The New Nontraditional Lending Facilities by the Federal Reserve, as Lender of Last Resort in the US, in Response to Financial Markets Turmoil **

Transcription

1 The New Nontraditional Lending Facilities by the Federal Reserve, as Lender of Last Resort in the US, in Response to Financial Markets Turmoil ** Marwan El Nasser Professor of Economics School of Business State University of New York at Fredonia Financial markets were liquid and stable through August 8, The spread of one month rates of LIBOR, FHLB NY, and host of other short term money market rates to OIS rate was stable and very narrow. After August 8, 2007 the spread of one month money market rates to OIS rate became very wide and very volatile. Chart1:IlliquidityinInterbankFundingMarkets* 1

2 Chart2:FinancialMarketsStabilityJan 07toJul 08 2

3 Chart3:FinancialMarketsInstabilityJan 07toSep 08 Since August 8, 2007 the global financial system has been under extraordinary stress that has decisively spilled over to the global economy more broadly. The subprime lending to finance housing in the United States and the associated rise in delinquencies on subprime mortgages triggered cascading effects that led to the collapse of the financial markets. The turn of the housing markets in the United States contributed to the substantial losses of many financial institutions and shook investor confidence in credit markets. However, though the subprime debacle triggered the crisis the collapse of financial markets was caused by many other factors and affected much wider forms of credit. Some of the causes that contributed to the crisis are the minimum or absence of regulations that led to widespread decline in underwriting standards, fraudulent and predatory lending practices. In addition there was sloppy monitoring by rating agencies, increased reliance on complex and incomprehensible credit instruments that proved fragile under market stress. In a speech on January 13, 2009 at the London School of Economics, London, England Chairman Ben S. Bernanke stated that The abrupt end of the credit boom has had widespread financial and economic ramifications. Financial institutions have seen their capital depleted by losses and writedowns and their balance sheets clogged by complex credit products and other illiquid assets of uncertain value. Rising credit risks and intense risk aversion have pushed credit spreads to unprecedented levels, and markets for securitized assets, except for mortgage 3

4 securities with government guarantees, have shut down. Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence and precipitated a sharp slowing in global economic activity. The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial. (1) As would be expected, the Federal Reserve has responded to the crisis since its emergence in the summer of 2007 by employing traditional monetary tools. The Fed cut the discount rate in August of that year, followed by the Federal Open Market Committee easing monetary policy in September 2007, by reducing the target for the federal funds rate by 50 basis points. The continued financial turbulence led the Committee to reduce its target for the federal funds rate by a cumulative 325 basis points by the spring of Though this policy response was rapid and bold and may have slowed down the financial turmoil and the deteriorating economy unfortunately, the intensification of the financial instability last fall led to further deterioration in the economic outlook. The Committee responded by further cuts in the target for the federal funds rate. In December the Committee reduced its target for federal fund rate further to a range of 0 to 25 basis points (1). The exceptional circumstances of interfered with the Open Market Desk s ability to implement monetary policy. Credit spreads widened, lending standards became more restrictive, and credit market led to tighter financial conditions overall. In particular, many traditional funding sources for financial institutions and markets have vanished, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. As extension of credit came to a halt and normal money supply process collapsed the money supply measures M1 and M2 have remained virtually unchanged but bank reserves and the monetary base have drastically increased. This is to say that the money supply multipliers with respect to bank reserves and to the monetary base had collapsed. Any reserves that were added to the banks were held as excess reserves. The Money Supply Process: 4

5 1. The money supply equals the money multiplier times the monetary base, or M = [1 + (ER /D) / (C /D + (R /D )+ (ER /D )] (B ). 2. The money supply equals the monetary base (B) times the money multiplier [1 + (C /D) / (C /D + (R /D) + (ER /D)]. 3. The monetary base comprises the nonborrowed base, determined primarily by the Fed through open market operations, and discount loans, determined jointly by banks and the Fed. 4. The money multiplier depends on the required reserve ratio R /D (determined by the Fed), excess reserves relative to deposits ER /D (determined by banks), and the currency-deposit ratio (determined by the nonbank public). ER /D. The process of bank lending has necessary prerequisites. Bank can lend and create money only if the following prerequisites are met: The availability of Monetary Base. A fractional reserve system. That is the required reserve ratio against deposits is < 1. This insures banks to have excess reserves to lend. Banks are capable of lending only if they have excess reserves. The desire of banks to supply loans meaning lending excess reserves. There should be (households, business and public) demand for loans. Desire of the households, business and the public to use demand deposits rather than currency for transaction purposes. An examination of bank reserves, excess reserves and the monetary base shows drastic increase in all of these variables after August The money supply on the other hand has been virtually unchanged signaling collapse in bank credit and money supply M1 and M2 multipliers. The following tables and charts show support to these observations. 5

6 Tabel1andChart4:MoneySupplyM1,M2,MonetaryBaseandMonetaryBaseMultipliers Date M1 M2 Monetary Base Multiplier M1/M. Base Multiplier M2/M. Base Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug MoneySupplyMultipliersM1,M2/M.Base Mul/plierM1/M.Base 3 Mul/plierM2/M.Base

7 Table2andChart5: SATotalReserves,RequiredReservesandNSAExcessReservesofDepository Institutions01 08 Date Req.Reserves SA TotalReservesSA 7 ExcessReserves NSA Total,RequiredandExcessReserves Req.ReservesSA TotalReservesSA ExcessReservesNSA

8 Table 3 Excess Reserves, Checkable Deposits and Excess Reserves Ratio September September 2009 Time Period Excess Reserves (A) Checkable Deposits (B) Excess Reserve Ratio (A/B) ExcessReserveRaOo(A/B) ExcessReserveRa/o (A/B)

9 The bottleneck that is breaking the bank creation of money after the start of the financial crisis is the unwillingness of banks to lend. That is, the bank holding of huge amounts of bank excess reserves. The significance of this is that the real activities can be significantly reduced or halted without money, the means to facilitate the creation and exchange of goods, services, financial assets and factors of production. The immediate challenge to policy makers in dealing with the financial crisis in order to revive the economy is how to reestablish the channels for bank credit and to induce banks to lend the mountainous amount of excess reserves that the Fed supplied to the banking system. The collapse of the credit markets made it clear that the liquidity of money markets is not measured solely by the reserves in the U.S. banking system, or by the size of the Fed s balance sheet. There are two types of financial liquidity, Market liquidity and funding liquidity. Market liquidity is the ease with which financial assets are traded. Funding liquidity is the ease with which a bank can acquire funding. Money Market may not be efficient for different reasons. First, there is the problem of asymmetric information because of the difficulty of understanding bank balance sheet due to incomplete information. An individual Bank would have better information than other financial participant institutions. Second, the interbank market may become more cautious in times of crisis. Third, banks may hoard liquidity and refuse to lend, especially term lending, if they are not themselves confident that they will be able to borrow from the interbank money market should the need arise. The Federal Reserve Act sets forth the goals of monetary policy, specifically "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." (2) Financial stability is an important prerequisite for achieving those goals. The exceptional circumstances of impeded the Open Market Desk s ability to implement monetary policy. The challenge for the Federal Reserve has been to restructure the composition of the Fed s balance sheet to influence both types of liquidity, as the Fed can lend to banks and other financial institutions by holding different financial assets as collateral. The Federal Reserve explicitly identified two policy approaches to support credit markets, Quantitative Easing measures and Credit Easing measures (1). Both approaches are similar in the fact that they involve expanding the Federal Reserve balance sheet. However, the focus of the Quantitative Easing approach is on the expansion of bank reserves or the monetary base. The focus is on the liabilities side of the central bank balance sheet without regard to how the liabilities are created in the asset side of the central bank balance sheet. This policy approach was used by the Bank of Japan from 2001 to In contrast, the credit easing approach focuses on 9

10 the type of loans and securities that the Fed holds and on the importance of the mix of assets in improving credit conditions. The Federal Reserve focused its credit easing policies on reducing credit spreads and improving the functioning of credit markets. This approach bypasses the traditional gauges of the stance of monetary policy. The quantity of the excess reserves or the monetary base does not measure the effect of the monetary actions as the link to the money expansion is malfunctioning. When markets are illiquid various types of central bank lending would have heterogeneous effects. For example lending to support commercial paper market has different effect from lending to banks. In addition, the usage of Federal Reserve credit is determined in large part by borrower needs and thus will tend to increase when market conditions worsen and decline when market conditions improve. The Federal Reserve created or redesigned many lending facilities. The purpose of the new lending facilities is to address funding risks of financial intermediaries and to improve market efficiency in short-term money markets. The new lending facilities are intended to strengthen the effectiveness of monetary policy. The Federal Reserve s Response to the Financial Crisis The Federal Reserve has responded aggressively to the financial crisis since its emergence in the summer of The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy (1). In addition, the Federal Reserve has implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These new programs have led to a significant change to the Federal Reserve s balance sheet. The Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy. Guided by the Credit Easing approach to unlock the frozen credit markets all the policy tools used all make use of the asset side of the Federal Reserve's balance sheet. That is, each tool involves the Fed's authorities focus on the type of extended credit or the securities purchased. The first set of tools consists of enhancing or modifying central bank's traditional role as the lender of last resort. This involves the provision of short-term liquidity to banks and other depository institutions and other financial institutions. Also, it includes approving bilateral currency swap agreements with 14 foreign central banks. These swap arrangements assist these central banks in their provision of dollar liquidity to banks in their jurisdictions (1). A second set of tools involve the provision of liquidity directly to key credit markets. The new facilities under this category include Commercial Paper Funding Facility, the Asset- Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money 10

11 Market Investor Funding Facility, and the Term Asset-Backed Securities Loan (Ben Bernanke). The third set of instruments includes the change in implementing the open Market operations. The Federal Reserve has expanded its traditional tool of open market operations to support the functioning of credit markets through the purchase of longerterm securities for the Federal Reserve's portfolio. For example, on November 25, 2008, the Federal Reserve announced plans to purchase up to $100 billion in governmentsponsored enterprise (GSE) debt and up to $500 billion in mortgage-backed securities. On March 18, 2009 the Federal Reserve announced plans to purchase up to $300 billion of longer-term Treasury securities in addition to increasing its total purchases of GSE debt and mortgage-backed securities to up to $200 billion and $1.25 trillion, respectively (1). The following section includes brief description of the new nontraditional instruments that has been introduced by the Federal Reserve in response to the collapse of the credit markets (3). Term Auction Facility On December 12, 2007, in view of the serious illiquidity of term bank funding markets and the hesitation of banks to use the discount window because of the stigma that accompanies bank borrowing through the discount window the Federal Reserve announced the creation of the TAF. Under the TAF program, the Federal Reserve auctions term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit discount window program are eligible to participate in TAF auctions. All advances must be fully collateralized with an appropriate haircut. Under the TAF facility the TAF auctions term funds of one-month and three-month loans to banks up to $150 billion per auction to depository institutions, at an interest rate that is determined by the auction. The Minimum bid rate is a market-based rate. Bids will be submitted by phone through local Reserve Banks. This facility Provides sure source of term funding to eligible banks and it has shown to be effective in reducing LIBOR-OIS spread (3). Term Securities Lending Facility The Term Securities Lending Facility was initiated by the FED to deal with illiquid functioning in repo funding markets illustrated by abnormal rates and high haircuts. The TSLF addresses the illiquid functioning in various repo financing markets, including abnormal rates, wide bid-ask spreads, and large and increasing haircuts on collateral. The TSLF adds Treasuries to dealers portfolios, reducing their scarcity in the repo market. It reduces the roll-over risk for dealers in their financing of the alternative 11

12 assets used as collateral. The facility assists in setting the right price for the Treasuries lent and avoids any reserve management problems (3) Primary Dealer Credit Facility The PDCF provides an alternative source of financing to a dealer that has difficulty financing a security in the market. It was necessary to provide such an alternative in the unusual and exigent circumstances surrounding the near-failure of Bear Stearns. The Primary Dealer Credit Facility was introduced to deal with the lack of market-based back-stop credit in repo markets. The PDCF provides back-stop liquidity in the system of tradable security finance. That role is important, and can contribute to the stability of trading in the system of tradable debt finance, possibly attenuating the negative effects of margin spirals. It has proven useful in the wake of the takeover of Bear Stearns and the bankruptcy of Lehman Brothers. Its future in normal times is an important policy issue that has not yet been fully resolved (3). Swap lines: This facility was created to deal with illiquid money markets that became segmented across countries and time zones. Under the swap agreements with various central banks, the Federal Reserve lends money to other central banks, collateralized by the other countries currency, which those central banks lend to commercial banks in their jurisdictions. The program was substantially expanded on October 13, 2008 when the form of lending was changed from fixed quantities of borrowing to a fixed interest rate, at which banks could borrow in amounts up to their eligible collateral (at the ECB, BoE, and SNB). (3) Commercial Paper Funding Facility: The Federal Reserve created the Commercial Paper Funding Facility to deal with illiquid functioning of short-term commercial paper funding markets. This facility provides a liquidity backstop to U.S. issuers of commercial paper. The CPFF is intended to improve liquidity in short-term funding markets and thereby contribute to greater availability of credit for businesses and households. Under the CPFF, the Federal Reserve Bank of New York will finance the purchase of unsecured and asset-backed commercial paper from eligible issuers through its primary dealers. The CPFF will finance only highly rated, U.S. dollar-denominated, three-month commercial paper. (3) 12

13 Asset-Backed Commercial paper Money Market Mutual Fund Liquidity Facility The Federal Reserve initiated this facility to help money market funds that hold asset backed commercial paper (ABCP) to meet demands for redemptions by investors and to foster liquidity in the ABCP market and money markets more in general. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility is a lending facility that provides funding to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper (ABCP) from money market mutual funds under certain conditions. (3) Money Market Investor Funding Facility The Money Market Investor Funding Facility (MMIFF), authorized by the Board under Section 13(3) of the Federal Reserve Act, will support a private-sector initiative designed to provide liquidity to U.S. money market investors. As money market mutual funds and other investors have increased their liquidity positions by investing in shorter-term frequently overnight assets short term debt markets became under considerable strain. In response to easing the short term debt strain the Federal Reserve created the Money Market Investor Funding Facility (MMIFF). Under the MMIFF the Federal Reserve Bank of New York will provide senior secured funding to a series of special purpose vehicles established by the private sector (SPVs) to finance the purchase of certain money market instruments from eligible investors. Eligible assets will include U.S. dollar-denominated certificates of deposit, bank notes and commercial paper issued by highly rated financial institutions. By facilitating sales of money market instruments in the secondary market, the MMIFF should give money market mutual funds and other money market investors the confidence that they can extend the terms of their investments and still maintain appropriate liquidity positions. Greater access to term financing from money market investors will enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households. (3) Term Asset-Backed Securities Loan Facility The Term Asset-Backed Securities Loan Facility (TALF) is a funding facility that will help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by loans of various types to consumers and businesses of all sizes. Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated 13

14 consumer and small business loans. The FRBNY will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS. The U.S. Treasury Department--under the Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of will provide $20 billion of credit protection to the FRBNY in connection with the TALF. The asset-backed securities (ABS) markets historically have funded a substantial share of credit to consumers and businesses. However, the (ABS) market had been under strain for some time since the start of the financial crisis. This strain accelerated in the third quarter of 2008 and the market came to a near-complete halt in October At the same time, interest rate spreads on AAA-rated tranches of ABS rose to levels well outside the range of historical experience, reflecting unusually high risk Premiums. Continued disruption of these markets could significantly limit the availability of credit to households and businesses of all sizes and thereby contribute to further weakening of U.S. economic activity. The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and business ABS at more normal interest rate spreads. Under the TALF, the Federal Reserve Bank of New York will provide non-recourse funding to any eligible borrower owning eligible collateral. On a fixed day each month, borrowers will be able to request one or more three-year TALF loans. Loan proceeds will be disbursed to the borrower, contingent on receipt by the New York Fed s custodian bank (custodian) of the eligible collateral, an administrative fee, and margin, if applicable. As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets. The asset-backed securities (ABS) facility will cease making loans on December 31, 2009, unless the Board of Governors extends the facility. (3) The Effect of the New Nontraditional Tools on the Federal Reserve Balance Sheet Extending credit through the new lending facilities has expanded the Federal Reserve balance sheet. Table 4 shows that the factors supplying reserve more than doubled from $902,993 on August 8, 2007 to $2,111,634 on April 9, Table 3 and chart 2 show that most of the expansion in the reserves has been in the excess reserves. Table 1 and chart 1 above show the monetary base and measures of the money supply M1 and M2. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as expected, the monetary base has risen significantly as the Fed's balance sheet has expanded. However, bank credit has been stationary therefore, money supply multiplier with respect to the monetary base collapsed as banks have chosen to leave the great bulk of their excess reserves idle. 14

15 Table 4: Factors Affecting Reserve Balances of Depository Institutions on Selected Dates Millions of dollars Factors Affecting Reserve Balances As of Reserve Bank credit Securities held outright Wednesday Wednesday Wednesday 8-Aug-07 1-Apr Sep ,160 2,059,537 2,141, , ,583 1,588,434 U.S. Treasury securities 790, , ,633 Bills 277,019 18,423 18,423 Notes and bonds, nominal Notes and bonds, inflation-indexed Inflation compensation Federal agency debt securities Mortgage-backed securities Repurchase agreements Term auction credit Other loans Primary credit 473, , ,923 35,735 39,378 44,588 4,670 4,076 5,699 53, , , ,595 18, , , , , ,037 28,505 Secondary credit

16 Seasonal credit Primary dealer and other brokerdealer credit ,300 0 Asset- Backed Commercial Paper Money Market Mutual Fund Liquidity Facility 6, Credit extended to American International Group, inc Term Asset- Backed Securities Loan Facility Other credit extensions 45,967 38,810 4,692 41, Net portfolio holdings of Commercial Paper Funding Facility LLC Net portfolio holdings of LLCs funded thr ough the Money Market Investor Funding F acility Net portfolio holdings of Maiden Lane LLC Net portfolio holdings of Maiden Lane II LL C Net portfolio holdings of Maiden Lane III L LC 249,731 42, ,336 26,189 18,516 14,662 27,661 20,554 Float ,782-1,916 16

17 Central bank liquidity swaps Other Federal Reserve assets Gold stock Special drawing rights certificate account Treasury currency outstanding 308,792 59,121 41,957 48,339 85,571 11,041 11,041 11,041 2,200 2,200 5,200 38,591 38,856 42,579 Total factors supplying reserve funds 902,993 2,111,634 2,199,875 Source: Federal Reserve Bank Statistical Release H.4.1, Table 5 Total F.R. Bank Assets Wednesday level08/08/ /16/2009 Time Period Total F.R. Bank Assets

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20 TotalF.R.BankAssets TotalF.R.BankAssets Longer Term issues and the Fed Exit Strategy As was discussed, the Fed has employed many weapons to deal with the financial crisis. The Fed has used the broadest Fed's powers since World War II. The regulation proposals being discussed by Congress seem likely to empower the institution even further. The Fed has intervened in the financial markets to deal with the financial crisis in ways never before thought possible by the Fed. It seems that the Fed had recognized the severity of the crisis and the potential for sinking the economy into depression and had decided to do whatever it takes to prevent anything like the Great Depression from happening again even at the risk of potential serious inflation. Although the Fed s actions are justified by the severity of the crisis and the extraordinary circumstances in which the Fed has found itself in, the Fed s monetary expansion risks unleashing serious increase in inflation that may add to the misery of rising unemployment and negative growth similar to the 1970s stagflation. However, if the Fed succeeds in restarting growth and avoid inflation the unconventional bold policy measures by the Fed will be viewed as a breakthrough in monetary management of the economy and a new frontier for the role of central banking. In developing countries structural rigidities could lead to monetary policy failure resulting in simultaneous inflation and high unemployment. Among the structural rigidities that lead to monetary policy failure in developing countries is the widespread corruption that 20

21 leads to altered market incentives. Perhaps, the Fed should be concerned if the culture of greed and corruption that contributed to the financial crisis became embedded in the behavior of some financial institutions to cause failure of its policies. This concern should give the need for new regulation of the financial system special urgency. The Fed's lending activities that have resulted in a large increase in the excess reserves held by banks have increased concern that, by expanding its balance sheet, the Fed s action will ultimately be inflationary. In the near term the weak economic activity and the low growth in the rates of growth of broader monetary aggregates, M1 and M2, there is little risk of inflation in the near term. However, the challenge to the Federal Reserve is to plan and implement an exit policy that will avoid inflation and provide economic growth after the crisis subsides. The Federal Reserve believes that there should be an exit strategy. According to the Fed s record the following is an excerpt from the Fed s website When credit markets and the economy begin to recover from the current financial crisis, the Federal Reserve will need to wind down some of its various lending programs and eliminate others. As conditions in credit markets improve, market participants' incentives for using some of the lending facilities will diminish. In addition, when the Federal Reserve no longer judges that conditions in financial markets are "unusual and exigent," a prerequisite for the use of the authority in Section 13(3) of the Federal Reserve Act, the facilities created under that authority will have to be discontinued. In general, the Federal Reserve will continue to monitor conditions in financial markets to assess the need for the liquidity facilities, and that assessment will be the principal factor affecting any reduction in the size of the Federal Reserve's balance sheet. (1) The Federal Reserve's balance sheet can be shrunk relatively quickly, as a substantial portion of the assets held by the Federal Reserve--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short term in nature and can simply be allowed to run off as the programs and facilities are scaled back or shut down. The Federal Reserve also holds, or expects to hold, significant quantities of longer-term assets, such as the agency debt and mortgage-backed securities that will continue to be purchased over the first two quarters of Although these longer-term securities could be sold, the Federal Reserve will likely not dispose of more than a small portion of them in the near term. Still, the Federal Reserve is monitoring the maturity composition of the balance sheet closely and expects to be able to reduce the balance sheet to the extent necessary at the appropriate time. As the size of the balance sheet and the quantity of excess reserves in the banking system decline, the Federal Reserve will be able to return to setting a target for the federal funds rate as its primary tool in the conduct of monetary policy. Management of the Federal Reserve's balance sheet and the conduct of monetary policy in the future will be made easier by recent congressional action to authorize the 21

22 Federal Reserve to pay interest on reserve balances held by depository institutions. The Federal Reserve expects that as excess reserves decline and financial conditions normalize, the interest rate paid on reserve balances will be an effective instrument to help foster trading in the federal funds market at rates near the target. Other tools are available or can be developed to improve control of the federal funds rate. For example, the Treasury could expand its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve, thereby effectively draining reserves from the banking system and improving monetary control. Moreover, reverse repurchase agreements and other methods could be used to drain reserves from the system. Despite the Federal Reserve concern about inflation and its plan to combat it there is concern that political pressure may slow the Federal Reserve ability to control inflation. Justifiably, many financial professionals are concerned that consumer prices will surge as a result of the Fed s record injections of reserves into the economy. After already more than doubling its balance sheet to $2.1 trillion, the Fed has pledged to buy $1.25 trillion of mortgage-debt and $300 billion of Treasuries, and finance a $1 trillion consumer-loan program. Some investors worry that the Fed will be too slow to combat inflation. I don t think there is a chance that we can have low inflation coming out of this, said Axel Merk, manager of the $300 million Merk Hard Currency Fund. All this money is going to stick at some point. (5) On March 23, the U.S. Treasury and Federal Reserve released a one-page joint statement on the division of economic responsibilities between the two agencies. The release said that while the Fed collaborates with other agencies to preserve financial stability, it alone is in charge of keeping consumer prices stable, its independence critical. Chairman Ben S. Bernanke s concern that attempts at political pressure later would delay the start of measures to combat inflation. If we have a slow recovery, which seems likely, who is going to watch them raise interest rates as the Treasury sells this mountain of debt stemming from fiscal deficits, Allan Meltzer, author of A History of the Federal Reserve, said in a Bloomberg Television interview. Politicians are not going to let them do that, they are not going to want them to do that. Allen Meltzer cites a 1979 lecture by Arthur Burns, who ran the Fed from 1970 to 1978, as an example of how the political climate can influence central bankers. Burns oversaw a surge in the U.S. inflation rate to 12.3 percent in 1974 from 5.6 percent in Another concern is about the possible inability of the Fed to shed the assets that they purchased to prop up liquidity in selected financial markets. The Fed lending program includes buying mortgage debt and finance securities backed by consumer loans, instead of their normal operation of purchasing Treasury securities. 22

23 The Fed and Treasury agreed to a pledge that in the longer term and as its authorities permit, the Treasury will seek to remove from the Federal Reserve s balance sheet, or to liquidate the assets the central bank has acquired from rescues of Bear Stearns Cos. and American International Group Inc. The Record of The Federal Reserve in dealing with the financial crisis is consistent with the policy statements of the Fed s intent discussed above. Table 5 and the relevant chart of the data in table 5 illustarte the Fedreal Resreve actions. Beginning September 17/2008 The Federal Reserve moved boldley and swiftly to increase its total assets in support of the accumulated bank reserves. Table 5 shows that by the end of October, 2008 the Federal Reserve more than doubled its total assets. Total F.R. Bank assets continued to increase and peaked at a level of $2,256,873 on 12/17/2008. Though total F.R. Bank assets declined after December 2008 they remained at a very high level. For the period from January, 2009 to the present the level of F.R. total assets was more than 110% of the level prior to September 17, Table 2 and chart 5 show that total bank reserves increased by 19 folds between August 2008 and January Most of the increase in bank reserves is held as excess reserves. Table 3 shows that excess reserve ratio, the level of excess reserves/checkable deposits, has increased from.29% in August, 2008 to 107.2% in January, Excess reserves remaind at about the January level since that time to the present with the exception of some slight decline in February, June, and July of The monetary base showed a similar pattern as the excess reserves. However, both the Money Supply measures, M1 and M2 remained relatively unchanged. Clearly, the behavior of bank excess reserves, monetary base and the money supply measures show that the economy entered a Keynesian liquidty trap beginning September, 2008 to the present. Table5andChartofDatainTable5:TotalFRReserveAssets,TotalF.R.SecuritiesHeld Outright,USTreasurySecuritiesHeldOutright,Mortgae BackedSecuritiesHeldOutright andcredit LiquidityFacilities. 08/08/09/16/2009 TimePeriod TotalF.R. Assets SecHeld TreasurySec.Held Outright 23 Mortgage Backed Securities Liquidityandcredit facilities 8/8/ /15/ /22/ /29/

24 9/5/ /12/ /19/ /26/ /3/ /10/ /17/ /24/ /31/ /7/ /14/ /21/ /28/ /5/ /12/ /19/ /26/ /2/ /9/ /16/ /23/ /30/ /6/ /13/ /20/ /27/ /5/ /12/ /19/ /26/ /2/ /9/ /16/ /23/ /30/ /7/ /14/ /21/ /28/ /4/

25 6/11/ /18/ /25/ /2/ /9/ /16/ /23/ /30/ /6/ /13/ /20/ /27/ /3/ /10/ /17/ /24/ /1/ /8/ /15/ /22/ /29/ /5/ /12/ /19/ /26/ /3/ /10/ /17/ /24/ /31/ /7/ /14/ /21/ /28/ /4/ /11/ /18/ /25/ /4/ /11/

26 3/18/ /25/ /1/ /8/ /15/ /22/ /29/ /6/ /13/ /20/ /27/ /3/ /10/ /17/ /24/ /1/ /8/ /15/ /22/ /29/ /5/ /12/ /19/ /26/ /2/ /9/ /16/ TotalF.R.Assets SecHeld TreasurySec.Held Outright Mortgage Backed Securi/es Liquidityandcredit facili/es /9/2011 8/9/2012 8/9/2013

27 ChartofDatainTable5:TotalFRReserveAssets,TotalF.R.SecuritiesHeld Outright,USTreasurySecuritiesHeldOutright,Mortgae BackedSecuritiesHeldOutright andcredit LiquidityFacilities. 08/08/09/16/2009 The Tools of Monetary Policy Employed by the Federal Reserve during the Financial Crisis The tools of monetary policy employed by the Federal Reserve in order to increase its total assets and thus the monetary base and bank reserves can broadly be categorized into two broad categories, purchase of securities through open market operations and extending credit through several lending facilities. The Federal Reserve traditionally limited its open market operations to U.S. Governement Securities. However, the Federal Reserve started a program in January to purchase up to $1.25 trillion of mortgage-backed securities. The total amount of mortgage-backed securities held by he Fed on 9/16/2009 was $685 billion. At the same date the Federal Reserve held $760 billion of U.S.Treasury securities. On September 23, 2009 the Federal Reserve announced that it intends to complete the full $1.25 trillion in purchases of mortgagebacked securities. Though the Federal Reserve began expanding its credit facilities earlier in March 2008 the major increase in bank excess reserve and the monetary base accelerated beginning September 2008 and reached its peak in November 2009 when the Federal Reserve level of extended credit reached a total of $1,304,744 billion through its liquidity and credit facilities. These facilities are discussed in this paper as the major immediate response that the Federal Reserve created. The Federal Reserve began winding down some of the liquidity facilities and this trend continues to the present. The Federal Reserve has been very successful in reducing the total credit provided through its credit and liquidity facilities significantly where the total credit extended through these facilities have been trimmed to $462 billion in September This is equivalent to approximately 1/3 the peak level in November Table 6 and the relevant chart shows the rise in the Fed s liquidity and credit facilities and the success it has thus far in winding down about 2/3 of the credit extended through these liquidity facilities. 27

28 Liquidity Time Period Series1 Series2 Series3 Series4 Series5 Series6 Series7 Series8 Series9 Series10 Series11 Series12 and Credit

29