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August 14, 2008

What the Fed did during macroblog's vacation

To state the very obvious, it has been quite an eventful twelve months since I last committed fingers to laptop. I might well have titled this post "Four Fed programs that did not exist one year ago." Over the four months from December to March, the Federal Reserve Board of Governors and the Federal Open Market Committee, or FOMC, introduced an alphabet soup of new lending programs to address acute stress in financial markets, some of which required the invocation of emergency powers based on "unusual and exigent circumstances."

I know that in some quarters—maybe the one where you reside—all this activity had a certain frenetic, whack-a-mole feel to it. But I think it appropriate to view the Fed's actions over this period as what I believe them to be: A measured and logical sequence of steps to address very specific liquidity distress in financial markets.

If I had to choose one picture to describe the crux of the "liquidity" problems to which I am referring it would be this one:

LIBOR - OIS Spread chart

In effect, the OIS (overnight index swap) yield is a measure of the rate that banks charge one another for overnight loans and the LIBOR (London Inter Bank Offered Rate) yields represent the rate charged for slightly longer-term (30- and 90-day) lending. The explosion in this spread in August 2007 was the marker for the emergence of a severe disruption in the means by which lending institutions typically finance their ongoing operations.

A brief chronology, then:

August 17, 2007: The Board of Governors cuts the primary credit rate (or discount rate), the interest rate Federal Reserve Banks charge on direct loans made to banks.

September 18, 2007: The FOMC cuts its target for the federal funds rate, the first in a string of seven consecutive rate reductions.

December 12, 2007: The Board of Governors introduces the Term Auction Facility (or TAF), initially a mechanism for providing loans to banks for a period of 28 days (as opposed to the typical overnight maturity associated with standard primary credit loans). Last week, the Board announced the program would be extended to make loans available for a term of 84 days.

March 7, 2007: The FOMC authorizes the New York Fed to conduct open market operations using Term Repurchase Agreements. Like the TAF, the term repo program allowed the Fed the flexibility to conduct operations over periods of about a month rather than the overnight basis that is typical in more normal environments.

March 11, 2008: The FOMC approves the creation of the Term Security Lending Facility (TSLF), which authorized swapping Treasury Securities (over a period of 28 days) for "other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS."

March 16: The Board of Governors creates the Primary Dealer Credit Facility (PDCF), authorizing direct loans to broker dealers who are authorized to engage in securities transactions with the Federal Reserve.

What do I want you to see? As I noted above, I see a progression of logically consistent steps that neither lurched to extreme solutions nor ignored the imperatives of the problem at hand:

  • The first step was to invoke the usual tools of monetary policy (in the form of discount window lending and federal funds rate adjustments).
  • Then it became obvious that injecting liquidity into overnight markets alone was not solving the problem of funding being unavailable for periods of time even as short as one to three months. The next step, then, was to lengthen the maturity of loans and asset exchanges in policy operations (in the form of the TAF and Term Repurchase Agreements). (An additional salutary effect of the TAF was apparently the lack of "stigma" that is thought to be attached to borrowing from the discount window.)
  • From there, it became clear that Treasury securities were rapidly emerging as the only widely accepted form of collateral to support short-term borrowing and lending, a function that securities backed by real estate assets were simply unable to perform. Some relief to this problem was already inherent in the form of the broader-than-Treasuries collateral options in the TAF. Further relief was provided by the TSLF, which in effect implemented a swap of in-demand Treasury securities from the Federal Reserve's balance sheet for less liquid mortgage-backed assets.
  • Finally, the potential systemic consequences of acute stress in the primary dealer network led us to the PDCF, in effect broadening the class of institutions to which the central bank would stand ready to infuse short-term liquidity.

Once again, in my view there is a methodical progression to the whole process that is too commonly overlooked: Start with the standard tools (the discount rate and federal funds rate), move on to a lengthening of the maturity in the term of those standard tools (TAF and Term Repurchase Agreements), on to a broadening of the collateral used to support monetary policy operations (TSLF), and finally expanding the class of institutions to which the Federal Reserve will lend (PDCF).

It is not entirely obvious that the new long-run level of the OIS-Libor spreads pictured above will once again converge to the values that prevailed prior to August 2007, but I would argue that the still-elevated levels of these spreads implies we have a ways to go before financial markets are again fully functional. Though the lending programs put in place in the past year have not been, and could not be, a magic elixir for solving all financial market woes, I would take the bet that they are least providing enough stability for the market to continue the painful process of healing itself. Getting to this point has not always been pretty in real time, and there is plenty of room for debate about the long-run costs and benefits of each step along the way. But given a little time for perspective I believe we will find a certain beauty to it all.

August 14, 2008 in Federal Reserve and Monetary Policy | Permalink

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Comments

Welcome back.

Just to point something out about this post; something that is emblematic of Fed commentary on policy in general.

Of course, the Fed's various tactics helped to stabilize the "system", just as the Fed's 1% policy rates and "measured" hikes helped avert a deeper 2002 recession. And yet, one never, or rarely, hears a discussion from the Fed of the costs of such actions.

So, I invite you to post again, and this time to discuss the long term cost of each successive stabilization. One could argue that we see in higher commodity prices, higher dollar-peg country inflation, and, last but not least, the very sticky problem of how to remove the policies without "killing the patient". It was just such a "measured" removal in the 2005/2006 time frame that contributed to the housing bubble.

Posted by: David Pearson | August 14, 2008 at 12:32 PM

I second what David said.

Posted by: tyaresun | August 14, 2008 at 01:29 PM

Is there any risk in taking MBS in what I understand to be trade for treasury securities?

I imagine a lot of folks would be willing to trade mbs for equal dollar amounts of treasuries.

Maybe some of this is just over my head but it seems your, read the tax payer's, collateral is questionable at best.

Posted by: wayne | August 14, 2008 at 02:57 PM

There are no questions about costs but any discussion of costs of the action taken but this has to be weighed against the cost of not doing anything.
I wonder if the shrinking of balance sheets by the GSE's via reduced interbank lending is contributing to the pressure that has re emerged in the TAF to Libor spreads we have seen this week.

Posted by: Terry Spenst | August 14, 2008 at 03:36 PM

Well, bailing out Bear doesn't seem quite consistent with "a progression of logically consistent steps that neither lurched to extreme solutions.."?

The reality is the Fed and the Treasury were scared that Bear going under would throw the entire financial system into chaos because they didn't know or understand the effects on the CDS market.
Thus leading to nationalization of a major Wall St. broker and also allowing those still among the "solvent" access to the discount window.

If that's not extreme, I'm unclear on the definition...

Posted by: gab | August 14, 2008 at 04:49 PM

Welcome back, Dr. Altig.

Two questions:

1) The phrase "Bear Stearns" appears nowhere in this post. Why not?

2) Bagehot wrote that in times of crisis, a central bank should lend freely against good collateral at a penalty rate. I see the Fed lending freely (boy howdy), and reasonable people can disagree about the collateral... But whatever happened to the penalty rate?

Posted by: Nemo | August 14, 2008 at 05:46 PM

What contributed to the whole "frenetic whack-a-mole feel" wasn't the actions taken, but the insistence that it "was all contained" .

If you keep insisting to the crowd, that nothing bad is happening, or going to happen, then turn around and implement a series of emergency facilities you lose credibility.

PS:I'm not sure restarting your blog is a good idea. There is a lot of anger out here, and if you are seen as a mouth piece for the fed, you will receive a large helping of it.

Posted by: bitteroldcoot | August 14, 2008 at 06:50 PM

The market overlooks not only the aspect of logical progression in the objectives of these programs, but also that their long-run “costs” are currently reflected as risk rather than debatable fact. We simply don’t know yet. And we don’t know whether the eventual costs will be surprising to the upside or to the downside. Indeed, it’s not clear that the market even reflects an analytical expectation for such costs beyond the notion of general worry.

The identification and analysis of ultimate “cost” is also part of the logical progression. In the interim, it is risk rather than cost.

Posted by: JKH | August 14, 2008 at 08:05 PM

Welcome back.

I think the Federal Reserve responded to meet the exigencies of some very unusual circumstances and they have bought the system time.

But the Fed has a strange trade on in which it has emptied its balance sheet of big blocks of pristine treasury paper for an eclectic pile of financial flotsam and jetsam. The problem that I observe is that there is no way for the Fed to exit those trades.

The FOMC is betting all on the assumption that time heals all wounds and that over time former relationships will be restored.

I think that the Open Market Desk will be rolling these repos for years to come.

Posted by: john jansen | August 15, 2008 at 01:19 AM

I don't think that your destinction between OIS and LIBOR is totally accurate..
When one looks at OIS.. no one cares about where O/N Fed funds are... OIS.. is and I think it best for conceptual clarity to call it exactly what it is a FED FUNDS Future.. and I mean exactly.. as OIS can and is only hedgeable with FED FUND futures..
OIS is simply the markets best guess today as to the path of FED activity..One Month OIS.. may or may not be interesting depending on the calendar...

But even there.. its a futures contract..
(set in arrears as you know)

The appropriate comparison.. by the way..
and of course the one that the market pays most attention to .. indeed to the extent that next month the CME to salvage the declining fortunes of Eurodollars. (LIBOR) is starting will be a Three MONTH OIS contract to trade side by side with the 3 Month LIBOR contract..

THE KEY DISTINCTION.. is that then both of these will be futures.. with no risk of principal to trade...

Libor.. cash libor.. has full credit risk..
if i do a trade i risk never getting my money back.. any of it..

If I do OIS.. its an exchange for differences.. my loss is just the maximum change in FED funds average due to FED action..

In this environment zero?

Comparing the two.. is truly apples and oranges..

by the nice to have you back

Posted by: stan jonas | August 15, 2008 at 09:39 AM

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