The Fed's Binge

How the Federal Reserve engineered the most dramatic peacetime experiment in monetary and fiscal stimulus in U.S. history without anyone noticing

Up until September, Federal Reserve Chairman Ben Bernanke effectively sterilized all his financial crisis-fueled monetary injections, either by directly trading Treasury bills for riskier financial securities or by indirectly loaning to financial institutions with money recouped by selling Fed-held Treasuries on the open market. Either way, there was no major impact on the monetary base. As a result, the annual rate of growth of the monetary base remained in the neighborhood of 2 percent through August, with total bank reserves remaining virtually constant.

But after September 17, when the interest on T-bills briefly went negative, Bernanke opened the monetary floodgates In August the monetary base had been $847 billion, with total reserves constituting $72 billion of that. (None of these figures are seasonally adjusted or adjusted for changes in reserve requirements.) A Fed press release on October 22 put the base at $1.149 trillion, a shocking 40 percent jump over the previous year. What has exploded even more is total bank reserves, where the base increase is concentrated. Reserves increased by an astonishing factor of five over the course of just one month, and as of late October were somewhere between $343 and $358 billion.

And that’s not all. Federal Reserve Bank credit also doubled to around $1.8 trillion. Although Fed credit once closely mirrored the monetary base, that is true no longer—not since the Fed activated its U.S. Treasury supplementary financing account in the fall. This boosted additional Treasury deposits from zero to approximately $560 billion. The new deposits resulted from what the Treasury calls its Supplementary Financing Program, initiated in September to try to staunch the growing demand for Treasury securities manifested in falling T-bill rates.

Essentially, the Treasury is now issuing extra securities to borrow money from the economy, then loaning the money to the Fed in these special deposits so that Bernanke can re-inject it to make his bailout purchases of various securities, all without increasing the monetary base. In other words, what the infamous bailout act permitted the Treasury to do directly is something it had already started doing indirectly through the Fed to the tune of half a trillion. All in the name of easing a tight Treasury market.

This means that the total bailout is not the $700 billion that Congress appropriated, but at least $1.2 trillion. And that figure doesn’t include the Fed’s mid-October promise of $540 billion to bail out money market funds, which if not covered by the Fed’s sale of other assets, will require either further monetary increases or further Treasury borrowing. Thus we now have the worst of both worlds: a massive bailout financed both by Treasury borrowing (in order to avoid inflation) and a Federal Reserve increase of the monetary base (which heralds future inflation anyway).

Of the $1.2 trillion increase in federal government borrowing, at least half took place within the space of a month. This sudden 25 percent increase in the outstanding national debt qualifies as the most dramatic peacetime experiment in fiscal stimulus the U.S. government has ever implemented. If Keynesian theory were correct, the economy should have been well beyond the reach of any potential recession by the end of October. But how many economists are going to acknowledge this striking empirical refutation of the fiscal policy they hold dear?

This enormous increase in government debt may at least partly explain the sudden stock market collapse after the bailout passed. Government borrowing represents a future tax liability, and expected future taxes affect the value of equities. Some argue that this new borrowing may not increase taxes at all because it merely finances the purchase of earning assets that the government can later resell. While that’s certainly possible in the long run, no one knows the true value of those assets in the short run. After all, the market’s anxiety about their worth was the justification for the bailout in the first place. So now the government is transferring that uncertainty from private financial institutions to the taxpayers.

Meanwhile, there will be a lag before the broader measures of the money supply feel the effects of the Fed’s money bomb. The year-to-year annual growth rate of M1—currency in circulation plus checking accounts—had already risen from 0 percent to over 7 percent as of late October, whereas that of M2 (M1 money plus other types of deposits and most money market funds) is up slightly from 6 to 7 percent. But as centuries of experience has shown, an increasing money supply will inexorably lead to increasing inflation.

Bernanke is betting that he can reverse the process before inflation gets out of hand. But that will require the Fed dumping billions worth of securities it has recently purchased back on the market. It is anybody’s guess when Bernanke will judge that the financial system is sound enough for him to do so. All the emergency initiatives of both the Fed and the Treasury since the subprime problem first emerged have not merely proved stellar and consistent failures. As Anna Schwartz, Milton Friedman’s esteemed co-author, and other economists have suggested, the thrashing about of Fed and Treasury policy has undoubtedly made the financial situation worse. The prospects do not look promising.

Jeffrey Rogers Hummel is an economics professor at San Jose State University and the author of Emancipating Slaves, Enslaving Free Men: A History of the American Civil War (Open Court).

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  • ||

    Wow, that is pretty amazing isnt it! I love it.

    www.anonymity.pro.tc

  • ||

    Bernanke is betting that he can reverse the process before inflation gets out of hand.

    I'm quite certain Bernanke is currently more concerned with spiraling deflation, not the reverse. With short term real interest rates over 6.5%, and money velocity collapsing, the term "easy money" is far from applicable.

    But that will require the Fed dumping billions worth of securities it has recently purchased back on the market.

    So be it - no more difficult than sending an email.

    It is anybody's guess when Bernanke will judge that the financial system is sound enough for him to do so. All the emergency initiatives of both the Fed and the Treasury since the subprime problem first emerged have not merely proved stellar and consistent failures.

    Hopefully sooner than later, but that depends on what happens. It's not at all clear that the many facilities the Fed has introduced this last year have been failures. To do so would require the proof of a counterfactual - that things would not be worse if the Fed had done nothing.

  • Egosumabbas||

    So... how's the fifth plank of the communist manifesto working out for everybody?

  • ||

    Domoarrigato, wow--normally the econ posts here bring out the gold standard crazies, not smart economic commentary.

  • ||

    I'm doing my best. thanks!

  • ||

    Right now Big Ben Bernanke is engaged in an uncomfortable staring contest with holders of cash. The rush out of anything risky (stocks, corporate bonds, hedge funds, commodities) has led to a massive deleveraging of available credit. So far the Feds efforts have focused on filling in the gap to provide cash to short term borrowers with good collateral.

    As we approach 0% policy rates, his situation becomes more difficult. Normally, lowering rates stimulates the economy by threatening those who refuse to lend (and instead hold cash at the Fed) with lower returns. If cash rates and t-bill rates approach 0% and people are still more concerned with safety - the "stick" effect of low rates dissappears. Further monetary expansion has no effect, since T-bills and cash become perfect substitutes.

    The only option becomes fiscal stimulus. This is the staring match. The question is: will Bernanke monetize the deficit spending that fiscal stimulus implies? He doesn't want to - no central banker of his caliber does. But he would like to convince the market that he will - and that inflation could be just around the corner.

    If the market won't blink, and start to price in inflation premiums, he will be forced to monetize parts of the deficit, though unsterilized interventions, perhaps by devalueing the currency in the open market.

  • ||

    Domo,
    You don't think that the Fed is already doing unsterilized interventions? I guess the big question is the scale of the unsterilized interventions.

  • ||

    Domo,
    I guess, from your post, that you're referring to direct intervention to devalue the dollar in the foreign exchange markets. In such a case, do you think that the counter-move by someone like China might be to buy more dollars?

  • ||

    Yes - I mean unsterilized in currency terms. Someone will get to sell dollars - it may as well be the bank - otherwise it will be soros (if he isn't max short already).

    I believe that China is well prepared for such a move by the US. Their policy has been to devalue their currency for decades (buying dollars along the way) and so far it's done very well for them. It's possible that they would step up for as long as we are buying their goods and inflation is low (negative!).

  • ||

    I'm quite certain Bernanke is currently more concerned with spiraling deflation, not the reverse.

    If one believes, as I do, that what we are seeing is something more like a reversion to the mean than a deflationary death spiral, Bernanke and Paulson are doing more harm than good.

    They are explicitly attempting to prevent prices from adjusting back to "rational" levels.

    The so-called credit freeze is mostly due to lenders (and everybody else) not wanting Treasury and the Fed to pull the rug out from under them with some crazy scheme to "fix" the economy.

  • Egosumabbas||

    Hmm, all the implications for this discussion are interesting. I'm thinking that buying real estate in say... 2010 would be a good investment.

    If Bernanke is going to join hands with Obama and send out a fiscal stimulus... where will the next bubble be? Green tech (my educated guess)?

  • ||

    P Brooks,
    There can be a reversion to the mean without deflation. Historically that is what housing prices have done. While some asset prices grew rapidly, many other goods fell in price during the past decade. This led overall inflation to be quite low. If you slow the reversion to the mean or you create inflation, you can accerlerate real prices reaching the long-run equilibrium without the major damage that deflationary cycles can create.

    Part of the challenge of intervening in the foreign exchange markets is that other governments could also be making similar moves as their domestic problems lead them to want to devalue their currency.

  • ||

    If one believes, as I do, that what we are seeing is something more like a reversion to the mean than a deflationary death spiral, Bernanke and Paulson are doing more harm than good.

    Price levels are pretty arbitrary, they aren't really mean reverting absent any other information. If you mean that Asset prices are inflated relative to disposable income, then I'm ok with that.

    They are explicitly attempting to prevent prices from adjusting back to "rational" levels.

    I think it's better to say they are explicitly trying to prevent people from expecting that prices will fall a lot - because that will discourage them from pushing money around in the economy.

    The so-called credit freeze is mostly due to lenders (and everybody else) not wanting Treasury and the Fed to pull the rug out from under them with some crazy scheme to "fix" the economy.

    I would argue that the freeze started on it's own, and the Fed was actually kind of late to the game. When the Bear Stearns Hedge fund had problems in June 06 and Bear stood by them instead of telling investors to stuff it - that was the beginning of the end.

  • ||

    Duncan,

    What currency or asset do you think would benefit most from that type of beggar-thy-neighbor devaluation race?

  • ||

    With regard to house prices in particular, I am thinking in terms of historical relationship to income.

  • Consumer Price Index||

    Deflation is non-existent in this economy.
    Look at my "core rate", it is the only one that counts.

  • ||

    Duncan,

    What currency or asset do you think would benefit most from that type of beggar-thy-neighbor devaluation race?

    Domo,
    That's a great question. I think that such a race would be somewhat like an arms race-everyone is worse off at the end. I think that there is a real risk of inflation increasing in the long-run to damaging levels. I'd be tempted to look to currencies, such as the Swiss Franc (except for their exposure to the banking mess) or even the Euro where the governments wouldn't enter into such a game. I don't see Germany's hold on the ECB weakening to such an extent that they would pursue such a policy. However, they did announce today that Europe with have a 1.5% of GDP stimulus package--and that agreement included Germany. The pressure on Germany and the ECB from many other euro states might reach such a point where the ECB would assume a more expansionary monetary policy. It is important to remember that ECB has a single mandate-fighting inflation, unlike the fed.
    On the other hand, China and Japan have a long history of foreign exchange market intervention, and I don't see that changing.
    As far as classes of assets to hold, hmmm...that's a bit tougher. I'd be tempted to bet against any sort of bonds because I'd expect interest rates to rise eventually in reaction to such expansionary policies. However, at this point, I am far more concerned about deflation than inflation.

  • ||

    Problem is that incomes are ratcheting back at the same time, so house prices relative to incomes are probably just treading water even as their absolute levels are circling the drain.

    Since more foreclosures will cause more losses, which will cause more layoffs, which will cause less income - there's no obvious reason why that cycle should break on its own.

  • ||

    Duncan,

    I think the big question is not "will europe et all expand" I think they must and will be forced to if they don't soon. The question is will the central banks take back the stimulus at the appropriate time, and pace to avoid an inflation spike. Their recent willingness to coordinate and act in concert makes me perhaps more optimistic than many. Ultimately, however, that question is political in nature, not economic.

  • ||

    Mr. CPI,

    I realize that core is 2% YoY. I also realize that the Nov headline print has terrible seasonals built into it. That said, TIPS going out for two years into the future are priced nearly 7% cheaper than nominal treasuries. While there may be little evidence of deflation in the current month that can't be explained by seasonals or nervous holiday spenders, the market clearly expects core to go negetive next year and the following.

  • cunnivore||

    It's not at all clear that the many facilities the Fed has introduced this last year have been failures. To do so would require the proof of a counterfactual - that things would not be worse if the Fed had done nothing.

    So you're saying it's essentially impossible to judge the efficacy of any Fed intervention whatsoever? If so, the gap between priests and central bankers just got a lot smaller. At least the priests put on a good show.

  • ||

    It's not that I don't think that Europe will launch into a more expansionary monetary policy--I just think that they'll be compartively more conservative in how they do it.
    Where would you invest in such a currency devaluation game?

  • ||

    Problem is that incomes are ratcheting back at the same time, so house prices relative to incomes are probably just treading water even as their absolute levels are circling the drain.

    Is this really true? At the margin, there are plenty of anecdotal horror stories, but I'm not convinced (as if that's worth much) that the overall economy is as deeply troubled as certain parties in Washington would have us believe.

    I admit to a deep and abiding scepticism when looking at government economic statistics.

  • ||

    Duncan,

    If your email address is correct - and you are indeed from the BLS - I guess I would like the opportunity to ask what you think the impact of the way homeowners equivilent rent is calculated in a regime of deflating asset prices? My thought is that valueing consumer prices of housing based on substituting the marginal rental property is a significant problem for the index. It tends to understate inflation in this environment.

  • ||

    Goddammit, reason, just put domo on the payroll already. His comments here provide more information on monetary policy in an understandable form than anything I read anywhere else.

  • What Matt Welch Would Say If H||

    RC Dean, I didn't become the man I am today by paying for that which I get for free.

  • ||

    On investing: I would be in favor of purchasing shares of small innovative US companies with positive cash flow, particularly ones with significant IP or where their industry displays significant inelasticity of demand - energy, healthcare (generics), consumer staples. I think innovation will have a premium. Sadly, I would also be in defense stocks.

    I could be convinced to by metals, though I would probably stick to those with some industrial use like platinum - but not before GM goes under.

    I agree that swiss, and Eur are probably the best bet near term - though if they wait too long to act, the exit could be ugly.

  • ||

    RC Dean,

    Thank you very much for your kind words.

  • ||

    I meant to say "understate deflation" @11:35

  • ||

    But he would like to convince the market that he will - and that inflation could be just around the corner.

    Bernanke has certainly convinced me--through speeches, published work, and public policy--that he considers Deflation to be one of the Four Horsemen of the Apocalypse.

    Insofar as he and a decisive policy-making majority consider anything short of hyperinflation preferable to sustained deflation, I think observers can set counterfactuals aside in agreeing that anything right now approaching official price-index deflation suggests the sheer magnitude of market movements countering Fed policy.

  • ||

    Problem with the credit markets at this point seems to be credit-worthy demand more than supply. Its not about easy money, its about easy lending standards that aren't there anymore. There is genuine old-fashioned due-diligence going on by lenders, and that has closed off lots of potential borrowers.

    People who are credit-worthy a year-and-a-half ago are probably still credit-worthy now, because they didn't over-leverage themselves or buy too much house on sketchy ARM mortgages. These people tend to read and understand the contracts they sign before signing them. Its why they have good credit, not because of their good credit. Its also why they aren't borrowing, given the economic situation seems to advise the wise in most circumstances not to go more in the hole. Good credit-worthy borrowers aren't created by policy nor can they be.

    Inadvertent victims of that reality include people trying to establish or honestly re-build credit, commercial paper markets, and the mortgage business in general. The smarties who want to buy a house or a car know the deals will only get better for the next six months, and the smarties tend to be the ones you want to lend money too.

  • ||

    So you're saying it's essentially impossible to judge the efficacy of any Fed intervention whatsoever?

    Judging the efficacy of monetary policy is difficult to the extreme. The time lags are very long, and the variables are too numerous.

    If so, the gap between priests and central bankers just got a lot smaller. At least the priests put on a good show.

    I make a lot of claims - but I never claimed it was a science.

  • ||

    Cramer is on CNBC making my exact point that the Fed is going to force people to lend and borrow using whatever means it can.

  • Yid-WASP Alliance||

    "Yoo" and White Traitor financiers are to blame for this financial anarcho-tyranny! The financier-caste of traitorous bourgeois swine must die!

    (Nothing says lovin' like a Jew in the oven...)

    (N I'm OUT)

  • ||

    What is so controversial about the obvious truth that artificially low interest rates cause malinvestment? The housing bubble was caused by just such a thing. The collapse is an inevitable result of the bubble. These bailouts cause bad loans and assets to stay on the books and prevent a recovery. Why is this so hard to understand?
    It's not called a "correction" for nothing.

  • ||

    Bernanke: We had to destroy the market in order to save it. Deflation would have been a far worse fate than the gangrape and beheading we were forced to do to prevent it.

  • </||

    ZIRP BABY !!!!

  • ||

    What is so controversial about the obvious truth that artificially low interest rates cause malinvestment?

    Who is disputing that? certainly not me. Greenspan should have been hiking in '02 according to the Taylor rule. Instead it was more easing and lazy hikes 18 months later. Don't forget government meddling with credit standards...

  • ||

    I'll tell you what's controversial about it.

    Some people think artificially low interest rates (and even moderate, predictable inflation) make possible real, sustainable growth that can end recessions.

    http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm

    The FOMC target is now between 0% and 0.25%

  • ||

    nonPaulogist,

    I think that news release pretty much confirms that you adhere to an obvious truth which is diametrically opposed by those institutionally invested with the authority to act on it.

    I'd say that makes our views controversial.

  • ||

    Cramer is on CNBC making my exact point that the Fed is going to force people to lend and borrow using whatever means it can.

    (!)

    Why doesn't Bernanke just get it over with, and open branches? He can recycle all the bankers canned by Citi.

    And then the Fed can buy up all the outstanding shares of GM. Buy a car, get a check!

    Thank goodness the Fed is immune from politics.

  • ||

    This is a perverse form of supply-side economics that lefties supposedly hate. Without a spurt in demand for loans, there's nothing the Fed or anyone else can do to generate the liquidity they want.

    Congress will have to pass a law here forcing the bailed banks to loosen their lending standards and start kicking out sketchy loans and mortgages to people down with 420 (no I don't smoke pot, that's my FICO score...). That's where the demand for the loans is.

  • ||

    the gold standard crazies

    Fuck you too, Duncan.

    -jcr

  • ||

    So... how's the fifth plank of the communist manifesto working out for everybody?

    Downside: it's turning this crash into the greater depression as we speak. Upside: it will eventually cause the collapse of the US government, just like the Soviet government before it.

    -jcr

  • ||

    the gold standard crazies

    Whoever said anything about the gold standard? I'm all for nine-ton stone wheels. Inflate that bitches!

  • ||

    As of the time of this post:
    Gold spot price: $859.20, up $22.30 since yesterday's close
    Silver spot price: $11.22, up $0.59 since yesterday's close

    I'm glad we have all you experts who understand how to run the world economy in control of things, so we go into a crisis or something.

  • ||

    HAL-9000

    9-ton stone wheels are hard to transport.

    So, it sounds like you favor harsh controls on international investment.

    Bad HAL.

  • ||

    Congress will have to pass a law here forcing the bailed banks to loosen their lending standards and start kicking out sketchy loans and mortgages to people down with 420...

    Actually that's not going to happen, nor would it help. I'd like to clarify my post about forceing people to borrow and lend. Cramer said that, not me. I made the point that spurring lending is exactly what Bernanke wants - which is similar. Cramer is a nutcase, and uses a lot of trader hyperbole. The fed can't force people to borrow and lend, but they can remove the incentive to avoid doing that by credibly signaling that they will create inflation and underwrite the banking system.

    I disagree strongly that the current fed actions will cause a great depression. If on the other hand, Obama jacks taxes to the moon... FWIW, there are good arguments for higher gold prices, two of them are not a) the end of the world is nigh. and b) prices increased a lot already, and therefore must go higher. I happen to be bearish, but I'm not married to it.

  • SIV||

    FWIW, there are good arguments for higher gold prices

    Surge in demand for jewelry and industrial metals.German Master Criminal detonates nuclear device at Fort Knox.

  • ||

    When is someone going to kick Cramer in the teeth?

  • ||

    Welcome to stagflation.

    Bernanke is following the Japanese blueprint, and we're going to wind up with Japanese results.

  • </||

    Tentacle Hentai?

  • nfl jerseys||

    ngh

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