So the Fed opens up the discount window, and drops the rate 0.5%, banks go gonzo, right? Well, no, I wouldn’t call it a “brisk business.” A lot of the “business” was in and out in short order, for average borrowings of $1.2 billion. For the discount window of its own to make a real dent in monetary policy, we would need to see more than $10 billion of net borrowings, because the Fed is decreasing the monetary base by $10 billion through other actions. As it is, after the discount rate was decreased, there was a flurry of action, and then nothing. So, in order to keep the monetary base up, the Fed injects temporary liquidity of $17.25 million, the most in 2 weeks (i.e., since permanent temporary injections started). Does this have a big impact on the Fed funds rate? No, it closes out the day at 4.875%, which is close to the average level of 4.90% over the past two weeks. The number looks big, but it is meaningless. Look at the monetary base or one of the monetary aggregates; they haven’t moved much. Should we expect a lot of incremental economic action of out of this? I don’t think so.
Onto the Commercial Paper Market. CP outstanding had its biggest weekly drop since 2000. It is down almost 10% over the past two weeks. Most of the decrease is asset-backed CP. Bill Gross declares that the ABCP market is “history.” He’s wrong. Again. ABCP will remain but with safer classes of asset-backed securities, wider spreads, and larger margins of safety, at least until the next lust for yield comes upon us. As it is, the safer parts of the ABCP market are beginning to function normally, albeit at higher spreads.
Things can get bad in the ABCP market, particularly if you are an issuer that doesn’t have a big balance sheet. That’s what happened to Canada’s Coventree. For banks issuing ABCP, it should not be as big of a problem; many banks will step up and make up the loss. If the risk is $891 billion in commercial paper, I would be surprised if the losses were more than 2% of that amount. At $18 billion, that is no threat to the system, though some rogue money market funds might get whacked.
Now corporate bond issuance is returning, though some of it is replacing CP. I expect that effect to stop soon. Things are returning to normal in corporates, though high yield will take more time.
This article helps point out that the Fed, though still powerful, has reduced powers because less of the financial system consists of depositary institutions. ABS and mutual funds have picked up the slack. What that implies is that ordinary bond buyers are willing to take on the risks that depositary institutions once did. That reduces the power of the Fed.
As for this article, I’m sure Fed Governors are thinking, “What’s next? Are we just running from fire to fire, or is there a systemic way to restore order?” I’m not so sure here. I think a permanent injection of liquidity would do it, temporarily, but there are so many places where leverage got too great that are in loss positions now. For the Fed, the only real question should be, how much did our banks lend to the overleveraged?
From Michael Sesit at Bloomberg, there are four things for the central banks to do in order to avert the crises: The world’s major central banks face four challenges as they strive to prevent the global financial system from unraveling and growth from stagnating: Acting in a concerted manner; improving transparency; deciding who gets bailed out and who doesn’t; and making sure whatever monetary medicine is administered doesn’t come with destabilizing side effects.
All four are not easy. I would argue that the last two are the most important, but that it is very difficult to legally discriminate between who needs it and who doesn’t. Destabilizing side effects are part and parcel of monetary policy. To the degree that the Fed can discriminate, it will eventually run the risk of being view as unfairly discriminatory, and unelected as well.
So, I don’t see much happening here from monetary policy. It is simply a question of how the excess leverage presents itself through the financial system. So far, it has served up some notable troubles, the question is how much more before it burns out. With residential housing prices sagging it may persist for a long while, until the Fed debases the currency such that debtors can pay back their debts in devalued terms. It almost reminds me of the bimetalism of the late 19th century; debasing the currency to let a wide number of debtors off the hook. Well, if the Fed doesn’t do it, maybe Congress will. After all, Congress can do something targeted,and live with the political heat. The Fed risks its independence if they look like they behave on behalf of the the few, nor the many.