The Fed’s New Approach

by Francis Cianfrocca

The Fed’s New Approach

Last week, at the height of the flap over AIG bonuses, Fed Chairman Ben Bernanke pulled out his biggest weapon and fired it. He announced a $1.15 trillion expansion of the Fed’s balance sheet. His intention is to purchase $300 billion in Treasury securities (term structure still to be determined), and the rest in bonds and debt issued by Fannie Mae and Freddie Mac.

This breathtaking amount of inflation is intended to finally break the logjam that is preventing consumers from getting new mortgages, car loans and other kinds of credit. With current low levels of consumer credit formation, demand for goods and services is lower than it would otherwise be, which adds upward pressure to the unemployment rate.

But there’s a problem. Bernanke may be firing at the wrong target.

What we’re talking about here is an announcement made by Bernanke in remarks accompanying the end of the Fed’s regular policy meetings. He reiterated a prior commitment to keep short-term interest rates at or near zero for some time to come (presumably, this means throughout next year). The Fed Chairman also restated his expectations that unemployment will continue to rise even after the recession formally ends. (GDP probably will swing from contraction to growth sometime next year or perhaps late this year, but it won’t feel like a return to prosperity.)

But the big thing that the Fed will do differently is that they will directly purchase Treasury debt. Earlier in this crisis, the Fed stepped up to provide a direct bid for debt issued by Fannie and Freddie. But to my knowledge, the Treasury purchases are the first since the early Fifties. (I welcome corrections on this point. Please send them along to me at fcianfrocca -at- newledger.com.)

A bit of history: World War II was largely funded by massive purchases of Treasury debt by the Fed, at interest rates well below the market. This created massive inflation, which was the point of the exercise. It made the huge step up in war production possible, but its spillover effects were managed with price controls and rationing. In the runup to the Korean War, President Truman tried to force the Fed to do the same thing again, but the Fed rebelled. In so establishing its independence from the Treasury, the Fed established a credibility for the US dollar that lasted until the fiscal inflation of the Sixties (aka “the Great Society”).

It then took Paul Volcker to snuff out high inflation with exceptionally high interest rates, at the expense of an evil recession in the early Eighties. For the next 25 years, the Fed happily maintained a global sense of confidence about the value of the dollar. That’s why to a historically-minded finance geek like myself, it’s extraordinary for Bernanke to be making common cause with Treasury over the level of inflation in the economy. What was the reaction of financial markets?

It was nothing short of electrifying. The 10-year Treasury note exploded upward in value in its biggest one-day rally since 1962, and its yield fell nearly half a percentage point to just over 2.5%. The value of the dollar fell about 5% in a day, an equally shocking move. Gold, oil, and copper all shot up over 5%.

The dollar and the commodities are holding their new levels, but bond prices have slumped a bit. Relative to the entire Treasury bond market, the new purchases are relatively small. The stepped-up purchases of mortgage debt are relatively much larger, and should impact prices for mortgage securities very significantly.

What is Bernanke really trying to do? Well, he’s said quite a few times that the biggest problem we face is the unavailability of credit for consumers and businesses in the mid-market. In short, he wants to end the credit crunch.

And he’s taking a pricing perspective on why banks won’t lend, consumers won’t borrow, and businesses won’t invest. This is critical if you want to understand what’s going on here. Risk-free interest rates have fallen sharply in nominal terms (the Fed-funds rate was 5.25% in mid-2007 and is now zero). But the interest rates available for mortgages, car loans, student loans and credit cards are now far higher relative to risk-free rates than they were, pre-crisis.

The spread (difference) between the risk-free rate and commercial credit rates represent the economic cost of providing loans. If the spreads are extraordinarily high as they are today, it makes little sense to borrow money. Ordinary people instinctively understand this in ways that economists can’t easily measure. What people do is: they look out at their job security and their likelihood of getting a raise, compare it to their prospective expenses like college tuition and retirement, and then they make marginal decisions about discretionary purchases. With credit-spreads so high today, those marginal purchases aren’t being made. Boil all of that down into a single word, and you get “recession.”

Now the Federal Reserve only controls a very narrow range of interest rates, and they’re very short-term: they control the rate at which banks borrow money from each other overnight. Right now, that interest rate is targeted to be zero. But the interest rates that are relevant to consumer and business credit formation are farther out in time. Mortgages are particularly sensitive to the 10-year Treasury rate.

The Fed can marginally affect interest rates over the next year or two by pledging to keep the overnight rate low. (A long-term interest rate is the sum of a series of short-term interest rates.) But that’s not enough to bring down the price of money sharply enough to suit Bernanke. That’s the objective of this trillion-dollar pulse of new debt-monetization. Bernanke wants to compete against the market for risk-free and near-risk-free (mortgage-based) debt, and so bring down the price of money in the medium term.

This strategy is based on a leap of faith, because it’s far from certain that price is the reason why consumers and small-to-medium businesses aren’t borrowing new money. It may turn out instead that people aren’t borrowing and investing because, after two decades of mad global expansion, everyone wants to deleverage for a while and grow more slowly.

If that turns out to be the case, we’ll know it because Bernanke’s strategy will NOT catalyze a new round of credit formation and economic growth. This actually is my own expectation of the outcome.

But wait, won’t this strategy create huge new inflation and sink the value of the dollar? The markets are certainly reacting as if this were the case. But then why do we see only mild hints of inflation in wages and consumer prices? It’s because the broad trend today is still toward massive asset deflation. We’re going through a cycle of reduction in outstanding and available credit that is very much like that of 1930-32. The Fed has been counteracting the deflation with gargantuan inflation ever since the crisis began. It’s like two hurricanes blowing against each other.

Don’t expect to see massive, noticeable inflation until a significant economic recovery begins. Inflation isn’t too many dollars. It’s too many dollars chasing too few goods. If demand continues to be impaired, the Fed can print an infinite amount of money and it won’t result in noticeable inflation. As Bernanke prepares to testify before Congress again Tuesday, he may be pushing on a string. We’ll find out soon enough.