The Fed and Treasury released a joint statement yesterday afternoon that was lost amid the official release of the Geithner Plan (hat tip Accross the Curve). Clearly, it revelas the concerns of the Federal Reserve that its expansive role in the crisis will eventually threaten monetary independence, and thus wants that right/privledge reasserted:
The Federal Reserve’s independence with regard to monetary policy is critical for ensuring that monetary policy decisions are made with regard only to the long-term economic welfare of the nation.
The need for such a statement was heightened by last week’s FOMC decision to expand the balance sheet via outright purchases of Treasury securities (in addition to mortgage backed securities). Considering the massive amount of red ink fiscal authorities are expected to spill for the foreseeable future, the Fed’s action could be interpreted as the first salvo in a campaign to monetize deficit spending. I do not believe that this is the interpretation the Fed intends. Indeed, I believe this is one reason the Fed has shied away from the term “quantitative easing.” Note Bernanke & Co. always place the expansion of the balance sheet in terms of the improving the functioning of private capital markets. See Federal Reserve Chairman Ben Bernanke’s speech last Friday:
These purchases are intended to improve conditions in private credit markets. In particular, they are helping to reduce the interest rates that the GSEs require on the mortgages that they purchase or securitize, thereby lowering the rate at which lenders, including community banks, can fund new mortgages.
The stated intent is not supporting fiscal stimulus, creating inflationary expectations, nor even fighting deflation. The Fed expects they will withdraw their extraordinary liquidity operations when financial conditions stabilize (see Monday’s Wall Street Journal). They expect they will have the political freedom to do so; but the deeper they delve into financial markets, the more politicized their activities become.
The broad points, with my comments:
1. Treasury-Federal Reserve cooperation in improving the functioning of credit markets and fostering financial stability
The Federal Reserve’s expertise and powers are indispensable for preventing and managing financial crises. The programs it has initiated since the onset of this crisis have played a critical role in helping to contain the damage to the broader economy. As long as unusual and exigent circumstances persist, the Federal Reserve will continue to use all its tools working closely and cooperatively with the Treasury and other agencies as needed to improve the functioning of credit markets, help prevent the failure of institutions that could cause systemic damage, and to foster the stabilization and repair of the financial system.
2. The Federal Reserve to avoid credit risk and credit allocation
The Federal Reserve’s lender-of-last-resort responsibilities involve lending against collateral, secured to the satisfaction of the responsible Federal Reserve Bank. Actions taken by the Federal Reserve should also aim to improve financial or credit conditions broadly, not to allocate credit to narrowly-defined sectors or classes of borrowers. Government decisions to influence the allocation of credit are the province of the fiscal authorities.
This Fed understands its role is to provide substantial support for the economy. But that support is not intended to be directed toward a particular sector. Of course, it can be argued that the Fed is targeting the housing sector, but they would argue that this is justified given the depth and magnitude of that sector’s role in the current crisis. They do not want to be pressured into supporting the auto industry, for example, absent a overriding concern for the economy as a whole. Understandably, they want to deflect critism that they are pursuing fiscal policy (and subverting the democratic process by doing so). And they do not want to be politically pressured to continue to support any sector – even housing – should they need to withdraw from the financial markets.
3. Need to preserve monetary stability
Actions that the Federal Reserve takes, during this period of unusual and exigent circumstances, in the pursuit of financial stability, such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy as needed to foster maximum sustainable employment and price stability. Treasury has in place a special financing mechanism called the Supplementary Financing Program, which helps the Federal Reserve manage its balance sheet. In addition, the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.
The Fed does not want the expansion of the balance sheet to be interpretted as a deliberate effort to devalue the US dollar – a natural concern of financial market participants, as failure to protect the purchasing power of the dollar is virtually the same as a default. Our foreign creditors would not be amused. Again, I believe this is why the Fed shies away from the term quantitiative easing, despite its widespread acceptance by commentators. I believe that term, in their minds, refers to a targeting of the growth of the balance sheet with the intention of generating a particular inflation rate. This is not consistent with the language the Fed uses to describe its actions. (Of course, the danger is that the Fed triggers some collapse of confidence in the US Dollar regardless of policymakers best intentions).
4. Need for a comprehensive resolution regime for systemically critical financial institutions
The Treasury and the Federal Reserve remain fully committed to preventing the disorderly failure of systemically critical financial institutions. To reduce the risk of future crises, the Treasury and the Federal Reserve will work with the Congress to develop a regime that will allow the U.S. government to address effectively at an early stage the potential failure of any systemically critical financial institution. As part of the framework set forth, the legislation should spell out to the extent possible the expected role of the Federal Reserve and other U.S. government agencies in such resolutions.
The Fed would like to make its future role in crisis management clear so that it is not again forced into a job that arguably exceeds its legal authority and threatens its institutional independence. Sounds reasonable. Finally:
In the longer term and as its authorities permit, the Treasury will seek to remove from the Federal Reserve’s balance sheet, or to liquidate, the so-called Maiden Lane facilities made by the Federal Reserve as part of efforts to stabilize systemically critical financial institutions.
It appears the Fed is unhappy with its holding of Bear Stern’s toxic debt, and wants the taxpayer liability out of its hands ASAP.
Bottom Line: The Fed is aware that its actions over the past eighteen months has put its independence in danger. They are hoping this agreement helps ensure that independence when the crisis is over. Note also that the Fed is reiterating its policy intentions regarding the balance sheet – and, as aggressive as those intentions are, they are not as aggressive as is commonly believed.
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Here is my own “Executive Summary,” or translation, of the Treasury-Fed Joint Statement::
Over the years, the Federal Reserve has become very smart and capable. It is also very important since it is the “lender of last resort”—a big help in financial crises. That is why the Fed involves itself in preventing and managing these crises. The Fed never has anything to do with creating crises—otherwise we would mention it in this Joint Statement.
The Treasury and the Fed agree they should cooperate to resolve crises. The Fed is indispensable in preventing and managing financial crises. (Did we mention this?) The Fed has already minimized the damage in the current crisis. It and the Treasury will continue to help improve credit market functioning (i.e., getting lenders to lend and borrowers to borrow—the free market has never been able to do this). We will also prevent institutions from failing if their failure would hurt the system. We will also help to stabilize and repair the financial system. The system is not capitalism or the free market. The system is big firms not failing.
The Fed will avoid taking too much risk on itself. The Fed will stay away from credit allocation, leaving that to the Treasury, if necessary. The Fed will continue to foster “maximum sustainable employment and price stability”—i.e., to pursue its Congressional mandate. We thought we should mention this.
Treasury has in place a special financing mechanism for the Fed (called the Supplementary Financing Program). This “helps the Federal Reserve manage its balance sheet.” It’s sort of like how they help General Motors and AIG. But the Fed and Treasury want laws passed so the Fed can “sterilize the effects of its lending or securities purchases on the supply of bank reserves.” (We’re too nervous about this particular topic to explain it further in this statement.)
The Treasury and the Fed agree they won’t permit “disorderly failure of systemically critical financial institutions.” That means any big failures that would embarrass the elite financial regulators, the politicians directly responsible for financial regulation and, of course, the executives in charge of the precarious institutions themselves.
As our proposal for avoiding future financial crises, we have come up with this idea. You have probably already heard it. The Congress, the Treasury, and the Fed will work to create a “regime” to anticipate and prevent any future really big, really embarrassing financial failures. (This never occurred to us before, but it seems like a good idea now. It should do the trick.)
By the way, all these special things we’ve done so far—like ballooning the Fed’s balance sheet beyond insanity and like lending incredible sums to financial institutions on collateral we never would have allowed before—we’ll try to undo all that stuff when we can.