The Federal Reserve on Friday announced two initiatives to address heightened liquidity pressures in term funding markets.
First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion. The auctions on March 10 and March 24 each will be increased to $50 billion--an increase of $20 billion from the amounts that were announced for these auctions on February 29. The Federal Reserve will increase these auction sizes further if conditions warrant. To provide increased certainty to market participants, the Federal Reserve will continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary.
Second, beginning today, the Federal Reserve will initiate a series of term repurchase transactions that are expected to cumulate to $100 billion. These transactions will be conducted as 28-day term repurchase (RP) agreements in which primary dealers may elect to deliver as collateral any of the types of securities--Treasury, agency debt, or agency mortgage-backed securities--that are eligible as collateral in conventional open market operations. As with the TAF auction sizes, the Federal Reserve will increase the sizes of these term repo operations if conditions warrant.
This crisp communication from the Fed has banking crisis written all over it. It announced that it will up its liquidity injections to $200 billion. So, the only answer that the Fed has to the present crisis is "more dollars". That is kind of ironic since it was low interest rates and easy money that got the economy into this mess in the first place.
It looks like financial markets are about to enter a new and more dangerous phase of the credit crisis. Banks are hoarding cash, and pulling back from lending, and this renewed credit contraction is accelerating the US economy's slide into recession.
However, this crisis is about mispriced risk. The lack of liquidity is a symptom not a cause of today's difficulties. As yesterday's foreclosure data showed, the US housing market is now a deep pit of defaulted debt. These losses are now showing up everywhere, and balance sheets beginning to deteriorate.
Although the Fed has cut their policy rate, US banks have not followed them and reduced lending rates. According to bankrate.com, today the 30 year Jumbo mortgage interest rate was 7.09 percent. This comes close to its peak at the height of the autumn credit crunch. With rates like that, and foreclosures at record highs, the US housing market can only get worse, and as it does, the crisis deepens.
The Fed has only itself to blame for this mess. It generated the housing bubble when it cut interest rates to just one percent. It sustained the bubble when it refused to increase rates until 2004. Thereafter, it raised rates too slowly, while its bank supervisors ignored the reckless lending practices and dubious securitization pranks of US banks.
Over the last couple of months, the Fed's actions have heightened the sense of panic. Its interest rate cuts have seemed ill-considered and stand in stark contrast to the more measured responses from both the Bank of England and the ECB. Moreover, the rate cuts have simultaneously lacked the credibility to avert a slowdown and at the same time heightened fears of higher inflation.
If that wasn't enough, the Fed has also managed to provoke at least two other bubbles; commodity prices and US treasury paper. As the fears of inflation have taken hold, investors have piled into commodities. The rate cuts have also prompted a "flight to quality". Investors have also moved into treasury paper, pushing real interest rates into negative territory.
The Fed has forgotten a simple principle; financial stability can not be achieved through generating macroeconomic instability. It has tried to take the easy route. Naively, Bernanke thinks that pumping out liquidity and tax rebates will avoid a recession. Instead, he has destabilized price expectations, pumping up commodity prices and failed to stop an economic slowdown.
There is a better way. The Fed should raise interest rates to ensure that they are positive in real terms. This will establish some stability for the dollar, which will in turn, stabilize commodity prices.
The Fed should allow the economy to slow. This will generate sufficient spare capacity utilisation to allow the recent dollar devaluation to boost exports. The Fed's attempts to maintain GDP growth has kept capacity utilisation high and has limited the gains in external competitiveness, thus delaying a long delayed adjustment. If the Fed allowed the economy to go its natural way, export-led growth will quickly re-establish GDP growth, reduce the current account deficit and limit US external indebtedness.
Higher real rates would also encourage savings and allow a quicker asset price adjustment. House prices will fall more rapidly, thus re-establishing the long term fundamentals in the real estate market. Some banks will fail, but the Federal Deposit Insurance Corporation (FDIC) is there to clean up the mess. If the FDIC runs out of cash, then the government should step in and repay depositors. Bank failures would also remind banks that there is such a thing as risk, and if it is ignored, bankruptcy is a real possibility.
Of course, the Fed will do nothing of the sort. At the next FOMC meeting, rates will come down again, further exacerbating the sense of macroeconomic policy incoherence. Once those rates fail to cure the problem, what then? Will the Fed cut rates further? The Fed could provoke a run on the dollar. Foreign investors might panic and start an unstoppable sell-off of US assets; unstoppable, that is, without a major hike in interest rates. Eventually, and only after a crisis of unimaginable proportions, the US might get the monetary policy it needs.