Pushing on a String In Academic Wonderland

Bloomberg is reporting Fed Boosts Cash Auctions to $900 Billion, May Do More.

The Federal Reserve will double its auctions of cash to banks to as much as $900 billion and is considering further steps to unfreeze short-term lending markets as the credit crunch deepens.

``The Federal Reserve stands ready to take additional measures as necessary to foster liquid money-market conditions,'' the central bank said in a statement released in Washington today. Fed and Treasury officials are ``consulting with market participants on ways to provide additional support for term unsecured funding markets,'' the statement said.

As part of today's steps, the Fed will increase its auctions under the 28-day and 84-day Term Auction Facility operations to $150 billion each. The two forward TAF auctions in November will be increased to $150 billion each, the Fed said.

Assets on the Fed's balance sheet expanded $285 billion last week to $1.498 trillion, the biggest one-week increase ever, according to JPMorgan Chase & Co.

In addition to the cash banks must hold at the Fed, lenders also sometimes place excess reserves. The central bank said today it will pay interest on those funds at the lowest targeted federal funds rate for each period less 75 basis points. That will put a floor under the actual fed funds rate each day and let the Fed `expand its balance sheet as necessary to provide the liquidity necessary to support financial stability.''

Banks Hoard Cash

Bernanke must be at wits end because in spite of his efforts Money-Market Rates Climb as Banks Hoard Cash.

The London interbank offered rate, or Libor, that banks charge each other for overnight dollar loans rose 37 basis points to 2.37 percent today, the British Bankers' Association said. The three-month rate stayed near the highest level since January. Asian rates increased and the Libor-OIS spread, a gauge of cash scarcity among banks, held near a record.

Interbank rates have jumped as banks store cash to meet anticipated funding needs after governments in Europe and the U.S. acted to prevent the collapse of six financial institutions in the past two weeks. The Libor-OIS spread, the difference between the three-month dollar rate and the overnight indexed swap rate, rose to 298 basis points today, before retreating to 291 basis points. It was at 129 basis points two weeks ago and 81 basis points a month ago.

The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened today to 393 basis points, the most since Bloomberg began compiling the data in 1984.

Failures of the TAF

The TAF did not spur bank to bank lending yet Bernanke keeps throwing more money at it as if it would do some good. It won't. I talked about Failures of the Term Auction Facility on April 10, 2008.

There is "no empirical evidence" the Term Auction Facility has reduced the premium that banks charge each other to lend cash for three months, Taylor, author of a monetary-policy formula cited as a benchmark by analysts, wrote in a research paper. San Francisco Fed economist John Williams co-wrote the study, which was posted on the San Francisco Fed's Web site yesterday.

The Fed's own website has a study showing why the TAF will not work but Bernanke keeps banging his head against a brick wall anyway. Bernanke might be advised to read the Fed's own report. Here is the conclusion.

In this paper we documented the unusually large spread between term Libor and overnight interest rates in the United States and other money markets beginning on August 9, 2007. We also introduced a financial model to adjust for expectations effects and to test for various explanations that have been offered to explain this unusual development.

The model has two implications. Fist is that counterparty risk is a key factor in explaining the spread between the Libor rate and the OIS rate, and second is that the TAF should not have an effect on the spread. Since the TAF does not affect total liquidity, expectations of future overnight rates, or counterparty risk, the model implies that it will not affect the spread. Our simple econometric tests support both of those implications of our model.

So What Does Bernanke Do?

Answer: Double the TAF to spur lending.

Gross Says Fed Should Buy Commercial Paper

Bill Gross is back at it with socialistic recommendations such as Fed Should Buy Commercial Paper.

Bill Gross, who manages the world's biggest bond fund, said the Federal Reserve should act as a clearinghouse to guarantee that transactions are completed and buy commercial paper to renew confidence in financial markets.

Credit markets are currently "frozen," Gross wrote in a note to clients published today on Newport Beach, California- based Pacific Investment Management Co.'s Web site. Without confidence in the markets, ``our economic center cannot hold.''

Rates on commercial paper, or short-term IOUs sold by companies, soared today and the interest banks charge each other for overnight dollar-denominated loans in London increased as banks remained reluctant to lend. Buying commercial paper would allow the Fed to make unsecured loans and encourage borrowing at rates beyond overnight levels.

Yields on overnight U.S. commercial paper jumped 94 basis points to 3.68 percent, according to data compiled by Bloomberg. Companies sell debt maturing in nine months or less to help pay for day-to-day expenses such as payroll and rent.

Fed To Pay Interest On Deposits; Considers Unsecured Funding

The $700+ Billion Bailout Bill contained a provision that allows the Fed to start paying member banks on required reserves and excess balances. Let's take a look at the Fed press release on deposits.

The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions' required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

Consistent with this increased scope, the Federal Reserve also announced today additional actions to strengthen its support of term lending markets. Specifically, the Federal Reserve is substantially increasing the size of the Term Auction Facility (TAF) auctions, beginning with today’s auction of 84-day funds. These auctions allow depository institutions to borrow from the Federal Reserve for a fixed term against the same collateral that is accepted at the discount window; the rate is established in the auction, subject to a minimum set by the Federal Reserve.

In addition, the Federal Reserve and the Treasury Department are consulting with market participants on ways to provide additional support for term unsecured funding markets.

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.

Bernanke wanted the provision to pay interest on reserves because it allows him to print at will without affecting the Fed Funds Rate, at least in theory.

Fed, Treasury mulling commercial paper support

Reuters is reporting Fed, Treasury mulling commercial paper support.

The U.S. Treasury Department and the Federal Reserve are considering additional steps to support strained commercial paper markets, a source familiar with the discussions said on Monday.

Among steps under consideration would be funding a special purpose vehicle as opposed to outright purchase of commercial paper, the source said. Strained commercial paper markets are seen as a major destabilizing force in financial markets.

"The Federal Reserve and the Treasury Department are consulting with market participants on ways to provide additional support for term unsecured funding markets," the statements said.

Aiding the commercial paper market may test the limits of the Fed's authority because of the possibility of losses. One way the government could get around that constraint would be for the Treasury to provide some buffer against losses, the source said.

Fed Wants To Sponsor Its Own SIV

In spite of the fact that Citigroup is sitting on $1 trillion in SIVs it does not know what to do with, the Fed wants to start its own SIV. Bear in mind the Fed has never in history made unsecured loans, the Fed has no authority to do so, and Congress just authorized $700 billion to buy mortgages purportedly to bail out housing. Yet remarkably, the Fed is considering making unsecured lending.

Bernanke Theories All Failing

• The Term Auction Facility (TAF) is not working to increase bank to bank lending.
• The Primary Dealer Credit Facility (PDCF) was supposed to prevent more dealers from blowing up. Yet, Lehman went bankrupt anyway and Merrill Lynch had to merge with Bank of America to avoid collapse.
• Slashing interest rates to 2% did not prevent a recession.
• The ABCP MMMF Liquidity Facility may have stopped a run on money markets but it has not done anything to restore confidence in in the ABCP market itself.

Keynesian theory suggests the Fed is in a dreaded "liquidity trap". The reality is there is no such thing as a "liquidity trap", at least in Austrian economic terms. There is no trap, because it is impossible to prevent the liquidation of credit boom malinvestments.

Purging of bad debts must take place before a lasting recovery can begin. The mistake the Fed is making is attempting to force liquidity down the throat of a market that does not need it and cannot use it.

Why Aren't Banks Lending?

• Banks do not have money to lend
• Consumers who want to borrow are not credit worthy
• Consumer spending is 75% of the economy and consumers are tapped out.
• Unemployment is rising
• There is rampant over capacity in every sector but energy
• Banks do not trust each other
  
• Cancellation of mark to market accounting heightens that sense of mistrust
  

The problem is not a failure to lend, the main problem is there simply is no pool of real savings to lend. Furthermore, given rampant overcapacity and rising unemployment, there is no reason to lend even if the funding was available.

Robbing taxpayers to the tune of $700 billion does not change the equation.

With that backdrop it's no wonder Bernanke's attempts to free up the credit markets are having the effect of pushing on a string. Should the Fed actually stimulate lending, more money will end up in money heaven as a consequence.

Academic Wonderland

The credit markets are choking on credit, yet Bernanke is attempting to force more credit down everyone's throats. Logic dictates the solution cannot be the same as the problem.

Trapped in academic wonderland, such simple logic is far too complex for Bernanke to understand. Sadly, we are all forced to watch Bernanke flop about like a fish out of water attempting to solve a solvency problem with ridiculous liquidity schemes like the TAF, PDCF, TSLF, TARP, and the ABCPMMMFLF.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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