Our Not-So-Elastic Currency

Before I start this evening, I want to point to a blog post of Barry’s. I have never heard James Grant as agitated as he is in this Bloomberg interview. I’ve heard James Grant disappointed or discouraged, but not annoyed. It was interesting to listen to, and compatible with my views on the credit markets.

This small PDF file contains my summary of the Fed’s H.4.1 report at two points in time: early August 2007, and the latest. I chose early August, because it was prior to the FOMC being willing to advertise that they might consider unorthodox monetary policy solutions. How have things changed? Let’s start with what hasn’t changed. For the most part, the Fed hasn’t expanded its balance sheet. Total assets are up only 2.5%, or 3.8% annualized. The liability side of the balance sheet has expanded even less — 1.7% or 2.7% annualized. The issuance of Federal Reserve Notes has crept up 0.5%, or 0.7% annualized. For a loosening cycle, this is unusual.

But what has changed? The composition of assets on the balance sheet, and the level Fed net worth.

  • Treasury bills down $163 billion
  • Treasury notes and bonds down $18 billion
  • Repurchase agreements up $82 million
  • Term Auction Credit up $80 million
  • Other loans (direct lending to dealers) up $37 million
  • Fed net worth up $7 billion (21%, I will not annualize that)

What you are seeing is a substitution of T-bills and T-notes for short-term lending against collateral with greater credit risk (though with haircuts). If you net all of the changes that I highlighted on the asset side, it adds up to the change in assets less $3.5 billion. As for the net worth of the Fed, it is curious to see it rising so much. I need to look at that series over time to see how it changes.

In short, the FOMC is providing a little more credit to the economy as a whole through the expansion of its own balance sheet. In the process, it is changing the composition of its own balance sheet (at least for a little while) in order to induce more liquidity into the mortgage markets, while offering out T-bills that are in hot demand. Both aim to narrow the spread between mortgage bonds and Treasuries, particularly on the short end.

That said the bond market is big, making the $200 billion allocated by the Fed look small. Now, there are also the actions of the GSEs, which are perhaps another $300 billion. Is that enough to right the prime residential mortgage market? It looks small to me, though in the short-run, it can change market psychology.

Why I titled this “Our Not-So-Elastic Currency” is that the amount of stimulus to the economy as a whole is small; the action is focused on fixing the mortgage markets, and the broker-dealers. That M2 and other broader monetary aggregates are rising aggressively stems from a willing ness of the banks to take on leverage at present. For banks that are healthy, funds are cheap; they can expand.

TSLF Auction

I had earlier predicted that direct lending to broker-dealers would limit the need for the Term Securities Lending Facility. Well, that’s not true, but the need for the TSLF was not that great today. $75 billion of credit was offered, with only $86 billion of bids. The rate that the exchange of collateral priced at was only 33 basis points, which was only 8 basis points above the minimum acceptable. The auction was close to failing, except that failure would be a good thing. If bids had not been sufficient, it would have indicated a lack of need for the facility, which would indicate that conditions aren’t so bad after all.

My guess is that the TSLF will not be one of the new credit systems that survives the current crisis. The direct lending through the Primary Dealer Credit Facility may prove harder to discontinue because of its greater flexibility.