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Fed Considering Unconventional Measures

September 16, 2007

Tags The FedInterventionismMoney and Banking

The Financial Times reports Fed mulls options in tacking liquidity problem. What options?

  • The possible steps range from the relatively orthodox — a disproportionately large cut in the discount rate at which the Fed lends directly to banks — to more unorthodox measures.

    At issue is whether it would be worth the Fed dusting down some rarely used tools — or improvising new ones — to help it reach beyond the banking system and channel liquidity to where it is needed most.

And it's not just the Fed. Bloomberg reports Australian Central Bank Will Buy Mortgage-Backed Debt. The article proceeds to describe some of these tools:

  • "encourage greater use of the discount window"
  • "extending the term of open market operations"
  • "lending directly to non-banks against their collateral"
  • establish currency swaps with European central banks
  • "creatiion of a temporary special liquidity facility that would accept commercial paper at a discount rate"
  • the sale of call options on interest rates

These and similar measures have been discussed by the Fed for several years. They were studied during the bogus 2002 deflation scare and disclosed in a series of papers and speeches that I have discussed elsewhere. It was my view at the time that the only for the Fed to avoid a total meltdown of the credit bubble is to monetize assets at prices sufficient to maintain the solvency of the banks and funds that hold them.

Although this point is somewhat obscured by the language of the article, a few of these measures are moving in the direction of monetization of securities. This can be direct monetization, if the Fed simply purchases the securities with newly created money, or indirect, if the Fed loans money into existence, taking the securities as collateral, valued at some fictitious non-market price, likely far in excess of the actual market value of the securities (if indeed they have any).

But don't worry; like all emergency government measures, they will be strictly temporary. "Mr Berner said the Fed's main concern would be to ensure it did not end up taking any credit risk and that any unorthodox arrangements were truly temporary."

What is more likely is that temporary measures only prevent this round of problems from blowing up for long enough until the next round of problems occur. Temporary measures might allow time for alternatives to emerge, but what if the securities really are still worthless on the market a month or two months later? (Jim Sinclair has some interesting thoughts along these lines in this MP3 interview which starts at the 34:00 mark in the file). Once the props are removed from these assets, what is to prevent the fund or banks that own them from becoming insolvent?

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