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Busch: Success Also Means Reform Of System

Yesterday, Federal Reserve chairman Ben Bernanke gave a long speech updating the markets on what the government has done to arrest the credit crisis and stabilize the economy. First, Bernanke discusses the Fed's action offset to the extent possible the effects of the crisis on credit conditions and the broader economy by cutting interest rates aggressively by 325 basis points.

Next, he talks about supporting the credit markets to reduce financial strains (credit crunch) by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets. Lastly, he discusses the Fed using "all our available tools to promote financial stability, which is essential for healthy economic growth."

However, it isn't until he gets to the outlook for policy that things get interesting. Here's the line that everyone is discussing: "Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited." This is the quantitative easing that goes beyond the scope of cutting interest rates to the Federal Reserve expanding their balance sheet to pump money into the economy. This takes us in to the realm of targeting things like "balance of outstanding current accounts" by commercial banks instead of the Federal Funds rate.

Bernanke gives this overview: "Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates."

Remember, Japan attempted a similar program between 2001-2006. To understand its effectiveness, studies have focused on the direct effect of increases in current account balances, an impact on the expectations of market participants, increased central bank purchases of long-term Japanese government bonds (JGBs) that would reduce long-term interest rates, and an encouragement of greater risk-tolerance in the Japanese financial system. (FRB) While the studies are still coming in, the conclusions have been that the intentions of the program worked, but with the side effect of delaying structural reform necessary to strengthening the bank system.

Without question, the Fed is pleased with the outcome of their actions in reducing a housing market interest rate and will be emboldened to do more in this aspect. Bernanke recognizes the risk and states that eventually, the Fed's balance sheet will be brought back to a more sustainable level. But this will occur long after the Fed has expanded beyond what will be needed and Bernanke may not be the man in charge of pulling back the "punch bowl." Moreover, the worst thing that could happen would be success without reform of the system. Both need to happen or the seeds for the next credit crisis will be planted today.

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Andrew Busch

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