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Jan 26, 2008

Page 1 of 3 THE ROAD TO HYPERINFLATION

Fed helpless in its own crisis

By Henry C K Liu After months of denial to soothe a nervous market, the Federal Reserve, the US central bank, finally started to take increasingly desperate steps to try to inject more liquidity into distressed financial institutions to revive and stabilize credit markets that have been roiled by turmoil since August 2007 and to prevent the home mortgage credit crisis from infesting the whole economy. Yet more liquidity appears to be a counterproductive response to a credit crisis that has been caused by years of excess liquidity. A liquidity crisis is merely a symptom of the current financial malaise. The real disease is mounting insolvency resulting from The Complete Henry C K Liu

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Further, the market is stalled by a liquidity crunch, but the economy is plagued with excess liquidity. What the Fed appears to be doing is to try to save the market at the expense of the economy by adding more liquidity. The Federal Reserve has at its disposal three tools of monetary policy: open market operations to keep Fed Funds rate on target, the discount rate and bank reserve requirements. The Board of Governors of the Federal Reserve System is responsible for setting the discount rate at which banks can borrow directly from the Fed and for setting bank reserve requirements. The Federal Open Market Committee (FOMC) is responsible for setting the Fed Funds rate target and for conducting open market operations to keep it within target. Interest rates affects the cost of money and the bank reserve requirements affect the size of the money supply. The FOMC has 12 members - the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy, and assess the risks to its long-run goals of price stability and sustainable economic growth. Special meetings can be called by the Fed chairman as needed. Using these three policy tools, the Federal Reserve can influence the demand for, and supply of balances that depository institutions hold at Federal Reserve Banks and in this way can alter the federal funds rate target, which is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Changes in the federal funds rate trigger a chain of effects on other short-term interest rates, foreign exchange rates, longterm interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and market prices of goods and services. Yet the effects of changes in the Fed Funds rate on economic variables are not static nor are they well understood or predictable since the economy is always evolving into new structural relationships among key components driven by changing economic, social and political conditions. For example, the current credit crisis has evolved from the unregulated global growth of structured finance with the pricing of risk distorted by complex hedging which can fail under conditions of distress. The proliferation of new market participants such as hedge funds operating with high leverage on complex trading strategies has exacerbated volatility that changes market behavior and masked heightened risk levels in recent years. The hedging against risk for individual market participants has actually increased an accumulative effect on systemic risk. The discount window is designed to function as a safety valve in relieving pressures in interbank reserve markets. Extensions of discount credit can help relieve liquidity strains in individual depository institutions and in the banking system as a whole.

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The discount window also helps to ensure the basic stability of the payment system more generally by supplying liquidity during times of systemic stress. Yet the discount window can have little effect when a liquidity drought is the symptom rather than the cause of systemic stress. Banks in temporary distress can borrow short term funds directly from a Federal Reserve Bank discount window at the discount rate, set since January 9, 2003 at 100 basis points above the Fed Funds rate. Prior to that date, the discount rate was set below the target Fed Funds rate to provide help to distressed banks but a stigma was attached to discount window borrowing. Healthy banks would pay 50 to 75 basis points in the money market rather than going to the Fed discount widow, complicating the Feds task in keeping the Fed Funds rate on target. Part of the reason for raising the discount rate 100 basis point above the Fed Funds rate on January 9, 2003 was to remove this stigma that had kept many banks from using the Fed discount window. (For a historical account of the change of the discount rate, see Central bank impotence and market liquidity, Asia Times Online, August 24, 2007.) Both the discount rate and the Fed Funds rate are set by the Fed as a matter of policy. On August 17, 2007, the discount window primary credit program was temporarily changed to allow primary credit loans for terms of up to 30 days, rather than overnight or for very short terms as before. Also, the spread of the primary credit rate over the FOMC's target federal funds rate has been reduced to 50 basis points from its customary 100 basis points. These changes will remain until the Federal Reserve determines that market liquidity has improved. The Fed keeps the Fed Funds rate within narrow range of its target through FOMC trading of government securities in the repo market. A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. Repos are contracts for the sale and future repurchase of top-rated financial assets. It is through the repo market that the Fed injects funds into or withdraws funds from the money market, raising or lowering overnight interest rates to the level set by the Fed. (See The Wizard of Bubbleland - Part II: The repo time bomb Asia Times Online, September 29, 2005). Until the regular FOMC meeting scheduled for January 29, 2008, the discount rate had been expected to stay at 4.75% while the Fed Funds target would stay at 4.25%, with a 50 basis points spread, half of normal, which had been set at a spread of 100 basis points since January 9, 2003. From a high of 6% set on May 18, 2000, the Fed had lowered the discount rate in 12 steps to 0.75% by November 7, 2002 and kept it there until January 8, 2003 while the Fed Funds rate target was set at 1.25%, 50 basis points above. On January 9, 2003, the discount rate was set 100 basis points above the Fed Funds rate target. Then the Fed gradually raised the discount rate back up to 6% by May 10, 2006 and again to 6.25% on June 29, 2006. On August 18, 2007, in response to the sudden outbreak of the credit market crisis, the Fed panicked and dropped the discount rate 50 basis points to 5.75%, and

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continued lowering it down to the current level of 4.75% set on December 12, 2007. On Monday, January 21, a week before the scheduled FOMC meeting, global equities plunged as investor concerns over the economic outlook and financial market turbulence snowballed into a sweeping sell-off. Tumbling Asian shares - which continued to fall early on Tuesday - led European stock markets into their biggest one-day fall since the 9/11 terrorist attacks of 2001 as the prospect of a US recession and further fall-out from credit market turmoil prompted near panic among investors, forcing them to rush to the safety of government bonds. About $490 billion was wiped off the market value of Europe's FTSE Eurofirst 300 index and $148 billion from the FTSE 100 index in London, which suffered its biggest points slide since it was formed in 1983. Germany's Xetra Dax slumped 7.2% to 6,790.19 and France's CAC-40 fell 6.8% to 4,744.45, its worst one-day percentage point fall since September 11, 2001. The price collapse was driven by general negative sentiments and not, so far as was apparent at the time, by any one identifiable event. After being closed on Monday for the Martin Luther King holiday, US stock benchmarks echoed foreign markets with big declines, extending large losses from the previous week, with bearish sentiments accelerated by heavy selling across global markets. About an hour before the NY Stock Exchange open on Tuesday, the Federal Reserve announced a cut of 75 basis points of the Fed Funds rate target to 3.50%, the first time that the Fed has changed rates between meetings since 2001, when the central bank was battling the combined impacts of a recession and the terrorist attacks. Fed officials decided on their move at a videoconference at 6pm US time on Monday, January 21, with one policymaker Bill Poole, the president of the St Louis Fed, dissenting. In a statement, the Fed said it acted "in view of a weakening of the economic outlook and increased downside risks to growth". It said that while strains in short-term money markets had eased, "broader financial conditions have continued to deteriorate and credit has tightened further for some businesses and households". And new information also indicated a "deepening of the housing contraction" and "some softening in labor markets". Subsequently, French bank Societe Generale SA said that bets on stock index futures by a rogue trader had caused a 4.9 billion-euro ($7.2 billion) trading loss, the largest in banking history. This led to speculation, rejected by the bank, that the market declines in Europe on Monday were in part the consequence of the Societe Generale unwinding trading positions linked to European stock index futures on January 21, when equity markets in France, Germany and the UK fell more than 5% and the day before the Fed rate cut. "It's not possible that our covering operations contributed to the market's fall,'' said Philippe Collas, the head of asset management at the bank, according to a Bloomberg report on

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January 25. The Fed in announcing its rate cut pledged to act in a "timely manner as needed" to address the risks to growth, implying that it expects to cut the federal funds rate rates still further and will consider doing so at its scheduled policy meeting on January 30. In overnight trade, Asian shares extended their losses. Japan's Nikkei 225 index accumulated its worst two-day decline in nearly two decades, losing more than 5% and falling below 13,000 for the first time since September 2005. Initially, the Fed move caused S&P stock futures to jump but within half an hour they were lower than they had been at the moment the rate cut was announced. The Dow Jones Industrial Average, down 465 points shortly after market open, fluctuated throughout the day before closing with a milder drop of 126.24, or 1.04%, at 11,973.06, the first closing below 12,000 since November 3, 2006. The move was the first unscheduled Fed rate cut since September 17, 2001 and its largest increment since regular meetings began in 1994. It was a sharp departure from traditional gradualism preferred by the Fed and wild volatility in the market can be expected as a result. S&P equity volatility as measured by the Vix index surged 38%, eclipsing the high set in August when the credit crisis first surfaced. The aggressive Fed action triggered a rebound in European stock markets, but was not enough to stop the US equity market - which had been closed when markets fell globally on Monday - from trading lower. At midday the S&P 500 index was at 1,302.24 down 1.7% on the day and 11.3% so far this year amid mounting concern over the prospect of a US recession and further credit market turmoil. While financial stocks had rebounded 1.8% in morning trading, other main sectors were sharply lower, by a 3.4% decline in technology shares. While the Fed has the power to independently set the discount rate directly and keep the Fed Funds rate on target indirectly through open market operations, the impact of short-term rates on monetary policy implementation has been diluted by longterm rates set separately by deregulated global market forces. When long-term rates fall below short-term rates, the inverted rate curve usually suggests future economic contraction. Both discount and Fed funds loans are required to be collateralized by top-rated securities. Since August 2007, the Fed has been faced with the problem of encouraging distressed banks to borrow from the Fed discount window without suffering the usual stigma of distress, accepting as collateral bank holdings of technically still top-rated collateralized debt obligations (CDOs) which in reality have been impaired by their tie to subprime home mortgage debt obligations that have lost both marketability and value in a credit market seizure. As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back. That is

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why home mortgage defaults create liquidity crises. This simple insight demolishes the myth that the central bank is the sole controller of a nations money supply. While the Federal Reserve commands a monopoly on the issuance of the nation's currency in the form of Federal Reserve notes, which are "legal tender for all debts public and private", it does not command a monopoly on the creation of money in the economy. The Fed does, however, control the supply of "high power money" in the regulated partial reserve banking system. By adjusting the required level of reserves and by injecting high power money directly into the banking system, the Fed can increase or decrease the ability of banks to create money by lending the same money to customers multiple times, less the amount of reserves each time, relaying liquidity to the market in multiple amounts because of the mathematics of partial reserve. Thus with a 10% reserve requirement, a $1,000 initial deposit can be loaned out 45 times less 10% reserve withheld each time to create $7,395 of loans and an equal amount of deposits from borrowers. But money can be and is created by all debt issuers, public and private, in the money markets, many of which are not strictly regulated by government. While a predominant amount of global debt is denominated in dollars, on which the Fed has monopolistic authority, the notional value used in structured finance denominated in dollars, which reached a record $681 trillion in third quarter 2007, is totally outside the control of the Fed. Virtual money is largely unregulated, with the dollar acting merely as an accounting unit. When US homeowners default on their mortgages en mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth. As the debt securitization market collapses, banks cannot roll over their off-balance sheet liabilities by selling new securities and are forced to put the liabilities back on their own balance sheets. This puts stress on bank capital requirements. Since the volume of debt securitization is geometrically larger than bank deposits, a widespread inability to roll over short term debt securities will threaten banks with insolvency. The Fed can create money, not wealth Money is not wealth. It is only a measurement of wealth. A given amount of money, qualified by the value of money as expressed in its purchasing power, represents an account of wealth at a given point in time in an operating market. Given a fixed amount of wealth, the value of money is inversely proportional to the amount Continued 1 2 3

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