The Federal Reserve is pushing its limits

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by J. Alfred Broaddus J

The Federal Reserve has taken several unprecedented and highly aggressive steps to contain the credit crisis since it erupted last August.  Beyond a sharp easing of interest rates, which has brought the target federal funds rate down 3.25 percentage points, the Fed has

• reduced the “discount” rate it charges for loans to commercial banks by a comparable amount;
• increased the maximum term of those loans from 30 to 90 days;
• put a so-called Term Auction Facility in place that allows banks to borrow from the Fed in a less visible manner, thereby reducing their risk of stigma;
• expanded the scope of its existing program for lending securities to banks; and
• perhaps most notably, instituted a Primary Dealer Credit Facility (PDCF) that, for the first time, will enable investment banks, as distinct from commercial banks, to borrow directly from the Fed against a broad range of collateral.

Finally, and most visibly to the average American, in mid-March the Fed aided JPMorgan Chase in its acquisition of Bear Stearns, an investment bank that was about to fail. The Fed provided a $30 billion enabling loan to Morgan in which the Fed accepted the risk of holding $29 billion of questionable collateral. 

In an early April speech, former Fed Chairman Paul Volcker said that some of these actions “extend to the very edge of [the Fed’s] lawful and implied powers, transcending in the process certain long-embedded banking principles and practices.”  While avoiding any direct criticism of the Fed, Volcker clearly was concerned about these actions and the precedents they set. 

Why the concern?  After all, the Fed’s steps — as of this writing — appear to have stabilized financial markets to some degree and therefore have reduced the risk that persistent financial turmoil presented to the broader economy. 

Nonetheless, there are at least two reasons for concern. The first is well-known and widely discussed in the media: In facilitating the acquisition of Bear and creating a permanent facility (the PDCF) that may take similar actions in the future, the Fed could perpetuate excessive risk-taking in financial markets.  A good case can be made that calling the Bear loan a “bailout” is inaccurate because the investment bank’s shareholders have suffered huge losses.  But the perception that the Fed is now more willing to intervene with emergency financial assistance in situations like this one may increase overall “moral hazard” in the markets.

The second reason for concern is, in this writer’s view, at least as important as the first.  The Fed’s actions summarized above are distinct from its ongoing conduct of monetary policy, in which it regulates the growth of the nation’s money supply to contain inflation and smooth out some of the short-term ups and downs in the economy.  They are more properly regarded as “credit policy,” to use a phrase coined by Marvin Goodfriend, a former Richmond Fed senior policy adviser. 

Fed credit policy actions change the composition of the assets on its balance sheet.  Before the current financial crunch, Treasury securities accounted for close to 90 percent of the value of these assets.  By early April that share had declined to a little more than 60 percent.  Much of the departed Treasuries share has been replaced by loans to banks, which are collateralized by lower-quality securities.  If the Fed suffers losses on any of this collateral, its earnings on its securities portfolio will be reduced commensurately, lowering the Fed’s annual remittance of most of its earnings to the Treasury.  This reduction, in turn, would have to be made up by reduced federal spending or higher taxes in the context of the overall federal budget. 

Federal expenditures and taxation, however, constitute fiscal policy, which is — appropriately — the province of Congress.  Fed entanglement in fiscal policy as a result of its recent credit policy actions and any similar actions in the future would, over time, almost certainly reduce the Fed’s independence from political pressure and undermine the credibility of its efforts to accomplish its principal mission:  protecting the buying power of the nation’s currency. 

This, in turn, could well destabilize the financial system more fully and more permanently than even the bad decisions that produced the current crisis.

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