Not yet the last resort
The Fed tries its own version of quantitative easing
WHEN, on October 3rd, America’s Congress eventually approved the Bush administration’s $700 billion plan to buy troubled mortgage assets, lawmakers earned not only the gratitude of Ben Bernanke, but also a promise from him. The Federal Reserve, its chairman declared, would do its part with “all of the powers at our disposal”.
He has certainly kept his word. On October 6th the Fed doubled, to $900 billion, the planned size of the loans it auctions to banks. A day later it said it would for the first time in its history make unsecured loans to companies, including banks, by buying commercial paper that they are unable to refinance. In theory, this tactic could be used to allow the Fed to make any kind of loan, including to state and local governments and in the interbank funds market. And a day after that it joined other leading central banks in cutting interest rates, lowering its target for the federal funds rate from 2% to 1.5%. It is unlikely to stop there. The rate could end up at zero.
The rate cut was a conventional response to the growing risk of a deep recession. The other steps take the Fed farther into uncharted territory. They were made possible in large part by a provision of the bail-out law that permits the central bank to pay interest on reserves that commercial banks keep on deposit at the Fed. This is important because every time the Fed makes a loan, it creates additional bank reserves. Banks lend excess reserves to each other, putting downward pressure on the federal funds rate. To drain those reserves and offset that pressure, the Fed sells Treasury debt. But it has been lending on such a huge scale that it has used up the bulk of its Treasuries. Had it run out, its lending would have had to stop or the funds rate would fall to zero. Paying interest on reserves largely removes that risk, because it leads the banks to lend the money back to the Fed.
The Fed tries its own version of quantitative easing
WHEN, on October 3rd, America’s Congress eventually approved the Bush administration’s $700 billion plan to buy troubled mortgage assets, lawmakers earned not only the gratitude of Ben Bernanke, but also a promise from him. The Federal Reserve, its chairman declared, would do its part with “all of the powers at our disposal”.
He has certainly kept his word. On October 6th the Fed doubled, to $900 billion, the planned size of the loans it auctions to banks. A day later it said it would for the first time in its history make unsecured loans to companies, including banks, by buying commercial paper that they are unable to refinance. In theory, this tactic could be used to allow the Fed to make any kind of loan, including to state and local governments and in the interbank funds market. And a day after that it joined other leading central banks in cutting interest rates, lowering its target for the federal funds rate from 2% to 1.5%. It is unlikely to stop there. The rate could end up at zero.
The rate cut was a conventional response to the growing risk of a deep recession. The other steps take the Fed farther into uncharted territory. They were made possible in large part by a provision of the bail-out law that permits the central bank to pay interest on reserves that commercial banks keep on deposit at the Fed. This is important because every time the Fed makes a loan, it creates additional bank reserves. Banks lend excess reserves to each other, putting downward pressure on the federal funds rate. To drain those reserves and offset that pressure, the Fed sells Treasury debt. But it has been lending on such a huge scale that it has used up the bulk of its Treasuries. Had it run out, its lending would have had to stop or the funds rate would fall to zero. Paying interest on reserves largely removes that risk, because it leads the banks to lend the money back to the Fed.
