Wednesday, December 17, 2008

US Fed shoots the big cannon!

Ushering in a historic era of monetary policy loosening, the US Fed has decided to cut the overnight federal funds rate, which affects how much banks charge when they lend their reserves to each other, to a range of 0-0.25% from 1%. This dramatic decision by the Federal Open Market Committee (FOMC) follows nine rate cuts in the previous 14 months and $1.4 trillion in emergency lending, all of which have failed to rein in the decline.

The rate cuts are largely symbolic, in so far as the funds rate had already fallen to nearly zero in recent days because the credit markets had frozen so much that the banks have been so reluctant to do any lending business. While the target fed funds was until yesterday still 1%, in the last few weeks — following the massive increase in liquidity by the Fed — the actual Fed Funds was already trading at a level literally close to 0%. The possibility of a Japan style liquidity trap with its attendant consequences now look real.

Though this historic low interest rate leaves the Fed with little room for conventional monetary loosening, the FOMC of the Fed still expressed its commitment to buy 'large quantities' of debt and mortgage-backed securities and debt issued by government-sponsored companies like Fannie Mae; commercial debt for businesses and consumer lending, and longer-term Treasury securities. These less conventional measures have meant that since September the Fed’s balance sheet has ballooned from about $900 billion to more than $2 trillion as the central bank has created new money and lent it out through all its new programs.

This open commitment now to even print money to keep credit flowing and prevent a deflation is in keeping with the well stated stance of Fed Governor Ben Bernanke (remember the parody of "helicopter Ben"). Martin Wolf has this excellent article about the dangers of deflation - higher real rate of interest, rising real value of debt as prices fall (debt inflation), and postponed conusmption and investments - and the comparisons with the Japanese crisis of the nineties.

Yields on Treasury debt, which have plunged this year as investors sought a haven for their money, fell to new lows after the Fed indicated it would buy long-term Treasury debt and promised to keep interest rates at "exceptionally low levels" for the foreseeable future. The yields on Treasury’s benchmark 10-year bill fell to 2.26% from 2.51% and the rate for a 30-year fixed-rate mortgage fell to 5.38% from 5.74% the previous day.

In order to revive corporate and consumer lending, from later this month the Fed will start purchasing $600 billion worth of securities that are backed by Fannie Mae, Freddie Mac and other government-sponsored entities, besides joining with the Treasury to introduce a joint program to buy up securities backed by consumer debt like automobile loans. All of these will take the Fed's balance sheet to beyond $3 trillion. The consequences of this massive build up of monetary base, which banks and other investors are essentially hoarding now, will be catastrophic if they are not destroyed once normalcy returns and banks start lending again.

The rate cuts follows a series of depressing news indicating that the recession is getting more severe than expected and has the potential to draw the economy into a depression. Unemployment figures for November have been dismal. In an increasing sign of deflation taking hold, consumer price index fell 1.7% in November, the steepest monthly drop since the government began tracking prices in 1947 as retailers have aggressively slashed prices in an effort to lure in Christmas shoppers. Home construction has skidded nearly 20% from October and 47% from the same time last year to its lowest levels in 50 years. Even the so-called core inflation rate, which excludes the volatile food and energy sectors, is essentially zero. Industrial production for November dropped 5.5% compared with November 2007 and 0.6% over the previous month, and manufacturing output declined 1.4% in November.

Meanwhile, despite a $ 5 bn cash infusion by Warren Buffet, with all its credibility spin-off (of immense value at such uncertain times), a corporate makeover into a universal bank, and a reputation for surviving many a crises, Goldman Sachs reported a quarterly loss of $2.12 bn, its first quarterly loss since it went public in 1999. The other big remaining investment bank turned universal bank, Morgan Stanley, too posted a $2.29 bn loss.

Update 1
Japanese Central Bank too follows suit and lowers rates to 0.1% from 0.3% and also announces its decision to buy up short term commercial paper to shore up the credit markets.

Update 2
Robert Lucas thinks that the Fed assuming the role of a lender of last resort at a time the markets are in a "flight to quality", has the potential to stumulate spending.

Update 3
The Economist reviews the Fed's unconventional monetary policy using quantitative easing.

Update 4
Janet Yellen of the Federal Reserve Bank of San Francisco summarizes the Fed's monetary policy response and compares the policies of the US Fed and Bank of Japan in the nineties. She makes the point that near the zero bound, short-term government securities and cash are almost perfect substitutes, and therefore simply expanding excess bank reserves by replacing G-Secs may have little effect on bank lending.

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