November 25, 2008 – The Baseline Scenario

There was a new theme buried in today’s announcements about purchasing $600 billion in mortgage-backed assets $200 billion in assets backed by other debt including student loans, credit cards, car loans, and small business loans. The New York Times story included these two paragraphs (emphasis added):

The action by the Federal Reserve on buying mortgage-backed securities brings the full force of monetary policy to bear on the credit markets. Having already reduced the benchmark federal funds rate to just 1 percent, the central bank is now effectively using what economists call “quantitative easing” to reduce the costs of money.

Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated.

The Bloomberg article has a similar passage, indicating that this is a message the Fed is consciously putting out, while taking care to deny that they are trying to increase inflation (emphasis added)

The Fed won’t be removing cash from other parts of the financial system to make up for the purchases, government officials told reporters on a conference call. They rejected any comparison with Japan’s so-called quantitative easing effort to combat deflation, saying that the Fed’s objective is to buttress credit markets rather than ramp up money.

What does this mean? It looks like the Fed will be buying securities either by wiring cold, hard cash to sellers, or by increasing their account balances at the Fed itself, without simultaneously selling Treasuries (or asking the Treasury Department to issue new Treasuries) to sop up an equivalent amount of cash. This ordinarily would run the risk of increasing inflation, but with short-term prices falling, arguably a bit of inflation is just what we need, as Simon and Peter argued yesterday.

(If you found the last paragraph confusing, see my Federal Reserve for Beginners post.)

More economics bloggers trying to be funny: Free Exchange reported on today’s $800 billion worth of announcements and concluded with this sentence: “So, you know, hopefully that will work out.”

By Peter Boone, Simon Johnson, and James Kwak (pdf version is here)

Summary

1. Debt and equity prices for U.S. banks at the close on Friday, November 21, indicated that the market is testing the resolve of the government to support the banking system. Allowing major banks to fail is not an option, as was made explicit in the G7 statement in mid-October. Significant recapitalization will be necessary to stem the pace of global deleveraging (the contraction of loans and sale of assets by banks around the world). However, the administration’s strategy is not clear.

2. While full bank recapitalization is not a panacea, it is an important part of the policy mix that will get us through mid-2009, at which point a broader set of expansionary fiscal and – most important – monetary policies can begin to take effect.

3. The response this weekend by the U.S. authorities in providing financial support to Citigroup is a partial, overly generous, and nontransparent recapitalization, including a large guarantee for distressed assets – which is very close to the asset purchases that Treasury only last week said it would not do. This U-turn confuses the market (again), leaves the fate of other major banks unclear, and implies much larger contingent liabilities and little upside for the taxpayer. This approach will be difficult to repeat multiple times because of likely political backlash.

4. The most important goal now is to put in place a stable, transparent set of rules for bank recapitalization, with sufficient political support and limits on the scope for further policy changes. Mr. Paulson’s seemingly haphazard approach has become a part of the system problem.

5. While all recapitalization options have problems, the “least bad” is requiring firms to raise more capital and, for those that cannot, injecting capital through substantial purchases of common stock by the government. These can be managed through a special purpose agency or control board, which is designed to keep credit from becoming politicized and to sell the equity stakes when market conditions are sufficiently supportive.

6. Another TARP-type round, on slightly tougher terms than October, may serve as an emergency stop-gap measure, but it will not solve the underlying problems and any positive effects could be short-lived.

Continue reading “Bank Recapitalization Options and Recommendation (After Citigroup Bailout)” →