Wednesday, September 17, 2008

The Fed is Broke

Three months ago we published Why Bennie Can't Lend, detailing the Fed's balance sheet and the limitations they were up against. We contended that they were out of cash and unable to sell their bond holdings without serious consequences. That is why their incremental actions have been limited to the TSLF, where they loan out the actual bonds rather than cash. Today, the Fed admitted that we were right all along by arranging for the US Treasury to raise more money for them so they can keep lending via the alphabet soup of liquidity facilities.

The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week. To manage the balance sheet impact of (ed. - ie. pay for) these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program,
which will provide cash for use in the Federal Reserve initiatives.

Basically, this is simply another holding action by the Fed to prevent the "fire sale" (actual price discovery) of assets held across many financial institutions. Yet the implications are profound. This would have been a perfect opportunity for the Fed to print money if it had any intention of actually doing so. Yet they did not, even under the extreme pressure of Lehman failing and AIG bailing. Instead they chose to stay within the framework of fractional-reserve banking and they BORROWED instead. If they were going to conjure money out of thin air, this would have been the time to do it and they demurred.

We believe that this is a shock to the market in a number of ways. It clearly demonstrates the limitations of the Fed's power when many market participants believe that power to be virtually unlimited. It shows that the Fed is no different than any commercial bank in this regard - they have to be able to borrow and lend to expand the money supply. They have the advantage of being able to turn to the Treasury in a pinch but they are trying to support asset prices (promoting asset inflation) and they need cash to do it. The Fed either won't or can't create that cash by decree.

Ironically, just as the weaknesses of the Fed's inflationary program are being made clear, the herd is stampeding back
into the inflation trades. This appears to be based on the assumption that today's Fed action is inflationary (true on a very small scale) and demonstrates some new power on their part (not true at all). What has been demonstrated is the INABILITY of the Fed to inflate asset prices without the willing cooperation of the market. With sentiment having turned, the best they can hope for at this point is to slow the crash in prices of risky debt used to fund credit expansion. This is a desperate rear-guard action by the Fed

1 comment:

notgreat said...

While not expanding the money supply immediately, does this not debase the currency? The Fed now has a liability to the Treasury offset by an IOU from AIG. The the extent that a dollar is a liability of the Fed as well, what does it do to the "hardness" of the dollar?