The Fed Is Terrified By Mish

The Wall Street Journal is reporting Fed Weighs Its Options in Easing Crunch.

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.

Among the options: Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed's name rather than the Treasury's; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.

The Fed holds assets to manage the nation's money supply and influence the federal-funds rate, which banks charge each other on overnight loans. When the Fed buys Treasurys or makes loans directly to banks, it supplies financial institutions with cash; in effect, it prints money. The cash ends up as currency in circulation or in banks' reserve accounts at the Fed.

Since reserves earn no interest, banks lend cash that exceeds their required minimum. That puts downward pressure on the federal funds rate, currently targeted by the Fed at 2.25%. The Fed could purchase securities and make loans almost without limit, expanding its balance sheet. That would cause excess reserves to skyrocket and the federal funds rate to fall to zero. The Fed would contemplate such "quantitative easing" only in dire circumstances. The Bank of Japan took this step this decade after years of economic stagnation.

Weighing the Possibilities

So the Fed is seeking ways to expand its balance sheet without causing the federal funds rate to drop. The likeliest option, one the Fed and Treasury have discussed, is for the Treasury to issue more debt than it needs to fund government operations. The extra cash would be left on deposit at the Fed, where it would be separate from bank reserves on deposit and thus would have no impact on interest rates. The Fed would use the cash to purchase an offsetting amount of Treasurys in the open market; for legal reasons, it generally cannot buy them directly from Treasury.

Treasury's principal constraint is the statutory limit debt. Treasury debt was $453 billion below the limit Monday. In the past, Congress always has responded to administration requests to raise the limit, sometimes only after political theatrics.

Fed officials also are investigating the feasibility of the Fed issuing its own debt and using the proceeds to purchase other assets or make loans. It has never done so; the legality is unclear. Some foreign central banks, such as the Bank of Japan, do so.

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The Fed is Terrified

Read the entire WSJ article. It's a good one. That the Fed officials are having these kinds of discussions at all shows just how terrified of the perception setting in that we are following Japan, which of course we are.

The Fed is effectively in a position of not to being able to print money to buy Treasuries from banks, because of restrictions mentioned in the WSJ article and also because the banks are insolvent. Simply put, banks do not have the cash to accumulate Treasuries on their books to sell to the Fed this time around. And more writedowns on commercial real estate, auto loans, credit card debt, Alt-A mortgages, and pay option arms are coming. This will require still more capital raising efforts.

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http://globaleconomicanalysis.blogspot.com/2008/04/fed-is-terrified.html