisis while waiting for the big dose of fiscal stimulus promised early next year by President-elect Barack Obama and congressional leaders.
So far this year, the Fed has aggressively reduced its overnight lending rate target to only 1 percent, and it probably will trim it by another 50 basis points at a Dec. 15-16 Federal Open Market Committee meeting.
Balance Sheet
It has also pumped unprecedented amounts of liquidity into the banking system using loans and new auction techniques. And recently the central bank began providing credit directly to businesses and financial institutions by buying commercial paper and other assets.
As a result, the Fed's balance sheet has ballooned to $2.1 trillion from less than $900 billion a year ago. On Nov. 25, it said it would buy another $800 billion worth of asset-backed securities, expanding the balance sheet to almost $3 trillion.
The Nov. 25 announcement knocked about 50 basis points off rates on conventional 30-year fixed-rate mortgages, leaving them at about 5.5 percent, a full percentage point lower than at the end of October. That in turn sparked a surge in mortgage applications.
Mortgage rates were affected because of the $800 billion, the Fed planned to use $100 billion to buy debt from Fannie Mae, Freddie Mac and the Federal Home Loan Bank System. Another $500 billion would be used to purchase mortgage-backed securities from Fannie, Freddie and Ginnie Mae.
The remaining $200 billion would finance a new facility to buy assets backed by student loans, car loans and other consumer loans.
Applications Soar
``This is an outside-the-box response to our credit problems that will eventually prove successful,'' said a Dec. 3 memo from Wells Fargo Bank economists.
The question is how many of those applications will result in offers of mortgages, given the tightening in lending standards this year.
More broadly, all the interest-rate cuts and additions of liquidity haven't spurred a significant resumption of lending by financial institutions or new commitments by risk-adverse investors. A significant chunk of the added cash is piling up in the form of excess reserves on deposit at Federal Reserve banks.
Normally, the Fed keeps overnight rates close to its chosen target through the daily addition or subtraction of reserves. An increase in reserves gives banks the ability to increase lending, adding to the money supply and spurring economic growth. When loans are withheld, this process is truncated.
Spur to Lending
All these reserves could stimulate the economy, but for
that to happen, you have to have lending,'' said economist Ray
Stone of Stone & McCarthy Research Associates.Right now, the
Fed is taking the horse to water but can't make him drink.''
The Fed announced yesterday which bonds it plans to buy, beginning today, as part of the $100 billion in debt it will acquire. Those purchases, and the mortgage-backed securities it will also buy, likely will further increase the amount of excess reserves. The key point, though, is to bring down longer-term interest rates, which the Fed can't control as closely as overnight rates.
In his Dec. 1 speech, Bernanke said the Fed could also influence financial conditions by purchasing ``longer-term Treasury or agency securities on the open market in substantial quantities.''
Just the hint the Fed might do that drove yields on 30-year Treasury bonds down to a record low of 3.17 percent.
While the Fed can't lower its overnight lending target much more, there's hardly any limit to the amount of liquidity it can add to the market.
As Peter Fisher of BlackRock, Inc., who for several years directed the Markets Group at the New York Federal Reserve Bank, said in a Dec. 2 interview, when the economy begins to recover ``there's going to be an exit problem. We hope the Fed is going to be as agile when they have to shrink their balance sheets and pull back.''
We all should be relieved when they have to try.
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