Putting the Genie Back Inside the Bottle
Posted by Larry Doyle on April 5, 2009 11:43 AM |
The genie, in the form of the Federal Reserve, has granted the markets a lot more than three wishes over the course of these challenging economic times. What are some of the wishes granted so far? Let’s review:
1. cutting the Federal Funds rate to a range of 0-.25%.
2. backstopping a wide array of short term funding operations, including the Commercial Paper market, Money Market funds, and Swaps market.
3. opening the Federal Reserve discount window for investment banks prior to their conversion to commercial banks.
4. utilizing a massive Quantitative Easing program to purchase government, mortgage-backed, and government agency securities in an attempt to bring interest rates down and jumpstart borrowing by consumers and corporations.
5. working in concert with the Treasury and FDIC to implement the TARP (Troubled Asset Recovery Program), TALF (Term Asset-Backed Lending Facility) and PPIP (Public-Private Investment Program).
In the process of implementing all of these activities, this genie, the Federal Reserve, in the person of chairman Ben Bernanke, has gone places no genie has ever gone before.
The question before the court is whether the free market can ever get the genie back in the bottle. Additionally, aside from getting the genie back in the bottle, these wishes granted by the genie aren’t exactly free. How so?
The Federal Reserve’s balance sheet has expanded so rapidly that many investors are concerned as to the potential cost of that expansion. When will investors lose confidence in the genie? When will investors discount the powers of the genie? When will investors view the genie as less magician and more human?
Given that the largest underpinning in any market is “confidence”, these questions in regard to the genie are being asked on a very regular basis. The genie, Ben Bernanke, and his sidekick, Donald Kohn, responded to these questions the other day. Bloomberg reports:
Chairman Ben S. Bernanke said yesterday in Charlotte, North Carolina that the Fed must retain the flexibility to withdraw its record cash injections to restrain prices. Vice Chairman Donald Kohn said in Wooster, Ohio, “the trick will be unwinding this balance sheet in a timely way to avoid inflation.”
I find it very interesting that Kohn actually uses the term “trick” to address this issue. These maneuvers have never been practiced prior to this time, so the “how to ” manual has never been written.
Will the powers of the genie spin out of control? Will the markets deem the genie to be less magical and actually more warlock? Will this genie, Bernanke and his helper, Kohn, be challenged by the partygoers (market participants) for ever greater tricks only for the parents of the partygoers to get so concerned that the party has gotten totally out of control? Bloomberg offers:
“They have two significant challenges — one is figuring out when to unwind,” said Christopher Low, chief economist at FTN Financial in New York, referring to U.S. central bankers. The second challenge is how, and that’s made tougher by “so many unwieldy positions. Nothing is as liquid as it used to be” on the Fed’s balance sheet, he said.
The U.S. central bank has effectively printed money to buy or lend against a range of assets to alleviate the credit crunch and revive the economy. Bernanke’s speech yesterday detailed steps that the Fed can take to remove that liquidity, including soaking up cash by the issuance of special bills.
The Fed normally raises interest rates by selling Treasuries on its balance sheet, draining reserves from the banking system. That task is tougher with the Fed’s commitment last month to buy more than $1 trillion in mortgage-backed securities, which are harder to sell quickly without roiling markets or potentially attracting political scrutiny.
Bernanke, 55, speaking at a conference hosted by the Richmond Fed bank, hailed last month’s joint statement with the Treasury that spelled out the principles underlying the central bank’s work with the Treasury to revive credit.
While the Fed has implemented “unconventional” measures and taken some “extremely uncomfortable” steps, it’s critical that the efforts “do not interfere with the independent conduct of monetary policy,” Bernanke said.
While these challenging times are certainly no party, the unwinding of the genie’s tricks represents very real issues for all involved. The price of not timely and effectively getting this genie back inside the bottle is massive inflation, if not hyper-inflation.
The only trick the genie knows to deal with that problem is dramatically increasing short term interest rates. While this current period is certainly no party, a rapid increase in short term interest rates is akin to a sentence in the pain chamber.