On Monday the Federal Reserve proposed a new term deposit facility that would allow the Fed to borrow directly from private institutions. Here I offer some thoughts on how this fits into the Fed’s long-term plans and what its implications for the rest of us might be.

Let’s begin with some background on how we got here. The Fed’s conception has been that the core problem we have been going through was a credit crisis– banks stopped lending and institutions stopped buying mortgage-backed securities, as a result of which businesses and consumers could not borrow adequate amounts. The Fed’s goal was to step in where private lenders would not, with the Fed initially lending directly to private banks through a new term auction facility and to foreign central banks through currency swaps, supporting issuers of commercial paper through the commercial paper funding facility, and lending broadly through a number of other new facilities. During 2009, these new programs were largely phased out and replaced by outright purchases of mortgage-backed securities and agency debt. The graph below details the asset holdings of the Federal Reserve over the last three years. Fed assets more than doubled in the fall of 2008 and remain at those elevated levels to this day.

Federal Reserve assets, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to December 23, 2009. Wednesday values, from Federal Reserve H41 release.
Agency: federal agency debt securities held outright;
swaps: central bank liquidity swaps;
Maiden 1: net portfolio holdings of Maiden Lane LLC;
MMIFL: net portfolio holdings of LLCs funded through
the Money Market Investor Funding Facility;
MBS: mortgage-backed securities held outright;
CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility;
TALF: loans extended through Term Asset-Backed Securities Loan Facility plus net portfolio holdings of TALF LLC;
AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III plus preferred interest in AIA Aurora LLC and ALICO Holdings LLC;
ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility;
PDCF: loans extended to primary dealer and other broker-dealer credit;
discount: sum of primary credit, secondary credit, and seasonal credit;
TAC: term auction credit;
RP: repurchase agreements;
misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding;
other FR: Other Federal Reserve assets;
treasuries: U.S. Treasury securities held outright.

Where did the Fed get the funds to do all this? At one level, the answer is simple– the Fed simply created the funds, unilaterally declaring that the seller of the asset or recipient of the loan now had a corresponding increase in that institution’s balance with the Federal Reserve. Those balances ultimately represent claims on green U.S. dollars, which the banks holding the credits could at any time request the Federal Reserve to deliver to the banks in armored vans. It is an accounting identity that any purchases or loans by the Fed necessarily have the consequence that the dollars thereby created must end up somewhere. One can therefore equivalently summarize the actions of the Fed in terms of the liability side of its balance sheet, which consists primarily of the credits created or dollars delivered. The graph below summarizes Fed liabilities over the last three years. The height of the graph for each week is by definition the same as that of the previous graph. Whereas the first graph summarizes what the Fed is holding, the second summarizes who is holding the stuff the Fed has created.

Federal Reserve liabilities, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to December 23, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

In normal times, the credits created by the Fed would not be held passively by banks at the end of the day, but would be actively lent out in a process that ultimately would result in the credits ending up as cash held by the public. However, so far there has been only a modest boost to currency, with the vast majority of the funds created by the Fed sitting idle at banks, represented by the green area in the graph above.

Year over year percent change in weekly currency held by the public. Source: FRED.

If banks were to return to the historical patterns of managing reserves, the trillion in excess reserves would end up as circulating currency with dramatically inflationary consequences. So there has been considerable discussion within the Federal Reserve of an exit strategy, or how to undo the doubling of the Fed’s balance sheet. Plan A is that the problem will take care of itself. As the economy improves, the need for the Fed to hold on to these loans and assets diminishes, and the Fed would stop rolling over loans and sell off assets to destroy the reserves it had previously created.

But there’s always been a serious question as to whether the Fed would risk sabotaging a fragile recovery by removing its support too quickly. For this reason, Fed officials have a number of backup plans in mind. The Fed set the stage for one of these by introducing the policy of paying interest on reserves in the fall of 2008. One of the reasons banks are content at the moment to let the reserves created by the Fed stand idle overnight is that, unlike the earlier rules, banks now earn interest on those idle balances. If banks become less willing to hold those surplus funds, the Fed could simply raise the interest rate it paid on deposits to whatever it took to persuade the banks to keep the reserves in their account with the Fed. In effect, reserves held in account with the Fed today function just like treasury bills. But whereas bills are used by the U.S. Treasury to borrow from the public, reserves are used by the Fed to borrow from banks, the proceeds of which borrowing the Fed has used to purchase MBS.

The problem with raising the interest rate as an exit strategy is the same as the problem with Plan A– the Fed is unlikely to want to raise interest rates as long as significant risk of a double downturn remains. Last summer Bernanke also detailed two other possible tactics, both of which again amount in effect to direct borrowing by the Fed. Initial steps to implement both of these have subsequently been announced by the Fed.

The first strategy would use reverse repos, which are essentially collateralized short-term loans from private institutions to the Fed. These are currently at around $60 billion, though the Fed has conducted preliminary steps for implementing these on a much bigger scale if need be.

The second strategy is Monday’s proposal for a term deposit facility:

Under the proposal, the Federal Reserve Banks would offer interest-bearing term deposits to eligible institutions through an auction mechanism. Term deposits would be one of several tools that the Federal Reserve could employ to drain reserves to support the effective implementation of monetary policy.

This proposal is one component of a process of prudent planning on the part of the Federal Reserve and has no implications for monetary policy decisions in the near term.

Like the expanded reverse repos, currently this still appears to be in the nature of contingency planning, getting the apparatus in place if needed. But it is the most direct implementation of the essence of the other two devices, namely, the proposal is for the Fed to borrow directly from the public in order to be able to support the prices of mortgage-backed securities and agency debt.

We sometimes describe fiscal policy as determining the overall level of the public debt, while monetary policy determines the composition of that debt between money and interest-bearing federal obligations. By that definition, the Fed has clearly now entered the realm of implementing fiscal policy, by issuing debt directly in the form of interest-bearing reserves, reverse repos, and now term deposits.

The Fed would no doubt argue that it is doing so wisely, and that the decision to absorb Fannie and Freddie’s debt and mortgage guarantees into the fiscal liabilities of the U.S. government has already been made by Congress and the President. The Fed is simply taking that reality as given and trying to minimize collateral damage.

Or one might see it this way: political pressures had been the cause of the quasi-nationalization and then de facto nationalization of mortgage debt in the first place, and the Fed found itself inextricably drawn into the mess. There is now political pressure to inflate the debt away, from which pressure the Fed nevertheless sees itself as immune.

But I fear that as this marriage between fiscal and monetary policy becomes consummated, an amicable divorce is not the most likely outcome.

My advice would be the sooner the Fed can return to plain vanilla central banking, the better.

Olivier Garrett, CEO of Casey Research, brings Contrarian Profits readers his analysis of the current state of the U.S. economy, including a look back at the deceisions of the Federal Reserve since this economic crisis began.

Olivier Garrett (Casey Research):

Ben Bernanke is a dubious choice to be named “Person of the Year” by Time magazine.  While Time’s Managing Editor Richard Stengel credits him with recognizing early and reacting appropriately to the ongoing financial crisis, in reality, he was wrong time and again with both his predictions and his remedies. Just remember these gems:

• On July 1, 2005, Bernanke stated without hesitation that we were not experiencing a housing bubble: “I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit.”
• November 2005, on derivatives: “With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly.” And “the Federal Reserve’s responsibility is to make sure that the institutions it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well managed and do not create excessive risk in their institutions.”
• February 15, 2006: “Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”
• February 2008: “I expect there will be some failures of smaller banks” (Bear Stearns collapsed a couple of weeks later).
• But then again, I guess in regards to his nomination we are talking about achievements in 2009. That was the year Bernanke said, “Currently, we don’t think [the unemployment rate] will get to 10 percent.”

This is the same chairman of the Federal Reserve who told us that Fannie and Freddie were “adequately capitalized” and “in no danger of failing.”  

Unfortunately, he has not just been wrong about housing, unemployment, banking, and derivatives — his policies have directly contributed to all of the problems we now face.

High unemployment and the weak dollar threaten to further undermine our economy, yet his policy is to just keep borrowing. The massive debt his policies have foisted on the American taxpayer is weakening the U.S.’s position as global economic leader and hurting already tenuous relations with foreign governments. Bernanke has supported the policies of Greenspan and our current and previous administrations – the very policies that got us into this mess.  He has supported the leveraging of the American economy to rescue companies long past saving and the  borrowing of billions from foreign governments to line the pockets of corrupt investment bankers. 

I could recommend a few alternative names for runner-up, if Time’s criteria are really as dubious as they appear:

• Lloyd Blankfein from Goldman Sachs for robbing taxpayers legally
• Rick Wagoner of GM for taking the world’s largest car maker to bankruptcy in a quarter-century
• Tim Geithner for ensuring that all of our bankers prospered during the worst financial crisis since the ‘30s
• Tiger Woods for providing the nation with great dinner conversations and helping to spur tabloid sales.

Bernanke is insistent on using inflation to make our personal debts seem small, all the while setting the country up for a much larger disaster long term. Bernanke is borrowing from Peter to pay Paul… and robbing taxpayers to pay Peter. 

As you may have noticed, the government will not save you from the reverberations of a declining U.S. economy. You’ll have to take matters into your own hands… and no one is better at pointing the way than the editors of The Casey Report. No matter how dire the economic trend, double- or triple-digit gains within 12 to 24 months are easy if you discover the right opportunities to profit. Find out more by clicking here.

Bill Bonner, daily columnist for The Daily Reckoning, UK Edition, turns his attention today to the latested antics of the U.S. Fed Chairman and the ten year rolling trends in the U.S. stock market.

Bill Bonner (The Daily Reckoning, UK):

Gold rose $15 yesterday. What to make of it?

Perhaps it was because Ben Bernanke’s extended his “extended period” pledge?

He said, in effect, if this economy doesn’t come out of its slump, it won’t be his fault. He’ll keep monetary policy as loose as possible for as long as possible. Not that we had any doubt about it. He has a theory. It’s a bad theory, but it’s all he has. And it tells him that you fight a depression with loose money.

So, what do you expect? Interest rates will remain artificially low as long as Bernanke can get away with it… or until the depression ends… whichever comes sooner.

That said, he hardly has to lift a finger. Judging from the last auction of short-term Treasury debt, lenders can’t think of anything better to do with their money than to give it to the government – in return for nothing. The last auction produced a yield of zero on one-month loans.

We went to visit a pair of clever Swiss bankers yesterday. These fellows manage money for clients all over the world. What do they think? They were focused on stocks:

“This year, the people who made the most money were those who were most heavily invested in equities. And if the patterns of the past hold up, 2010 will be a good year for equities too.

“Whenever the ten-year performance goes close to zero, the next few years tend to be very good for stock market investors.

“In fact, there has never been an exception, going all the way back to 1881. Last year was one of the worst years in stock market history. This has been one of the best. And next year should be one of the best too.”

He handed us a chart to illustrate his point. It shows the 10-year performance of the stock market.

We see that very rarely are stock market returns negative over a 10-year period. In fact, there are only two worth mentioning. One was in the ‘30s, when in August ‘39 stocks had returned MINUS 4.68% for the previous ten years.

The other major losing period came in February of this year, when investors had gotten an average annual return of -3.43% since 1999.

The message seems simple enough. When the market turns down sharply… expect a sharp turn-up to follow. But studying the chart more carefully, we see two things.

Click here for the rest of Mr. Bonner’s commentary on The Daily Reckoning, UK Edition.

~~~

Source:
Person of the Year, My Foot! Bernanke “Failed Miserably,” Chris Whalen Says
Aaron Task
Yahoo Tech Ticker, Dec 16, 2009

http://finance.yahoo.com/tech-ticker/person-of-the-year-my-foot!-bernanke-”failed-miserably”-chris-whalen-says-391846.html

By Andrew Snyder, TodaysFinancialNews.com

Baltimore — (TFN): It’s not an award I would want. First Putin, then Obama, now Bernanke. Big Ben is not joining the best of company with his “Person of the year” award. If history is an indication, the Fed boss’ approval rating will be significantly lower in the next twelve months.

As if being the master of the secret domain known as the Federal Reserve isn’t a hard enough job to handle, Time goes and slaps Bernanke on the cover and tells us the award is due not because of where Bernanke got us today, but because of where we have not ventured.

In other words, it’s like giving out a Nobel Prize to a guy with big plans for humanity, never mind the fact the goal of world peace is further away than ever before and Iran proved today it is just a step away from nuking Israel.

I am not sure what Time’s policy is on awarding this title posthumously, but it may be something worth investigating. After all, the true ramifications of letting one, unelected politically motivated man in charge of a great nation’s monetary future isn’t a near-sighted event. It could be a while to we learn Bernanke’s true merit.

Who knows, this time next year, China’s president, Hu Jintao, could be gracing the glossy’s cover as we hail his decision to extend our debt obligations for just a couple more years while we get things back on track.

I am not saying Bernanke didn’t do a decent job. I’m saying we should wait before sending him any praise. Last I checked, one out of every ten of my fellow Americans was in the unemployment line and currency risk is rising across the globe.

But that can’t have anything to do with free money flowing from the Fed, can it?

*** By now, you’ve got to know my thoughts on gold… sell the stuff. I was all about the precious metal this time last year, but that was a different situation and time. Now, you can’t turn on the radio, TV or open the newspaper without hearing some pitchman’s take on the stuff.

Remember the contrarian motto: when everybody else wants in, you want out.

For those of you that are viewers of late-night cable news parodies, I am a huge fan of Comedy Central’s Colbert Report. When trends get out of control, his dry humor has a way of bringing things back to Earth.

That’s why when Colbert talked about the sudden rush to the gold markets this week, I knew we were in trouble.

Here’s what I told TFN readers this morning:

“Finally an up day for gold. After sliding for nearly two weeks, the precious metal is moving far enough into positive territory today to bother noting it.

“Did Glen Beck up his marketing? Did Rush bring on a few more listeners? Or is this yet another example of the Colbert bump?

“Does it even matter? Nope, when gold is getting this much attention, the only thing that matters is how quickly you dump your position.

“Gold is supposed to be the safest investment around. Just as real estate investors love to say, there is only so much of the stuff. Unfortunately, we all know how well the real estate folks are doing these days.

“Back in the day when gold actually backed the nation’s debt and played an integral role in the monetary system, a horde of gold made sense. But today, when it’s only value comes from the fact we say its valuable, gold’s no different than a fiat currency.

“If the economy collapses like so many gold bugs are sure is about to happen, wouldn’t you rather have something of tangible value? Colbert is right. Sheep are the way to go. Better yet, follow the natives and take advantage of a buffalo’s ability to provide food and shelter.

“While I’m pushing the argument over the top, many investors are using similar logic in their bullish pursuit of gold. It has created a micro-bubble that is ready to burst.

“That is not good news for the investors that have piled into the junior gold miner sector.”

Keep reading to learn why.

*** I cannot believe this is not getting more press. If you think a handful of bank failures dealt a blow to your portfolio, wait until you see what happens when a few heavy-hitting governments begin to drop.

The good-old-boy network is alive and well on Wall Street. Just about every major financial firm has some vested interest in its “competition.” But it is nothing like the international scene where friendships and rivalries date back centuries and nuclear weapons are used as bargaining tools.

Less than a month ago, Dubai started the default-scare trend. Since then, we’ve heard from Greece, Austria and Spain. Earlier this week, Mexico made the list when Standard and Poor’s cut our southern neighbor’s credit rating.

This is not good news. It proves that, although the dollar looks weak, it’s stronger than its competition. In all things financial, value is relative.

Over the next few weeks, the dollar is going to strengthen, the Dow will drop and gold bugs will wonder what all the hoopla was about.

With most investors working on polishing their year-end portfolio, now is a good time to get in position to take advantage of the upcoming action. Come January 1, it’s a whole new game.

Person of the Year 2009

I have nothing to say about this.

Feel free to go off in comments . . .

As much as I disagree with the macro view currently being espoused by Merrill Lynch (too optimistic), I completely agree with their just-released view on tampering with the Fed.

This is a topic that was covered Friday by Bonddad, who compares Why the Audit the Fed Movement is the Equivalent of Economic Birthers.

Here is Merrill’s Senior US Economist on the Fed Audit:

“The Federal Reserve System is facing its most extensive scrutiny in several decades. Plans to audit the Fed’s monetary policy decisions are likely to raise expected and actual inflation, reduce financial stability, and undermine policy transparency. In our view, a significant erosion of Fed independence represents one of the greatest long-term risks to the outlook.

Just about every major central bank today conducts day-to-day policy — setting interest rate targets or some other policy instrument — without direct political oversight. The proposed audits of the Fed’s interest rate decisions do not directly compromise the Fed’s independence along this dimension, but they do represent a sizable step down the slippery slope of politicizing US monetary policy.

The current proposal is supposed to avoid direct political interference by imposing a six-month lag between Fed decisions and potential audits of those decisions. However, for policy to be pre-emptive, the Fed must start hiking before the economy has fully returned to normal. Moreover, moving from warning about a possible hike to finishing a tightening cycle can take the Fed several years. These policy lags give Congress ample opportunity to double-guess the Fed before the hiking cycle is completed. The mere hint of a delay in raising rates could ratchet up inflation expectations.

Politicians are not known for their restraint when it comes to manipulating the economy to gain potential votes. Most democracies have chronic budget deficits, and fiscal policy is often eased ahead of elections. Applying these same principles to monetary policy is a recipe for ever-escalating inflation.[…]

Criticizing the Fed once again seems to be a sure-fire way to gain votes this political cycle. But we think it is a far cry from a responsible way to implement sound economic policy.[...]

We think it is ironic that those who criticize the Fed for laissez faire policies earlier in the decade are now lining up behind a Fed audit proposal introduced by a devout libertarian. One, if not both, of these sides is bound to be disappointed with the likely consequences should it become law.

>

Sources:
How not to fix the Fed
Michael S. Hanson, Senior US Economist
Merrill Lynch, 11 December 2009

http://www.ml.com/index.asp?id=7695_8137

Why the Audit the Fed Movement is the Equivalent of Economic Birthers
Hale Stewart
Bonddad Blog, December 11, 2009

http://bonddad.blogspot.com/2009/12/why-audit-fed-movement-is-equivalent-of.html

That’s a question recently taken up by
the Wall Street Journal. Here are my thoughts.

Before we can discuss this issue, we’d need to agree on what we mean by a “bubble”. Here’s one definition that a lot of people may have in mind: a bubble describes a condition where the price of a particular asset is higher than it should be based on fundamentals and will eventually come crashing back down.

If that’s what you believe, then there’s a potential profit opportunity from selling the asset short whenever you’re sure there’s a bubble. And if that’s the case, my question for you would be, why don’t you do put your money where your mouth is instead of telling the Fed to do it for you? Your answer might be that it could take years for the bubble to pop, and you’re not willing to absorb the risk in the interim. Or maybe you don’t have the capital to cover the necessary margin requirements while you’re shorting the bubble on the way up.

Even so, posing the statement in this way should bring a dash of humility to those currently claiming to see a plethora of bubbles that the Fed supposedly needs to fight. What exactly persuades them that they are right and all the other players in the market are wrong? How much of their personal wealth are they staking on the strength of their convictions? And even if you’re absolutely sure you know how to identify bubbles, raising interest rates as a response is, as Tim Duy observes,
“a rather blunt weapon that kills indiscriminately”.

Another concept of a bubble that some people may instead have in mind is one involving the fundamentals themselves, in the form of temporarily and unsustainably low interest rates that are causing the temporarily and unsustainably high asset price. Professor James MacGee of the University of Western Ontario had an interesting discussion (hat tips: Marginal Revolution and reader Robert Bell) of why house prices in the U.S. overshot their long-run values by so much more than those in Canada.

Indexes of house prices in the U.S. and Canada. Source:
MacGee (2009).

MacGee notes that the Bank of Canada, like the U.S. Federal Reserve, had lowered interest rates quickly in 2001-2002, though it did not follow the U.S. quite as far down in 2003-2004.

Interest rate targets for the U.S. Federal Reserve and Bank of Canada. Source:
MacGee (2009).

The Canadian path for interest rates is closer to the one that Stanford Professor John Taylor has suggested that the U.S. should have followed.

Source: Taylor (2007).

MacGee argues, and I agree, that weak underwriting standards in the U.S. were a bigger problem than the low interest rates. And we share Tim Duy’s assessment that better regulation would have been more important than getting the interest rate right. Nevertheless, I am also sympathetic to Taylor’s suggestion that the exceptionally low U.S. interest rates in 2003-2004 were pouring fuel on the fire.

It is hardly the role of the Fed to be deciding that it knows better than the market what the price of every asset should be. Nevertheless, I think it is necessary for the Fed at least to be forming an opinion about what’s driving asset prices as one input into the Fed’s decision making. Booming U.S. real estate prices were accurately signaling that there was a problem with both the interest rate target and financial supervision, and it’s desperately important to ensure that this same mistake is never repeated.

Of course, it’s easy enough to say what should have been done in 2004. but the real challenge is figuring out what to do in 2010. Are commodity prices experiencing a bubble right now, and if so, is it something the Fed needs to stop? To me, the evidence suggests that U.S. interest rates are an important factor in recent movements in relative commodity prices. I also believe that further big increases in commodity prices could be destabilizing for the real economy. Nevertheless, other economic objectives take precedence at the moment, and it is too early to start raising rates yet. But it is not too early to remember that there are limits to how much you can help the U.S. economy by keeping interest rates low.

I suggest watching commodity prices in the months ahead as one practical guide for acting on that wisdom.

via RJ Matson, NY Observer

THIS is simply brilliant and hysterical: Dr. Blankcheck von Moneypants

Go watch it now.