This is one of Gary North’s daily commentary - for his subscribed members. He comments on Bernanke’s speech you’re referring to.
Bernanke on the Balance Sheet: He Promises That We Won’t Get Mass Inflation, Despite the Evidence.
April 4, 2009
In his April 2 speech, Bernanke follows his usual strategy: “Bore 'em to death.” He learned how to pad term papers as a teenager, and he cannot break out of the pattern.
The speech is long. It has footnotes. But at least it deals with the #1 problem the FED is facing: the enormous, unprecedented increase in its balance sheet: the nation’s monetary base.
He admitted that what the FED has dine – and other central banks have done – is unprecedented. This is a step forward.
In ordinary financial and economic times, my topic, “The Federal Reserve’s Balance Sheet,” might not be considered a “grabber.” But these are far from ordinary times. To address the current crisis, the Federal Reserve has taken a number of aggressive and creative policy actions, many of which are reflected in the size and composition of the Fed’s balance sheet. So, I thought that a brief guided tour of our balance sheet might be an instructive way to discuss the Fed’s policy strategy and some related issues. As I will discuss, we no longer live in a world in which central bank policies are confined to adjusting the short-term interest rate. Instead, by using their balance sheets, the Federal Reserve and other central banks are developing new tools to ease financial conditions and support economic growth.
The banks have pushed overnight loan rates to zero, and still the economies are tanking. Nothing is working as it used to. Banks won’t lend.
Here is how he describes the problem: as a Keynesian. He sees it as insufficient demand.
Before I get into the details of our balance sheet and how it reflects various Federal Reserve initiatives, I would like to note some general considerations that have been important in shaping our policy approach. As you know, financial markets and institutions both in the United States and globally have been under extraordinary stress for more than a year and a half. Relieving the disruptions in credit markets and restoring the flow of credit to households and businesses are essential if we are to see, as I expect, the gradual resumption of sustainable economic growth.
He uses the word “creative” to describe “winging it.”
Though we have been creative in deploying our balance sheet, using a multiplicity of new programs (and coining a multiplicity of new acronyms, I might add), we have done so prudently. As much as possible, we have sought to avoid both credit risk and credit allocation in our lending and securities purchase programs. As I will discuss further today, the great majority of our lending is extremely well secured. And our programs have been aimed at improving financial and credit conditions broadly, with an eye toward restoring overall economic growth, rather than toward supporting narrowly defined sectors or classes of borrowers.
The security of the loans is irrelevant from the FED’s view. Anything it buys serves as collateral. Nobody has any say in the matter. So, when the FED swaps T-bills for toxic assets at face value, it does not change the monetary base, but it bails out the big banks.
In pursuing our strategy, which I have called “credit easing,” we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.
Here is where the Keynesian nonsense begins. The fiat money serves as the monetary base. To shrink it would mean that there is no more stimulative effect. The recovery goes back into recession. Consumer demand will be based on bank expansion. Bank expansion will be based on the increased monetary base.
The Treasury will run a $2 trillion deficit. Foreigners cannot buy 50% of this, as they have in the past. Neither can money market funds. The FED will have to monetize a large chunk of this deficit. If you have any doubt about this, click here.
We are also committed to working with the Administration and the Congress to develop a new resolution regime that would allow the U.S. government to effectively address, at an early stage, the potential failure of systemically critical nonbank financial institutions.
Got that? The U.S. banking system is still at risk.
The Treasury must now take over specific bailouts. The FED will “cooperate closely.” With what? With funding the deficit. But he does not say this openly.
The principles I have just noted were recently formalized in a joint Federal Reserve-Treasury statement.1 Those principles are: (1) that the Fed will cooperate closely with the Treasury and other agencies in addressing the financial crisis; (2) that the Fed in its lending activities should avoid taking credit risk or allocating credit to narrowly defined sectors or classes of borrowers; (3) that the Fed’s independent ability to manage monetary policy must not be constrained by its programs to ease credit conditions; and (4) that there is a pressing need for a new resolution regime for nonbanks that, among other things, will better define the Fed’s role in preventing the disorderly failure of systemically critical financial institutions. I welcome the clarity that this public statement brings to the principles underlying our policy strategy during this very difficult period.
Clarity! This guy is hopeless. The entire bailout is one long series of hail Mary desperation calls. There is nothing resembling a coherent plan.
He surveys the history of the arrival of a 0% FedFunds rate. It will stay there, he says.
Now comes the central issue: the huge run-up of the monetary base.
The Federal Reserve has been a global leader in developing such tools. In particular, to further improve the functioning of credit markets and provide additional support to the economy, the Fed has established and expanded a number of liquidity programs and recently initiated a large-scale program of asset purchases. These actions have had significant effects on both the size and composition of the Federal Reserve’s balance sheet. Notably, the balance sheet has more than doubled, from roughly $870 billion before the crisis to roughly $2 trillion now.
In short, it has more than doubled.
Let me begin with the asset side of our balance sheet. For decades, the Federal Reserve’s assets consisted almost exclusively of Treasury securities. Since late 2007, however, our holdings of Treasury securities have declined, while our holdings of other financial assets have expanded dramatically.
In short, the entire financial system came unglued. The FED bought assets of lower security. He then summarizes them. He does not use the words “toxic assets.” Furthermore, “the Federal Reserve also has provided support directly to specific institutions in cases when a disorderly failure would have threatened the financial system.” The system came close to a bust.
The first of these categories of assets–short-term liquidity provided to financial institutions–totals almost $860 billion and today represents nearly 45 percent of the assets on our balance sheet. These loans are made to sound institutions, are fully secured, and are for maturities no greater than 90 days, usually less. Thus, they are very safe. The main components of this category are lending to commercial banks and primary dealers, as well as currency swaps with other central banks to support interconnected global dollar funding markets.
The assets are safe, he says. Then why did the FED have to intervene to buy them? Because they did not have a market. Why not? Because the commercial banks and primary dealers were the only buyers, and they faced collapse. But he doesn’t admit this.
This problem was international.
Like depository institutions in the United States, foreign banks with large dollar funding positions were also experiencing powerful liquidity pressures. This unmet demand for dollars was spilling over into U.S. markets, including the federal funds market. To address this issue, the Federal Reserve has cooperated with foreign central banks in establishing what are known as reciprocal currency arrangements, or liquidity swap lines. In these arrangements, the Federal Reserve provides dollars to foreign central banks which they, in turn, lend to banks in their jurisdictions.
He goes on about credit risk of the corporate issuers of short-term debt. The central issue is not credit risk. The issue is that the lending institutions are leveraged so high that they are close to bankruptcy.
Credit risk is minimal in these arrangements, as the foreign central bank is responsible for repayment, rather than the institutions that ultimately receive the funds; in addition, the Fed receives foreign currency from its central bank partner of equal value to the dollars lent. Liquidity provided through such arrangements peaked ahead of year-end 2008 but has since declined as pressures in short-term funding markets have eased; the outstanding amount currently stands at about $310 billion.
Then there were the 20 primary dealers that acts as the FED’s agents in buying and selling. One of them was Bear Stearns. They were tottering at the edge of bankruptcy.
In addition, following the sharp deterioration in market conditions in March 2008, the Federal Reserve used its emergency lending authority to provide primary dealers access to central bank credit.
He referred to the FED as the lender of last resort. In 2008, that was what it was.
As I mentioned, the provision of liquidity on a collateralized basis to sound financial institutions is a traditional central bank function. This so-called lender-of-last-resort activity is particularly useful during a financial crisis, as it reduces the need for fire sales of assets and reassures financial institutions and their counterparties that those institutions will have access to liquidity as needed.
Remember this phrase: liquidity as needed.
Money market funds were at risk. They hold T-bills. This meant that the Treasury’s market was at risk. He did not mention this.
Following the long-standing principle that the central bank should lend into a panic, the Federal Reserve established two programs to backstop money market mutual funds and to help those funds avoid fire sales of their assets to meet withdrawals. Together with an insurance program offered by the Treasury, the Fed’s programs helped end the run; the sharp withdrawals from the funds have been replaced by moderate inflows. Although credit extended to support money funds was high during the intense phase of the crisis in the fall, borrowings have since declined substantially, to about $6 billion.
There will be more purchases of assets.
The Fed’s holdings of high-quality securities are set to grow considerably as the FOMC, in an attempt to improve conditions in private credit markets, has announced large-scale open-market purchases of these securities. Specifically, the Federal Reserve will purchase cumulative amounts of up to $1.25 trillion of agency MBS and up to $200 billion of agency debt by the end of the year, and up to $300 billion of longer-term Treasury securities over the next six months.
This is astronomical. It means an increase of one-third for the doubled monetary base.
Then he gets to the touchy issue of excess reserves. He dies not call them this.
Depository institutions also maintain accounts at the Federal Reserve, of course, and over recent months, as the size of the Federal Reserve’s balance sheet has expanded, the balances held in these accounts have increased substantially. The large volume of reserve balances outstanding must be monitored carefully, as–if not carefully managed–they could complicate the Fed’s task of raising short-term interest rates when the economy begins to recover or if inflation expectations were to begin to move higher.
In short, banks will start lending. The fractional reserve system will then translate the balance sheet increases into M1 increases. The money supply will shot upward.
We have a number of tools we can use to reduce bank reserves or increase short-term interest rates when that becomes necessary. First, many of our lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly.
Wound down means “we will sell assets and shrink the base.” Sell them to whom? Toxic assets? Not likely. Treasury bills? Watch rates skyrocket! Hello, Recession Part 2.
Sell assets? That’s what he said.
Second, the Federal Reserve can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC.
So, if the FED sells assets (an FOMC decision), this will have to be monitored by the FOMC. You can’t fool Ben Bernanke!
Third, some reserves can be soaked up by the Treasury’s Supplementary Financing Program.
The Treasury is running a $2 trillion annual deficit. Soaked up? With what?
Fourth, in October of last year, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves. Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate.
So, banks will lend to the FED. What will the FED use to pay interest? Where will it get this income? I know! By buying more Treasury debt. Then the Treasury will pay interest to the FED. But it will have to borrow this money, probably from the FED.
Ben Bernanke’s playbook is taken from Alice’s looking glass.
These are extraordinarily challenging times for our financial system and our economy. I am confident that we can meet these challenges, not least because I have great confidence in the underlying strengths of the American economy. For its part, the Federal Reserve will make responsible use of all its tools to stabilize financial markets and institutions, to promote the extension of credit to creditworthy borrowers, and to help build a foundation for economic recovery. Over the longer term, we also look forward to working with our counterparts at other supervisory and regulatory agencies in the United States and around the world to address the structural issues–some of which have been discussed in this conference–that have led to this crisis so as to minimize the risk of ever facing such a situation again.