The Fed’s policy space is not one-dimensional

It’s easy right now to view the Fed as trapped. If the Fed fails to lower rates, asset prices will continue to collapse, the housing crisis will worsen, and the broad economy will suffer. If the Fed does lower rates, capital flight from the US will continue, gold, commodities, and foriegn currencies will surge, and weakness of the dollar will eventually translate into a dangerous inflation. The Fed is damned if it lowers, damned if it raises, and damned if it does nothing at all. In the usual cliché, the Fed is “in a box”.

But the Fed has more options than “raise or lower”. Let’s go back to Bernanke’s famous 2002 speech about deflation. Note that the root of the current crisis is deflation, though of a particular kind, a deflation in the value of certain financial assets. If all the terrible paper Wall Street has been producing over the past few years really had been as solid as their boosters and the rating agencies claimed, we’d have no crisis today to fuss about. A collapse in the value of supposedly “ultrasafe” assets held by parties with little capacity to take risk or bear losses is at the heart of the today’s financial mayhem. Whatever its deeper roots, the proximate cause of the crisis is a deflation.

Here’s Dr. Bernanke:

[T]hat deflation is always reversible under a fiat money system follows from basic economic reasoning… [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services… Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.

Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral.

The first thing to note here is the candor and prescience of Dr. Bernanke’s remarks. The future Fed chairman is describing very unconventional monetary policy options, and discussing how the central bank could, in a time of crisis, circumvent regulatory obstacles designed to constrain bank behavior. And obviously, these turned out to be more than mere musings. Bernanke’s first response to the present crisis was to try to lend indirectly to holders of struggling collateral via the discount window.

Suppose that the Fed were not restricted in the sorts of assets it could buy. What might the Fed do about the present crisis? Consider the obvious. The Fed could bail out holders of the compromised paper. It could determine a “fair long-term value” for all those struggling RMBSs and CDOs, something less than par but much higher than the market bid, and purchase securities outright with freshly printed money. You might think that a cash bail-out would be inflationary, and “ceteris paribus”, it certainly would be. But “ceteris paribus” doesn’t hold here. By strategically choosing which assets to buy, the Fed could mitigate the harm that higher interest rates would otherwise do to the financial sector. Becoming the “bagholder of last resort”, the Fed would purchase the freedom to raise interest rates without provoking a “nonlinearity” (knzn‘s delightful euphemism for a meltdown). The Fed would have its cake and eat it too. It would promote full employment by stopping a dangerous financial crisis in its tracks. It would promote price stability by hiking interest rates to support the purchasing power (and FX value, and commodity value) of the dollar.

There would be some danger that, even with the banks bailed out, interest rate hikes would slow the economy. But that hazard is unusually small now, because the binding constraint on lending is not the Fed-set interest rate, but concerns about creditworthiness and quality of collateral. The larger the credit spread is, the less of an effect changes in core rates have upon behavior. Raising rates certainly won’t help homeowners struggling with their mortgages, for example. But it won’t hurt homeowners who have no hope of refinancing affordably anyway. There will always be someone caught at the margin. But in macro terms, a bad situation would be made very little worse by a moderate rate hike, if the financial sector could withstand it.

In reality, the Fed is not permitted to buy up dodgy CDOs outright. But as Bernanke has suggested, lending on sufficiently easy terms can approximate a purchase. Bernanke’s initial try at using the discount window to fight the structured-credit deflation didn’t work. But it was not a very radical attempt. So long as there is a “penalty spread” between the federal funds rate and the discount rate, any use of the discount window signals a lack of confidence by other banks and is reputationally costly. Suppose the Fed were to offer to lend against specific sorts of collateral at a negative spread to Federal Funds. Then all banks would have a clear financial incentive to take advantage, regardless of the quality of their own portfolio. Banks holding the privileged collateral might claim their assets are performing beautifully, but that it would be foolish not to take advantage of the Fed’s subsidy. Lining up at the discount window would suddenly become shrewd rather than shameful.

Of course, this might not work. Markets might be spooked rather than reassured, a l&agrave the Northern Rock fiasco. And even if it would work, I don’t advocate any of it. I don’t mean to be a “liquidationist“. But piling moral hazard on top of moral hazard, making ever lighter the consequences of poor choices by people whose choices are consequential for all the rest of us, strikes me as a bad way to encourage quality decision-making.

Nevertheless, if financials and asset prices continue to struggle, while commodities spike and the dollar falls, expect the unexpected from the Federal Reserve. Ben Bernanke has devoted his career to thinking about how a central bank might forestall financial catastrophe. He will not confine his options to “quarter point or half a point, up or down”.

Update History:
  • 11-Nov-2007, 2:00 p.m. EST: Removed an excess “but”. Changed “expected the unexpected” to “expect the unexpected”. Oops.

One Response to “The Fed’s policy space is not one-dimensional”

  1. tim straus writes:

    well said, Bernanke, like Greenspan before him is wired to seek out all available policy choices to reduce economic cyclicality and any excessive “pain” to the financial system and general economy–regardless of long term costs. As no governmental or financial central authority can hold back forever the inevitable power of the market to rvolt against economic and monetary policies designed to eliminate the effects of malinvestment and excessive risk taking in the pursuit of maximizing short term finanical rewards, it is only a matter of when not if–any Fed actions will fail in their intended results of preventing the system from self-correcting.