Another Chapter about the Fed

 

I have been scratching my head trying to figure out what has happened to the financial market and what are the implications of the Federal Reserve’s actions since the housing market in the US started to crack and a chain of derivatives of debt instruments were collapsed. It is probably one of the best real-life questions for which we cannot find a standard and authoritative answer in any economics textbooks. Unless we believe that the economics is a voodoo science, we should be able to define the current problems and have a sound judgment of what needs to be done to tackle the problems.

So it becomes a perfect excuse for me to get the economics textbook that I had read more than ten years ago. Although the same title, it is many editions later than what I had read at school. The difference is that the content is much richer today. To much of my surprise, the book does read familiar and many reflections of my school times come to mind.

So far, I do not reach any conclusions on what will happen after the Fed’s rescue of the financial market. What I got instead, by flipping through the textbook, is some facts about what the Fed did to its balance sheet and what the follow-up the market will focus on after the current turmoil subsides.

The following are the facts about the Federal Reserve’s book and its actions in recent months about its balance sheet.

 

1. The Fed is a US government branch that is responsible for issuing government IOU to the public in the form of those green papers we hold in the wallet or on bank accounts. The US government also issues debt in exchange of the public’s money to finance the government work. And the Fed is also a buyer or seller of such debts in exchange of greenbacks from the public (or the financial system in another word).
2. Before the financial crisis, the majority of the values held by the Fed is the US treasury securities, which are deemed as the most liquid and secure assets that can be exchanged into real dollars at a stroke of a computer key, because the US government debt (bond) market is a hundred times as big as the Fed’s total assets.
3. The Fed is NOT totally independent from the government although it does not need to rely on the government for its budget and its governors’ tenure is longer than any congress members or the President. But it still needs the approval of the government (i.e. the US Treasury) when it comes to the matter such as loaning securities to banks, because the Fed does not own those securities. Those securities represent the debt obligations of the US government. It is the government, rather than the Fed, who is obliged to pay the interests to whoever holds those debt securities. The Fed alone cannot decide to loan those securities out without the approval of the US Treasury Department.
4. What the Fed did since the end of last year is that it handed out its treasury securities holdings to the commercial banks and later to investment banks, and in exchange, it got back from those banks the securities that are less liquid and are of lower quality as their repayment in full is questionable. As of last week, the Fed loaned out its government securities of about $100billion out of its total assets of $870billion. The amount of the loan is still a small proportion of the Fed’s assets. It is unknown how much securities the Fed received as the collateral from the banks for its $100billion loan.

 

The focus of the Fed’s operations in terms of its effectiveness is two folds:

 

1. How much of these loans will be translated into commercial loans issued by the banks. Interbank lending rate will be an indicator that people will watch closely. As of now, interbank lending is not back to the level before the crisis but much better than the worst it has seen at the height of liquidity crunch. The commercial bank lendings have been curtailed due to the deteriorating balance sheets. With the help of the Fed, lending activities should in theory pick up. But it is not a given. On the contrary, lending activities are expected to shrink despite the Fed’s liquidity action, because the banks have too much lending (leverage) before, and now they have to entrench and reduce the size of the balance sheet, at least in a short period. How short? It is anybody’s guess—from one or two quarters to half a year, a year… This is probably one factor that the Fed is based on to predict the near term economic contraction. Hopefully this is only short-term, and the U-turn of lending activities will not be too far out of sight.
2. Where do these securities loaned by the Fed go? After these loans arrived on the banks’ book, they are equivalent to cold hard cash, which means they can be sold on the bond market for cash in a blink of an eye. Right now, the government securities yield about 5% for long bonds and less than 1% for short term securities. So it is not attractive to let these bonds sit on the balance sheet. And they will inevitably be transferred into other markets seeking higher yields. These places could be stocks, commodities, and emerging markets, wherever it can get a higher return. The liquidity has been injected into the financial system, although it is not in the form of fresh cash. It is nonetheless acting much like the cash and will show their footprint on the markets. Therefore, it is not unsurprising if we see in the coming days that market volatility remains high as the liquidity is put in the “work”. When prices of grain, rice, canola oil, or the prices of gold, oil going up or down in a big swing, is it just a coincidence? Think again.

It is likely to see that the Fed’s actions have relieved the stress of the banking system; however, it is not certain that these actions have solved any fundamental economic problems plagued the housing, consumer debt and commodities markets. There is at least one more act of the Fed to unwind the loans it made to the banks. How the Fed will do it without hurting banks’ balance sheet is not clear. The market will have to deal with that later, if all the current problems are gone. But it may take a long time for the Fed to stage that act.

The economics textbook I have been reading through looks familiar yet provides more analytical tools than the one I read more than 10 years ago. The current economic situation just makes me confident that a new chapter about how and why we have got to the current financial turmoil will be added and the next edition will be out in the near future.

The economist knows at least one thing for sure—that is how the economics of textbooks works.

 

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