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.