PrefBlog

There has been a lot of commentary regarding the coordinated liquidity injection (discussed on December 12) led by the Fed. First to the plate was Stephen Cecchitti, who has written many high quality essays for VoxEU, the most recent of which was discussed on December 5.

The problem of credit tightness has as its most visible sympton a spike in LIBOR, as discussed on December 13 and December 14 (after the announcement) with a graph shown on November 28. Mr. Cecchetti claims that:

Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers. My guess is that banks were having enough trouble figuring out the value of the things they owned, so they figure that other banks must be having the same problems. The result has been paralysis in inter-bank lending markets.

and that the critical problem being addressed is:

The Fed can get liquidity to the primary dealers, but it has no way to ensure that those reserves are then lent out to the banks that need them.
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Not only do Central Banks need to ensure distribution of funds within a country’s banking system, they also need to make sure that cross-border distribution is adequate to meet the needs of banks in one country that require the currency of another. Today we have the new problem that dollars are in short supply outside of the United States.

He emphasizes that:

Standard open market operations give the Fed control over the level of short-term interest rates. The purpose of the Term Auction Facility is to give them a tool for influencing interest rate spreads.  

This is what I noted (in a much less knowledgable manner) on December 13:

The redemption of T-Bills is significant: it means there is (basically) no net improvement in systemic liquidity. What there is is simply a smearing of the extant Fed-provided liquidity over a broader section of the market. For a while.

James Hamilton of Econbrowser reviews the facility and concludes:

So why is it the responsibility of the Fed to try to set not just the level of the fed funds rate but also the spread between the funds rate and the LIBOR rate? One possibility is that the Fed thinks that the market is currently overweighting the riskiness of short-term interbank loans. If so, that seems to be a different vision of the role of monetary policy from that articulated by Ben Bernanke in 2002:

I think for the Fed to be an “arbiter of security speculation or values” is neither desirable nor feasible.

A second possible justification is that the market is correctly pricing the riskiness of these assets, but that the chief risk involves an aggregate financial event that the Fed, through actions like the TAF, could mitigate or avoid altogether.

I’m not sure that Professor Hamilton is focussing on the most relevant part of the Bernanke speech he references. I take note of:

Finally, if a sudden correction in asset prices does occur, the Fed’s first responsibility is to do its part to ensure the integrity of the financial infrastructure–in particular, the payments system and the systems for settling trades of securities and other financial instruments. If necessary, the Fed should provide ample liquidity until the immediate crisis has passed. The Fed’s response to the 1987 stock market break is a good example of what I have in mind

Bernanke’s speech continues with a presentation of the arguments in favour of accounting for asset prices when formulating central bank policy:

I think one can usefully boil down many of these arguments to the idea that it may be worthwhile for the Fed to take out a little “insurance,” so to speak, against the formation of an asset-price bubble and its potentially adverse effects. Like all forms of insurance, bubble insurance carries a premium, which includes (among other costs) the losses incurred if the Fed misjudges the state of the asset market or the cost of a possible reduction in the transparency of Fed policies. But, as a matter of theory, it is rarely the case in economics that the optimal amount of insurance in any situation is zero. On that principle, proponents of leaning against the bubble have argued that completely ignoring incipient potential bubbles, if in fact they can be identified, can’t possibly be the best policy. I will discuss below why I believe that, nevertheless, “leaning against the bubble” is unlikely to be productive in practice.
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But as a practical matter, this is easier said than done, particularly if we intend to use monetary policy as the instrument, for two main reasons. First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.
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The Federal Reserve went on to make a number of serious additional mistakes that deepened and extended the Great Depression of the 1930s. Besides trying to pop the stock market bubble, the Fed made little or no effort to protect the banking system from depositor runs and panics. Most seriously, it permitted a severe deflation in the price level, which drove real interest rates sky-high and greatly increased the pressure on debtors. A small compensation for the enormous tragedy of the Great Depression is that we learned some valuable lessons about central banking. It would be a shame if those lessons were to be forgotten.

The Fed Jackson Hole conference was discussed in PrefBlog on August 31 and September 4; a great deal of debate there centred on the proper role of Central Banks when confronted with a market pricing problem. I suggest that the Fed is terrified of a lock-up in the interbank markets and, by the new liquidity injection, is taking steps to ensure that such a lock-up doesn’t happen. This may thought of as the downside analogue of ‘leaning against the bubble’.

It may be thought to represent a change of thinking at the highest levels of the Fed, but I’m not so sure. I have a lot of confidence in these guys and do not think that they are idealistic zealots, parsing every suggestion for ideological purity and substituting slogans for thought. I suggest that they are beyond that and take a pragmatic approach: Whatever Works.

Paul Krugman of Princeton University, for instance, takes the view that the risk of a “liquidity trap” is rising:

Mr. Krugman, now at Princeton University, said no, but the risk of one has increased. “In general, we wouldn’t say that there’s a liquidity trap unless you’re up against the zero bound,” that is, when the short-term interest rate falls to zero, and can’t fall any lower. “So we’re not in one by the normal definition, which is a situation in which people are indifferent between cash and bonds, so that open-market operations in which the central bank trades monetary base for bonds have no effect.”

But he added: “What you could say, though, is that the unwillingness of banks to lend has reduced the effectiveness of Fed policy — and increased the likelihood that we’ll find ourselves in a liquidity trap sometime soon.”

If there’s one thing the Fed must do, it’s ensure its continued relevance! At the moment there is little evidence that credit tightening has affected the real economy and the Fed wants to keep it that way.

Prefs were down again today – particularly the BAM issues, which lends credence to prefhound‘s speculation in the comments to December 14 that Brookfield weakness could be due to their Hudson Yards project, which got a lot of ink in the Globe on the weekend.

There were thirty-five other index-included $25.00-equivalent issues trading over 10,000 shares today.

Update: Typo has been struck out of the notes for BNA.PR.C.

This entry was posted on Monday, December 17th, 2007 at 9:48 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.