from Follow the Money

Today’s Fed statement speaks for itself

December 17, 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 Fed cut policy interest rates to zero, more or less. And it signaled that it hasn’t run out of ammunition even if it cannot cut rates further.

Not so long as there are still financial assets that it is willing to purchase. The Fed:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity. (emphasis added)

Over the last few months, the Fed has more or less taken over a slew of functions previously performed by the private financial system.

Banks with spare cash (more deposits than loans) used to lend to banks that were short of cash (more loans than deposits). Now they lend to the Fed, and the Fed lends to the banks that are short on cash. That way no bank risks taking losses lending to a bad bank ….

Money market funds used to lend both to the financial sector and to firms with short-term financing needs. Now they (to simplify a bit) just buy Treasuries. The Treasury met this demand by increasing its issuance, and (to simplify a bit) putting the cash it raised on deposit with the Fed. That in turn allowed the Fed to lend to institutions in the US and abroad that previously relied on money market funds for financing.

Foreign central banks used to buy rather significant sums of Agency bonds, and in the process finance (indirectly) the extension of credit to American households. Now foreign central banks just want Treasuries. The Fed now plans to purchase rather significant quantities of Agencies, in effect making up for the fall off in demand from other central banks.

As Dr. Krugman notes, "we are in very deep trouble" —and it isn’t clear if the Fed’s various initiatives will be sufficient to pull the US economy out of its current tailspin. But the Fed can hardly be accused of not trying. It isn’t the ECB.

The real criticism of the Fed is that it – for a host of reasons – didn’t try very hard to limit the build up of financial vulnerabilities that generated the current mess.

UPDATE: Yves Smith isn’t at all convinced the Fed’s approach will work. John Jansen highlights the obvious risk of a debtor cutting interest rates to near zero, namely no one will want to finance its deficits. I am less worried, if only because I suspect a host of emerging market central banks will resist any pressure for the dollar to depreciate against their currencies when their exports are shrinking (see China) and in the process support the dollar and finance a (smaller, due to falling oil prices) current account deficit. Remember, more of the fiscal deficit will be financed domestically, as Americans start savings and stop investing ....

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