"What Could the Fed Do?"

Whenever Greg Ip, the Wall Street Journal reporter whose beat includes the Fed, writes a piece about the central bank, one has to wonder whether the story was a plant. This isn’t to denigrate Ip’s coverage; it’s the reality of the quid pro quo of access journalism.

His page one story today, “Fed Weighs Options on Crunch,” has the aura of being a sanctioned piece. It seeks to dismiss the idea which has been widely discussed on the Internet and is getting some attention in the media, that the Fed is at risk of exhausting its abiiity to take on more collateral for loans, or as it has been put more colloquially, that the Fed might run out of firepower. Steve Waldman’s estimate that the Fed has an addittional $300 to $400 billion of unsterilized capacity is representative.

To illustrate, John Dizard in a Financial Times article discussed the Fed’s options:

At the moment, for example, the Washington policy people and the Wall Streeters buzzing around them are trying to figure out how to get yet more liquidity for housing-related paper. The Wall Streeters seem to assume that the next step will be the creation of something like the Resolution Trust Corporation….. Or, as David Rosenberg of Merrill Lynch told the firm’s clients last week, “ . . . the outright purchase (by government agencies) of illiquid mortgage-backed securities is probably required, and could employ government-backed fiscal action . . . The Federal Reserve itself could buy some of those securities, but the Fed alone cannot unclog the congestion in the capital markets, in our opinion.”

That is not what the Fed, or the Feds, want to hear. The Fed is already uneasy about the scale of its on-balance-sheet exposure to mortgage-backed paper….

Here is where the ancient bureaucratic trick of three choices comes into play. The “policy options” presented by the stone-faced civil servant-expert to the political master are always, respectively: 1) one that will cause the end of life on earth as we know it; 2) an alternative that will mean the end of your political career; or 3) another possibility that we could “staff out” if you’re interested.

In the case of illiquid housing assets, the End Of Life On Earth is an inflationary expansion of the Fed’s balance sheet. The career-ender is the direct use of taxpayer money. The third way is the use of government guarantees to induce the investment of private capital.

Ip’s coverage of the same issue in a WSJ Economics Blog post, “What Could the Fed Do?” was more pointed and informative than his article:

Since the Federal Reserve began rolling out ever more creative steps to unfreeze credit markets, it has sold or pledged a growing portion of its portfolio of Treasurys in order to put loans on its balance sheet to banks and securities dealers backed by mortgage-backed securities and other shunned collateral. This has led some observers to worry that if the Fed continues at such a pace, it could run out of ammunition, forcing it to move to quantitative easing – in essence, buying up assets wholesale and allowing the federal funds rate to fall to zero.

But Fed officials believe those fears are misplaced….

This still leaves the Fed with about $500 billion in unencumbered Treasury bonds. Some of that is spoken for — the Fed has promised to lend $29 billion to a new entity to take over assets now on the books of Bear Stearns, and up to $125 billion more in its Term Securities Lending Facility. However, anything more such commitments would likely be at least partly offset by reduced borrowing in its other facilities.

All the same, the Fed likes to think of worst-case scenarios and thus has been thinking about ways to expand its ability to lend. In an extreme case it could resort to quantitative easing as the Bank of Japan did from 2001 to 2006, that is buying up large amounts of assets, and letting the fed funds rate fall to zero. But it would rather avoid that. Here are some ways it could expand its lending capacity while maintaining control of the fed funds rate.

1. The easiest would be to ask Treasury to issue more debt than it needs to fund government operations. As investors pay for the bonds, their cash moves from bank reserve accounts at the Fed to Treasury accounts at the Fed. The Treasury would allow the money to remain there, rather than disbursing it or shifting it to commercial banks who, unlike the Fed, pay interest. Because the shift of cash out of reserve accounts leads to a shortage of reserves, it puts upward pressure on the federal funds rate. To offset that, the Fed would enter the open market and purchase Treasurys (or some other asset), replenishing banks’ reserve accounts. The net result is that the Fed’s assets and liabilities have both grown but reserves and the federal funds rate are unaffected. This wouldn’t cost Treasury anything so long as it doesn’t bump up against the statutory debt limit. The loss of interest on its cash deposits at the Fed would be roughly offset by the additional income the Fed pays Treasury each year from the interest on its bond holdings.

2. The Fed could issue its own debt or short-term paper. The debt would be an increase in liabilities and it could presumably buy whatever it wanted with the proceeds. Whether the Fed can do so legally is less clear. It previously used the “incidental powers” given it under the Federal Reserve Act to issue options on federal funds around the turn-of-the century date change, and issuing its own debt would likely require invoking the same thing. As one Fed study has noted, use of such power must be “necessary to carry on the business of banking within the limitations prescribed by [the Federal Reserve] Act.”

3. The Fed could seek to pay interest on reserves. Banks lend out excess reserves at whatever rate they can get because the Fed doesn’t pay interest. That’s one reason the federal funds rate often crashes late in the day, when banks realize they have more reserves than they need. Paying interest on reserves would put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate.

The Federal Services Regulatory Relief Act of 2006 empowers the Fed to start paying interest at a rate or rates not to exceed the general level of short-term interest rate effective Oct. 1, 2011. The distant date was a result of Congress’ effort to hold down the cost, since payment of interest will cut into how much money the Fed remits to Treasury each year. The Fed could ask Congress to bring that date up to the present. As a general rule the Fed hates to ask Congress for anything for fear of what else Congress might ask for in return. But if the crisis got to the point the Fed felt it really needed this, it’s hard to imagine Congress refusing.

4. The Fed could try to do the mirror image of the Term Securities Lending Facility. In other words, take the mortgage backed securities pledged to it by dealers in return for Treasurys, and re-pledge them to other dealers, taking Treasurys back. Since the Fed is highly unlikely to fail, dealers might be more comfortable accepting MBS as collateral from the Fed than from other parties. But this might be complicated to do if the MBS are held by a custodial bank as is typical in a triparty repo.

The first page Journal story adds a couple of useful pieces to the equation. The Treasury’s unused debt limit is roughly $450 billion. But more important, despite the contemplation of extreme measures, the central bank is loath to undertake the one most keenly sought by the Street, namely, buying MBS outright:

The Fed is inclined to use any additional maneuvering room to lend through its existing and recently expanded avenues. Officials are reluctant to buy mortgage-backed securities directly. They worry that such purchases would hurt the market for MBS that the Fed is not permitted to buy: those backed by jumbo and subprime and alt-A mortgages, which are under the greatest strain.

Moreover, the Fed is not operationally equipped to hold MBS and would probably have to outsource their management. Such holdings wouldn’t help avert foreclosures much, since the Fed would have little control over the mortgages that comprise MBS.

Note that there is nothing in Ip’s discussion that disproves Dizard’s argument that the Fed is not willing to engage in issuing liabilities so as to expand its balance sheet (while it was listed as #2 above, it was clearly the least favored option). But if the IMF’s forecast of $945 billion of debt related losses comes to pass (versus $232 billion in writedowns taken so far by the banking industry), the Fed may wind up turning to its contingency plans.