Page 1 of 3 THE ROAD TO HYPERINFLATION Fed helpless in its own crisis
By Henry C K Liu
After months of denial to soothe a nervous market, the Federal Reserve, the US
central bank, finally started to take increasingly desperate steps to try to
inject more liquidity into distressed financial institutions to revive and
stabilize credit markets that have been roiled by turmoil since August 2007 and
to prevent the home mortgage credit crisis from infesting the whole economy.
Yet more liquidity appears to be a counterproductive response to a credit
crisis that has been caused by years of excess liquidity. A liquidity crisis is
merely a symptom of the current financial malaise. The real disease is mounting
insolvency resulting from
excessive debt for which adding liquidity can only postpone the day of
reckoning towards a bigger problem but cannot cure. Further, the market is
stalled by a liquidity crunch, but the economy is plagued with excess
liquidity. What the Fed appears to be doing is to try to save the market at the
expense of the economy by adding more liquidity.
The Federal Reserve has at its disposal three tools of monetary policy: open
market operations to keep Fed Funds rate on target, the discount rate and bank
reserve requirements. The Board of Governors of the Federal Reserve System is
responsible for setting the discount rate at which banks can borrow directly
from the Fed and for setting bank reserve requirements. The Federal Open Market
Committee (FOMC) is responsible for setting the Fed Funds rate target and for
conducting open market operations to keep it within target. Interest rates
affects the cost of money and the bank reserve requirements affect the size of
the money supply.
The FOMC has 12 members - the seven members of the Board of Governors of the
Federal Reserve System; the president of the Federal Reserve Bank of New York;
and four of the remaining 11 Reserve Bank presidents, who serve one-year terms
on a rotating basis. The FOMC holds eight regularly scheduled meetings per year
to review economic and financial conditions, determine the appropriate stance
of monetary policy, and assess the risks to its long-run goals of price
stability and sustainable economic growth. Special meetings can be called by
the Fed chairman as needed.
Using these three policy tools, the Federal Reserve can influence the demand
for, and supply of balances that depository institutions hold at Federal
Reserve Banks and in this way can alter the federal funds rate target, which is
the interest rate at which depository institutions lend balances at the Federal
Reserve to other depository institutions overnight. Changes in the federal
funds rate trigger a chain of effects on other short-term interest rates,
foreign exchange rates, long-term interest rates, the amount of money and
credit, and, ultimately, a range of economic variables, including employment,
output, and market prices of goods and services.
Yet the effects of changes in the Fed Funds rate on economic variables are not
static nor are they well understood or predictable since the economy is always
evolving into new structural relationships among key components driven by
changing economic, social and political conditions. For example, the current
credit crisis has evolved from the unregulated global growth of structured
finance with the pricing of risk distorted by complex hedging which can fail
under conditions of distress. The proliferation of new market participants such
as hedge funds operating with high leverage on complex trading strategies has
exacerbated volatility that changes market behavior and masked heightened risk
levels in recent years. The hedging against risk for individual market
participants has actually increased an accumulative effect on systemic risk.
The discount window is designed to function as a safety valve in relieving
pressures in interbank reserve markets. Extensions of discount credit can help
relieve liquidity strains in individual depository institutions and in the
banking system as a whole. The discount window also helps to ensure the basic
stability of the payment system more generally by supplying liquidity during
times of systemic stress. Yet the discount window can have little effect when a
liquidity drought is the symptom rather than the cause of systemic stress.
Banks in temporary distress can borrow short term funds directly from a Federal
Reserve Bank discount window at the discount rate, set since January 9, 2003 at
100 basis points above the Fed Funds rate. Prior to that date, the discount
rate was set below the target Fed Funds rate to provide help to distressed
banks but a stigma was attached to discount window borrowing. Healthy banks
would pay 50 to 75 basis points in the money market rather than going to the
Fed discount widow, complicating the Fed’s task in keeping the Fed Funds rate
on target. Part of the reason for raising the discount rate 100 basis point
above the Fed Funds rate on January 9, 2003 was to remove this stigma that had
kept many banks from using the Fed discount window. (For a historical account
of the change of the discount rate, see
Central bank impotence and market liquidity,
Asia Times Online, August 24, 2007.)
Both the discount rate and the Fed Funds rate are set by the Fed as a matter of
policy. On August 17, 2007, the discount window primary credit program was
temporarily changed to allow primary credit loans for terms of up to 30 days,
rather than overnight or for very short terms as before. Also, the spread of
the primary credit rate over the FOMC's target federal funds rate has been
reduced to 50 basis points from its customary 100 basis points. These changes
will remain until the Federal Reserve determines that market liquidity has
improved. The Fed keeps the Fed Funds rate within narrow range of its target
through FOMC trading of government securities in the repo market.
A repurchase agreement (repo) is a loan, often for as short as overnight,
typically backed by top-rated US Treasury, agency, or mortgage-backed
securities. Repos are contracts for the sale and future repurchase of top-rated
financial assets. It is through the repo market that the Fed injects funds into
or withdraws funds from the money market, raising or lowering overnight
interest rates to the level set by the Fed. (See The Wizard of Bubbleland -
Part II:
The repo time bomb Asia Times Online, September 29, 2005).
Until the regular FOMC meeting scheduled for January 29, 2008, the discount
rate had been expected to stay at 4.75% while the Fed Funds target would stay
at 4.25%, with a 50 basis points spread, half of normal, which had been set at
a spread of 100 basis points since January 9, 2003. From a high of 6% set on
May 18, 2000, the Fed had lowered the discount rate in 12 steps to 0.75% by
November 7, 2002 and kept it there until January 8, 2003 while the Fed Funds
rate target was set at 1.25%, 50 basis points above. On January 9, 2003, the
discount rate was set 100 basis points above the Fed Funds rate target. Then
the Fed gradually raised the discount rate back up to 6% by May 10, 2006 and
again to 6.25% on June 29, 2006. On August 18, 2007, in response to the sudden
outbreak of the credit market crisis, the Fed panicked and dropped the discount
rate 50 basis points to 5.75%, and continued lowering it down to the current
level of 4.75% set on December 12, 2007.
On Monday, January 21, a week before the scheduled FOMC meeting, global
equities plunged as investor concerns over the economic outlook and financial
market turbulence snowballed into a sweeping sell-off. Tumbling Asian shares -
which continued to fall early on Tuesday - led European stock markets into
their biggest one-day fall since the 9/11 terrorist attacks of 2001 as the
prospect of a US recession and further fall-out from credit market turmoil
prompted near panic among investors, forcing them to rush to the safety of
government bonds.
About $490 billion was wiped off the market value of Europe's FTSE Eurofirst
300 index and $148 billion from the FTSE 100 index in London, which suffered
its biggest points slide since it was formed in 1983. Germany's Xetra Dax
slumped 7.2% to 6,790.19 and France's CAC-40 fell 6.8% to 4,744.45, its worst
one-day percentage point fall since September 11, 2001. The price collapse was
driven by general negative sentiments and not, so far as was apparent at the
time, by any one identifiable event.
After being closed on Monday for the Martin Luther King holiday, US stock
benchmarks echoed foreign markets with big declines, extending large losses
from the previous week, with bearish sentiments accelerated by heavy selling
across global markets. About an hour before the NY Stock Exchange open on
Tuesday, the Federal Reserve announced a cut of 75 basis points of the Fed
Funds rate target to 3.50%, the first time that the Fed has changed rates
between meetings since 2001, when the central bank was battling the combined
impacts of a recession and the terrorist attacks.
Fed officials decided on their move at a videoconference at 6pm US time on
Monday, January 21, with one policymaker - Bill Poole, the president of the St
Louis Fed, dissenting. In a statement, the Fed said it acted "in view of a
weakening of the economic outlook and increased downside risks to growth". It
said that while strains in short-term money markets had eased, "broader
financial conditions have continued to deteriorate and credit has tightened
further for some businesses and households". And new information also indicated
a "deepening of the housing contraction" and "some softening in labor markets".
Subsequently, French bank Societe Generale SA said that bets on stock index
futures by a rogue trader had caused a 4.9 billion-euro ($7.2 billion) trading
loss, the largest in banking history. This led to speculation, rejected by the
bank, that the market declines in Europe on Monday were in part the consequence
of the Societe Generale unwinding trading positions linked to European stock
index futures on January 21, when equity markets in France, Germany and the UK
fell more than 5% and the day before the Fed rate cut.
"It's not possible that our covering operations contributed to the market's
fall,'' said Philippe Collas, the head of asset management at the bank,
according to a Bloomberg report on January 25.
The Fed in announcing its rate cut pledged to act in a "timely manner as
needed" to address the risks to growth, implying that it expects to cut the
federal funds rate rates still further and will consider doing so at its
scheduled policy meeting on January 30.
In overnight trade, Asian shares extended their losses. Japan's Nikkei 225
index accumulated its worst two-day decline in nearly two decades, losing more
than 5% and falling below 13,000 for the first time since September 2005.
Initially, the Fed move caused S&P stock futures to jump but within half an
hour they were lower than they had been at the moment the rate cut was
announced. The Dow Jones Industrial Average, down 465 points shortly after
market open, fluctuated throughout the day before closing with a milder drop of
126.24, or 1.04%, at 11,973.06, the first closing below 12,000 since November
3, 2006.
The move was the first unscheduled Fed rate cut since September 17, 2001 and
its largest increment since regular meetings began in 1994. It was a sharp
departure from traditional gradualism preferred by the Fed and wild volatility
in the market can be expected as a result. S&P equity volatility as
measured by the Vix index surged 38%, eclipsing the high set in August when the
credit crisis first surfaced.
The aggressive Fed action triggered a rebound in European stock markets, but
was not enough to stop the US equity market - which had been closed when
markets fell globally on Monday - from trading lower. At midday the S&P 500
index was at 1,302.24 down 1.7% on the day and 11.3% so far this year amid
mounting concern over the prospect of a US recession and further credit market
turmoil. While financial stocks had rebounded 1.8% in morning trading, other
main sectors were sharply lower, by a 3.4% decline in technology shares.
While the Fed has the power to independently set the discount rate directly and
keep the Fed Funds rate on target indirectly through open market operations,
the impact of short-term rates on monetary policy implementation has been
diluted by long-term rates set separately by deregulated global market forces.
When long-term rates fall below short-term rates, the inverted rate curve
usually suggests future economic contraction.
Both discount and Fed funds loans are required to be collateralized by
top-rated securities. Since August 2007, the Fed has been faced with the
problem of encouraging distressed banks to borrow from the Fed discount window
without suffering the usual stigma of distress, accepting as collateral bank
holdings of technically still top-rated collateralized debt obligations (CDOs)
which in reality have been impaired by their tie to subprime home mortgage debt
obligations that have lost both marketability and value in a credit market
seizure.
As economist Hyman Minsky (1919-1996) observed insightfully, money is created
whenever credit is issued. The corollary is that money is destroyed when debts
are not paid back. That is why home mortgage defaults create liquidity crises.
This simple insight demolishes the myth that the central bank is the sole
controller of a nation’s money supply. While the Federal Reserve commands a
monopoly on the issuance of the nation's currency in the form of Federal
Reserve notes, which are "legal tender for all debts public and private", it
does not command a monopoly on the creation of money in the economy.
The Fed does, however, control the supply of "high power money" in the
regulated partial reserve banking system. By adjusting the required level of
reserves and by injecting high power money directly into the banking system,
the Fed can increase or decrease the ability of banks to create money by
lending the same money to customers multiple times, less the amount of reserves
each time, relaying liquidity to the market in multiple amounts because of the
mathematics of partial reserve. Thus with a 10% reserve requirement, a $1,000
initial deposit can be loaned out 45 times less 10% reserve withheld each time
to create $7,395 of loans and an equal amount of deposits from borrowers.
But money can be and is created by all debt issuers, public and private, in the
money markets, many of which are not strictly regulated by government. While a
predominant amount of global debt is denominated in dollars, on which the Fed
has monopolistic authority, the notional value used in structured finance
denominated in dollars, which reached a record $681 trillion in third quarter
2007, is totally outside the control of the Fed. Virtual money is largely
unregulated, with the dollar acting merely as an accounting unit. When US
homeowners default on their mortgages en mass, they destroy money faster than
the Fed can replace it through normal channels. The result is a liquidity
crisis which deflates asset prices and reduces monetized wealth.
As the debt securitization market collapses, banks cannot roll over their
off-balance sheet liabilities by selling new securities and are forced to put
the liabilities back on their own balance sheets. This puts stress on bank
capital requirements. Since the volume of debt securitization is geometrically
larger than bank deposits, a widespread inability to roll over short term debt
securities will threaten banks with insolvency.
The Fed can create money, not wealth
Money is not wealth. It is only a measurement of wealth. A given amount of
money, qualified by the value of money as expressed in its purchasing power,
represents an account of wealth at a given point in time in an operating
market. Given a fixed amount of wealth, the value of money is inversely
proportional to the amount
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