April 9, 2008
Fed Weighs Its Options in Easing
Crunch
By GREG IP
April 9, 2008; Page A3
WASHINGTON -- The Federal Reserve is considering contingency plans for
expanding its lending power in the event its recent steps to unfreeze credit markets
fail.
Among the options: Having the Treasury borrow more money than it needs to
fund the government and leave the proceeds on deposit at the Fed; issuing debt
under the Fed's name rather than the Treasury's; and asking Congress for
immediate authority for the Fed to pay interest on commercial-bank reserves
instead of waiting until a previously enacted law permits it in 2011.
• The Issue: The Fed has sold or committed a lot of its Treasury portfolio to
support markets. Some worry it will soon run out of room to do more.
• The News: The Fed is considering several contingency plans for getting more
lending capacity so that won't happen.
• The Bottom Line: The Fed has lots of firepower left before it has to turn to these
contingencies.
No moves are imminent because the Fed still has plenty of balance sheet room for
additional lending now. The internal discussions are part of a continuing effort at
the Fed, similar to what is under way at foreign central banks, to determine its
options if the credit crunch becomes even more severe. Fed officials believe the
availability of such options largely eliminates the risk of exhausting its stockpile of
Treasury bonds and thus losing its ability to backstop the financial system, as some
on Wall Street fear.
British and Swiss central banks also are contemplating contingency plans. For now,
the European Central Bank is reluctant to consider options that require substantial
modifications of its standard tools.
The Fed, like any central bank, could print unlimited amounts of money, but that
would push short-term interest rates lower than it believes would be wise. The
contingency planning seeks ways to relieve strains in
credit markets and restore liquidity without pushing
down rates.
The Fed is reluctant to heed calls from some Wall
Street participants and foreign officials for the Fed to
directly purchase mortgage-backed securities to help
a market that still is not functioning normally.
Before the credit crunch began in August, the Fed had
$790 billion in Treasury securities on its balance
sheet, about 87% of its total assets. Since then, it has
sold or lent about $300 billion. In their place, the Fed
has made loans to banks and securities firms to assist
them in financing holdings of mortgage-backed and
other securities. Some on Wall Street say the
potential for further declines in Fed treasury holdings
could leave it out of ammunition.
The Fed holds assets to manage the nation's money
supply and influence the federal-funds rate, which
banks charge each other on overnight loans. When
the Fed buys Treasurys or makes loans directly to
banks, it supplies financial institutions with cash; in effect, it prints money. The
cash ends up as currency in circulation or in banks' reserve accounts at the Fed.
Since reserves earn no interest, banks lend cash that exceeds their required
minimum. That puts downward pressure on the federal funds rate, currently
targeted by the Fed at 2.25%. The Fed could purchase securities and make loans
almost without limit, expanding its balance sheet. That would cause excess reserves
to skyrocket and the federal funds rate to fall to zero. The Fed would contemplate
such "quantitative easing" only in dire circumstances. The Bank of Japan took this
step this decade after years of economic stagnation.
Weighing the Possibilities
So the Fed is seeking ways to expand its balance sheet without causing the federal
funds rate to drop. The likeliest option, one the Fed and Treasury have discussed, is
for the Treasury to issue more debt than it needs to fund government operations.
The extra cash would be left on deposit at the Fed, where it would be separate from
bank reserves on deposit and thus would have no impact on interest rates. The Fed
would use the cash to purchase an offsetting amount of Treasurys in the open
market; for legal reasons, it generally cannot buy them directly from Treasury.
Treasury's principal constraint is the statutory limit debt. Treasury debt was $453
billion below the limit Monday. In the past, Congress always has responded to
administration requests to raise the limit, sometimes only after political theatrics.
Fed officials also are investigating the feasibility of the Fed issuing its own debt
and using the proceeds to purchase other assets or make loans. It has never done so;
the legality is unclear. Some foreign central banks, such as the Bank of Japan, do
so.
Another possibility is seeking congressional approval to pay interest on banks'
reserves immediately instead of waiting until a 2006 law permits that in 2011. If the
Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out
excess reserves once the federal funds rate fell to that level.
Congress put off the effective date because paying interest on reserves reduces the
Fed profits that are turned over to the Treasury each year, widening the budget
deficit. Although preliminary explorations suggest Congress would be open to
accelerating the date, the Fed is leery of depending on action by Congress.
The Fed is inclined to use any additional maneuvering room to lend through its
existing and recently expanded avenues. Officials are reluctant to buy mortgagebacked securities directly. They worry that such purchases would hurt the market
for MBS that the Fed is not permitted to buy: those backed by jumbo and subprime
and alt-A mortgages, which are under the greatest strain.
Moreover, the Fed is not operationally equipped to hold MBS and would probably
have to outsource their management. Such holdings wouldn't help avert
foreclosures much, since the Fed would have little control over the mortgages that
comprise MBS.
Write to Greg Ip at greg.ip@wsj.com1
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