from Follow the Money


August 13, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The Economist -- in the course of its analysis of the Fed’s response to the credit crisis -- noted that only a few years ago the Fed got rid of its Agency holdings because it didn’t want its asset purchases to distort the allocation of credit in the US economy.

"Politicians have asked the Fed to favour certain industries or keep interest rates low almost from its birth. In 1921 the Fed rejected requests from Congress to buy long-term agricultural debt. In the 1940s and again in the 1960s, under pressure from the Treasury, it bought bonds to hold down long-term interest rates. In the 1970s, at the behest of Congress, it bought the debt of federal agencies such as Fannie Mae and Freddie Mac.

A 2002 staff study pointed out the risks of favouring particular assets or borrowers: it could result in too much investment in preferred sectors and too little in others, drag the Fed into arguments about fiscal policy and compromise its monetary policy. In recent decades the Fed largely extracted itself from anything resembling credit allocation. The last of its Fannie bonds matured in 2003."

Obviously, the Fed has shed its inhibitions here over the past year -- though helping the banks avoid forced sales of their existing assets into an illiquid market arguably has less impact on the allocation of future credit than buying securities other than Treasuries when times are good. still, there are concerns that the Fed is now shaping the allocation of credit in the US economy. The Economist writes:

"The central bank is lending to private companies on an unprecedented scale and is thus making decisions it long sought to avoid about the allocation of credit. It is also acquiring new powers of oversight. Politicians could chafe at the Fed’s power: why, they might ask, should unelected officials choose who benefits from taxpayers’ money? And they might press the central bank to pursue political ends—such as propping up favoured borrowers—that interfere with monetary policy ....

That brings up an interesting question: If Americans are uncomfortable having the Fed shape the allocation of credit in the US economy, shouldn’t they be equally uncomfortable when foreign central banks -- notable China’s central bank -- shape the allocation of credit in the US economy through their asset purchases?

The PBoC now has a larger dollar balance sheet (on the asset size) than the Fed. It holds around a trillion dollars of Treasuries and Agencies (over $950b can be identified using the TIC data, and the TIC data understates China’s holdings ... ). The Fed has around $900 billion in assets -- $940 billion, to be precise.

Moreover, the PBoC’s dollar balance sheet is growing far faster than the Fed’s dollar balance sheet. The Fed has responded to the credit crisis by changing the composition of the assets it holds, not by increasing its holdings. The PBoC by contrast is adding to its foreign assets at an extraordinary rate.

Back when the Fed was getting out of the Agency market in 2003, China was getting into the Agency market. In a really big way. China has bought close $100 billion of Agency debt a year now for several years - and likely bought far more over the past year, though accurate data isn’t yet available. As the US stood down, China stood up -- so to speak.

There is an argument, popular at the Fed, that claims central bank intervention in the market has little impact. If a central bank buys Treasuries and pulls rates below their "true" rate, private investors will sell Treasuries until they return to their natural equilibrium. Consequently, central bank demand doesn’t have a big impact on Treasury yields. If central banks buy a ton of Agencies, lowering the yield for mortgage backed securities, private investors will shift their funds toward sectors that central banks are ignoring and push yields back up. There won’t necessarily be more funds available to finance housing.

If this argument holds for the actions of foreign central banks, it presumably also holds for the actions of the Fed -- and there wasn’t much need to worry that the Fed’s purchase of assets other than Treasuries might influence the cost of credit in the US. And well, if the Fed’s small purchases could favor one sector over another, wouldn’t far larger purchases from foreign central banks have a similar effect?

That possibility though raises a host of difficult issues that the United States has preferred to ignore. Among other things, it implies that China’s government already plays a significant role in determining the allocation of credit inside the US economy, not just the allocation of credit inside China’s economy.

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