Greg Ip

Articles by The Economist’s U.S. Economics Editor

Quantitative easing, Fed style

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Not yet the last resort

Oct 9th 2008
From The Economist print edition

 

 

The Fed tries its own version of quantitative easing
 

Illustration by Jac Depczyk
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WHEN, on October 3rd, America’s Congress eventually approved the Bush administration’s $700 billion plan to buy troubled mortgage assets, lawmakers earned not only the gratitude of Ben Bernanke, but also a promise from him. The Federal Reserve, its chairman declared, would do its part with “all of the powers at our disposal”.

He has certainly kept his word. On October 6th the Fed doubled, to $900 billion, the planned size of the loans it auctions to banks. A day later it said it would for the first time in its history make unsecured loans to companies, including banks, by buying commercial paper that they are unable to refinance. In theory, this tactic could be used to allow the Fed to make any kind of loan, including to state and local governments and in the interbank funds market. And a day after that it joined other leading central banks in cutting interest rates, lowering its target for the federal funds rate from 2% to 1.5%. It is unlikely to stop there. The rate could end up at zero.

The rate cut was a conventional response to the growing risk of a deep recession. The other steps take the Fed farther into uncharted territory. They were made possible in large part by a provision of the bail-out law that permits the central bank to pay interest on reserves that commercial banks keep on deposit at the Fed. This is important because every time the Fed makes a loan, it creates additional bank reserves. Banks lend excess reserves to each other, putting downward pressure on the federal funds rate. To drain those reserves and offset that pressure, the Fed sells Treasury debt. But it has been lending on such a huge scale that it has used up the bulk of its Treasuries. Had it run out, its lending would have had to stop or the funds rate would fall to zero. Paying interest on reserves largely removes that risk, because it leads the banks to lend the money back to the Fed.

 

None of this is certain to work. Share prices fell heavily this week, and the spread of interbank lending rates over the federal funds rate set new records. Yet the Bernanke doctrine is clear: the Fed will lend as much as it must and to whomever it must to contain the credit crisis. It is far from finished. The Fed’s balance-sheet has ballooned from $900 billion in August to $1.5 trillion on October 1st, and could soon pass $2 trillion. But even that sum equals just 14% of GDP. Vincent Reinhart of the American Enterprise Institute, a think-tank in Washington, DC, notes that at the high point of its policy of “quantitative easing”, the balance-sheet of the Bank of Japan (BoJ) equalled 30% of that country’s GDP.

Indeed, the Fed’s latest actions have drawn comparisons to quantitative easing: having already cut rates to zero, the BoJ bought loads of government bonds between 2001 and 2006 in order to expand the supply of bank reserves. That helped reinforce the BoJ’s commitment to zero rates and bring down long-term rates. Its direct impact on lending, however, was much less clear.

 

Made in America, not Japan

In fact the Fed’s actions are fundamentally different. The creation of excess reserves (Fed liabilities) is merely the by-product of its actual goal, which is to expand loans (Fed assets). Frederic Mishkin, an economist at Columbia University who recently quit as a Fed governor, says quantitative easing is aimed at raising the overall level of liquidity in the financial system. By contrast, the Fed is aiming at the sectors that are encountering problems. “It does not want its targeted liquidity determining overall liquidity,” a job best left to standard monetary policy.

The Fed does face some constraints. One is legal: like most central banks, it is generally prohibited from unsecured lending. It gets around this, in part, by lending to its own off-balance-sheet vehicle, which holds the unsecured commercial paper. Another is political: Americans may object to their central bank displacing private lenders. But Mr Mishkin says the political risks of doing too little and letting the economy slide are far greater. A final constraint, notes Kenneth Kuttner, an economist at Williams College, is that the Fed could in theory suffer loan losses so great that it needs recapitalisation, as central banks in Chile, Hungary and the Philippines have in the past. Fears of such losses were one reason why the BoJ did not purchase much private-sector debt earlier in this decade. In 2003 Mr Bernanke, then a Fed governor, argued that such concerns were misplaced because, unlike a commercial bank, a central bank cannot go bankrupt.

Mr Bernanke seems set on a different path from the BoJ’s. Its quantitative easing came a decade after Japanese banks began to fail, when they were too weak to lend out the excess reserves the BoJ gave them. Most American banks can still lend, but uncertainty about their own and their customers’ access to funds holds them back. The Fed’s expanded liquidity thus has a better chance of being used and supporting the economy. “We have learnt from historical experience with severe financial crises that if government intervention comes only at a point at which many or most financial institutions are insolvent or nearly so, the costs of restoring the system are greatly increased,” Mr Bernanke said on October 7th. “This is not the situation we face today…the great majority of financial institutions have sufficient capital and liquidity to return to their critical function of providing new credit for our economy.”

That belief may be standing in the way of even more radical measures. Mr Bernanke has seen this crisis chiefly as one of illiquidity, not insolvency. He has thus pressed first for measures that improve liquidity, such as buying tainted assets from banks and expanding the Fed’s own lending, while being less keen than outside economists on injecting public capital into banks, as Britain did this week. Some sceptics note that banks will not seem so solvent once unavoidable loan losses are realised. Mr Bernanke may be coming round: he has played up the fact that the bail-out programme can also be used to inject capital.

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Written by gregip

October 9, 2008 at 7:35 pm

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