After the Federal Reserve's blockbuster decision on Dec. 16 to cut its target rate to a range of zero to 0.25% and keep it there "for some time," market anticipation surrounding the Fed's Jan. 27-28 meeting dropped several notches. Having moved beyond conventional rate-setting, the Fed now is concentrating on keeping the markets abreast of its new policy, dubbed "credit easing" by Fed Chairman Ben Bernanke. That's not an easy task. Right now, the overall effort is an alphabet soup of about a half-dozen lending facilities and other programs with such acronyms as TAF and TALF, not to be confused with the Treasury's Dept.'s TARP. Credit easing took root as a side feature of traditional policy about a year ago. Now it's the main event, and Bernanke & Co. are trying to communicate to investors how all the pieces fit together as a unified policy and what its goals are.
Bernanke took a stab at it in a speech on Jan. 13. The strategy comprises three sets of programs. The first group enhances liquidity via the Fed's traditional role as lender of last resort to banks. These are programs that make loans of cash or Treasury securities in exchange for less-liquid collateral.
The second set is aimed at supplying liquidity outside the banking system directly to borrowers and investors in key credit markets. These activities include the upcoming program, to be coordinated with the Treasury, to buy up to $200 billion of asset-backed securities, debts backed by car loans, credit cards, and student loans.
Finally, the Fed has begun to buy longer-term securities, most notably some $600 billion in debt and mortgage-backed paper held by federal agencies. On Jan. 28 it reiterated that it's prepared to buy longer-dated Treasuries. The objective of the Fed's new direction is to lower a broad range of interest rates and foster easier credit conditions, even though the Fed has run out of room to lower its target rate.
Instead of manipulating its target rate, the Fed now uses its balance sheet as an instrument of policy. Operating all these tools implies a huge expansion in the volume of the Fed's assets. The asset side of the balance sheet increases by the value of either the new loan collateral or the securities bought, and the corresponding funds that enter the banking system show up on the liability side. Since the September turmoil, the Fed's balance sheet has exploded from $940 billion to $2.1 trillion, and as new programs begin, the total could hit $3 trillion.
But will it all work? The new problem is the recession's severity, which is eroding the credit quality of household and business borrowers. The weakening economy and tighter credit conditions are now mutually reinforcing, as individuals and banks are even more hesitant to invest and lend.
Housing, so crucial to a recovery, is a prime example of these headwinds. Anticipation of the Fed's plan to buy mortgage-backed securities has pushed fixed rates down sharply, but conventional mortgages, those conforming to federal guidelines, are still difficult to obtain and often have costly restrictions. Large, or jumbo, loans are even more restrictive.
Even if the December jump in existing home sales is a sign of stabilizing demand, heavy inventories imply little relief from home price declines this year. The fall accelerated in November. More price declines mean more defaults, more losses on mortgage-backed securities, and more writedowns that destroy bank capital and make banks less able to lend.
Another potential obstacle could be the bond market's recent negative reaction to all the Treasury borrowing required by the Administration's fiscal stimulus. The yield on 10-year Treasury notes has risen since mid-January from 2.2% to 2.7%, lifting mortgage rates along with it. If the rise continues, it could be the trigger for the Fed to begin buying Treasuries.
The Fed's unique ability to create money means there is virtually no limit on how much the Fed can expand its balance sheet. The question is not: Will this new policy work? The key to a recovery is: When will it work?