The Fed Steps In

At today’s Federal Reserve Open Market’s Committee [‘FOMC’] meeting the Federal Reserve Board announced some major policy moves designed to ease credit markets further. Here’s the official press release: FRB: Press Release–FOMC statement–March 18, 2009

What the FOMC has decided to do is to expand the Fed’s own balance sheet by a further $1.5 trillion over the next few months. This is an excellent move. By expanding the its own balance sheet the Fed essentially provides liquidity to the market. It buys and holds assets which eventually it can sell at a profit. Meanwhile it receives interest on those assets. So this is not a ‘bailout’.

When the Fed moves like this it buys assets from private investors – in this case it will be banks and pension funds mainly – and thus provides those investors with cash to invest in other more attractive, better performing assets. The effect is to inject cash into what are now turgid markets, making them flow a lot better. Once the markets return to life assets that are currently sitting around in places where they are not wanted can be sold off to new owners who have more capital or a bigger appetite for risk. In other words the market allocation of risk can return to normal.

Not only does this move inject cash, but it helps in the assessment of losses on bank, insurance company, and pension fund books. Once markets are working again it becomes possible to discover the current value of an asset. There will be willing buyers who will bid for them and so a price can be set. One of the biggest issues besetting Wall Street currently is the dearth of willing buyers. No one knows the value of what they would be buying, so they don’t get involved in the market. This is what is meant by the ‘credit markets freezing up’. This Fed move will go a long way to restarting things.

Already since the announcement interest rates have moved favorably a sure sign that the initial reaction is very positive.

Just for the record the Fed’s balance sheet has traditionally been quite small: in the order of $750 billion to $1 trillion. It’s main assets are usually Treasury Bonds and its main liabilities are the cash we all carry around in our pockets [aka our ‘currency’]. However due to all the moves made during this crisis it has more than doubled from May 2007 to February 2009 – from $906 billion to $1.882 trillion – and this move will grow it more, all the way to approximately $3.25 trillion. Parenthetically: the doubling of the balance sheet over the last year did not mean a doubling of currency, instead most of the increase in liabilities went into bank reserves in an attempt to stimulate lending and provide capital to the banking system.

Finally on this story: we should all recall that this leaves the Fed with assets it can redeem in the future. It does not add to the deficit. It is what economists refer to as unconventional monetary policy. It is certainly unusual to have the central bank be such a major investor. But these are unusual times, and conventional monetary policy, lowering interest rates isn’t possible: they’re already at zero.

So this is good news.