Federal Reserve Chairman Ben Bernanke has made a significant speech in Austin Texas:
in my view, the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. In such cases, intervention is necessary to protect the public interest. The problems of moral hazard and the existence of institutions that are “too big to fail” must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and to address the problem of “too big to fail” should be a top priority for lawmakers and regulators.
No more Lehmans!
In the absence of an appropriate, comprehensive legal or regulatory framework, the Federal Reserve and the Treasury dealt with the cases of Bear Stearns and AIG using the tools available. To avoid the failure of Bear Stearns, we facilitated the purchase of Bear Stearns by JPMorgan Chase by means of a Federal Reserve loan, backed by assets of Bear Stearns and a partial guarantee from JPMorgan. In the case of AIG, we judged that emergency Federal Reserve credit would be adequately secured by AIG’s assets. However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan sufficient to pay off the firm’s counterparties and continue operations. The firm’s failure was thus unavoidable, given the legal constraints, and the Federal Reserve and the Treasury had no choice but to try instead to mitigate the fallout from that event.
Fortunately, we now have tools to address any similar situation that might arise in the future.
But Lehman wasn’t the Fed’s fault!
Indeed, the actual federal funds rate has been trading consistently below the Committee’s 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target. We will continue to explore ways to keep the effective federal funds rate closer to the target.
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Footnote:Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.
Acknowledging the puzzle of the Effective Fed Funds Rate and saying he doesn’t know how to fix it either. His provisional explanation – that it’s mainly an administrative log-jam – fits with my earlier hypothesis:
I will suggest, however, that the immense volume of Fed Funds has simply overwhelmed the operational procedures set up in calmer times; accounts need to be opened, credit limits need to be increased, all the bureaucracy of modern banking has to be brought to bear on the issue before we can again deal with a situation in which liquidity may be approximated to “infinite”.
Back to Dr. Bernanke:
Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver–the provision of liquidity–remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.
Quantitative easing, here we come! This is step one of Econbrowser‘s James Hamilton’s plan, discussed here on November 21.
Bloomberg reports:
Treasury prices rose on Bernanke’s remarks, with yields on 10-year Treasuries tumbling about 10 basis points to 2.74 percent and two-year notes dropping to 0.85 percent.
Also of note was a Bloomberg report that at least one Government Bond fund is being squeezed into guaranteed corporates:
BB&T, BlackRock Inc., T. Rowe Price Group Inc. and Sage Advisory Services Ltd. are looking elsewhere for returns, including bonds of the banks that were almost ruined by $967 billion in losses and writedowns since the start of 2007. Treasury funds are receiving permission to buy debt of Morgan Stanley, JPMorgan Chase & Co. and Goldman Sachs Group Inc. after the Federal Deposit Insurance Corp. finalized plans on Nov. 21 to guarantee their debt.
