The Fed's new tools (II)

Last week I described the traditional tools of the Fed (open market operations and the discount window) and an old, but less well-known one (repurchase agreements). Then I described the first innovation, the Term Auction Facility, inaugurated in December.

This week I’ll go over the forms of lending introduced in 2008, and then I'll discuss the options that the Fed is rumored to be considering next.

* * *

In 2007 the Federal Reserve made an effort to provide liquidity through channels other than open market operations and repos. To that effect, it created the Term Discount Window Program (TDWP) and the Term Auction Facility (TAF), as I explained last week. Both of those facilities, however, are available only to depository institutions.

So far I’ve been using the ambiguous term “banks” to refer to institutions that borrow funds or buy Treasurys from the Fed. There are however two broad classes of “banks”: depository institutions and primary dealers. Depository institutions are allowed to accept deposits. Primary dealers, on the other hand, are investment banks and brokers that trade in Treasurys with the Federal Reserve. Bear Stearns and Lehman Brothers are two examples in the latter group. As of today, there are 20 of them.

One defining characteristic of depository institutions is that they can use a broad range of assets to secure their loans from the Fed. The discount window, the TDWP and the TAF all accept a set of assets known as “discount collateral.” That includes pretty much all paper of investment quality, including performing sub-prime mortgages. Primary dealers, on the other hand, only have access to open-market operations (OMOs) and repos. The latter only can be obtained after posting General Collateral —that is paper issued by the Treasury or US agencies only.

Following problems in the mortgage and real estate markets last summer, primary dealers found it increasingly hard to obtain short-term financing because nobody would take their suspicious assets as collateral —or would do so only at very high prices. The Fed stepped up to the plate by opening the Term Securities Lending Facility (TSLF) to primary dealers, on March 27. Roughly speaking, a TSLF loan is an exchange of risky securities for Treasuries for 28 days between Federal Reserve and primary dealers. The range of acceptable collateral, although not as wide as at the discount window, includes some types of paper issued by non-agency institutions (AAA/Aaa-rated private label RMBS and CMBS).

To be sure, the Fed has had a securities lending program for a number of years. The novelty of the TSLF is that it extends the range of acceptable collateral beyond Treasuries. A second novelty is that the term of the loans increases from overnight to 28 days.

Unlike the other tools I have discussed, the TSLF does not have an effect on reserve balances by design. This allows the Fed to pursue its recent strategy of providing liquidity to the banking system without increasing the monetary base.

This is what these loans would look like on the balance sheet of the Fed:

Changes in the Fed's balance sheet after a $1,000M TSLF loan
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	TSLF loan	+1,000
	Other assets	0
Liabilities	Currency in circulation	0
	Reserve balances	0

In March the Fed inaugurated a second form of lending: the Primary Dealer Credit Facility (PDCF). This venue provides overnight cash loans to all primary dealers, at the same interest rate as the discount window does, and by pledging the same type of collateral. With the PDCF the Federal Reserve has de facto opened the discount window to primary dealers.

PDCF loans increase the monetary base (read the FAQ). Because this facility is meant to oil the credit market, not to provide a monetary stimulus, the Fed will continue to offset the increase in reserves using "a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements, redemptions of Treasury securities, and changes in the sizes of conventional RP transactions." Here's what a PDCF loan looks like, after it has been offset:

Changes in the Fed's balance sheet after a $1,000M PDCF loan, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	PDCF loan	+1,000
	TSLF loan	0
	Other assets	0
Liabilities	Currency in circulation	-1,000 + 1,000
	Reserve balances	0

The composition of the Fed’s assets has changed substantially over the last nine months. Here’s the balance sheet of the Fed again, in December and March:

Federal Reserve's balance sheet, $ millions
Assets		Aug. 15, 2007	Mar. 19, 2008
	US government securities	789,601	660,484
	Repurchase agreements	24,000	62,000
	Reverse repurchase agreements	-31,941	-46,143
	Term Auction Facility loans	0	80,000
	Primary Dealers Credit Facility	0	28,800
	Direct loans	264	125
	Other assets	37,058	36,603
Liabilities	Currency in circulation	813,085	818,362
	Reserve balances	5,897	3,507

Source: Federal Reserve, H.4.1 release.

With its new tools, the Fed has provided liquidity without printing much money. In a way, the Fed has become a pawnbroker.

The future?

Loans to commercial banks and primary dealers, from one facility or another, represent now a much larger fraction of assets (see chart, from the Wall Street Journal). The fraction of Treasurys has declined to 53% from 87%.

The concern now is that the Fed may run out of Treasurys. In theory, the Fed could continue extending loans indefinitely. The problem is that, with no Treasurys left over, the Fed would not be able to offset expansions of the monetary base, as it’s been doing for months. Reserve balances would balloon, pushing down the federal funds interest rate to zero. So the Fed is now pondering the following alternatives:

1) Purchase mortgage-backed securities directly —as opposed to taking them as collateral, as it does through the discount window programs and the PDCF. The Fed could finance such purchases by selling Treasurys, and in that case reserve balances would not be affected. But the amount of Treasurys in the Fed’s balance sheet is, as I said, limited and shrinking rapidly.

2) Have the Treasury issue more debt than it needs and deposit the cash at the Fed. The extra cash would be separate from reserve balances, and thus a priori wouldn’t have any impact on the fed funds rate. The Fed would use that cash to purchase Treasurys. This is what this maneuver would look like:

Changes in the Fed's balance sheet after taking $1,000M worth of Treasury deposits, after an issue of "unnecessary" Treasurys
Assets	US government securities	+1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	PDCF loan	0
	TSLF loan	0
	Other assets	0
Liabilities	Currency in circulation	0
	Reserve balances	0
	Treasury deposits	+1,000

While lending conditions don't improve, the new funds would soon turn into loans to banks, so the actual effect on the balance sheet would be (assuming the funds are loaned through the discount window; other forms of lending would affect different lines in the asset side of the balance sheet):

Changes in the Fed's balance sheet after taking $1,000M worth of Treasury deposits, after an issue of "unnecessary" Treasurys
Assets	US government securities	0
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	+1,000
	PDCF loan	0
	TSLF loan	0
	Other assets	0
Liabilities	Currency in circulation	0
	Reserve balances	0
	Treasury deposits	+1,000

This would change the way we view sovereign debt. Traditionally, the government’s power to raise taxes and set public expenditures have determined the creditworthiness of sovereign debt. With this plan, the value of the government’s debt obligations would become contingent on the portfolio of dodgy securities that the Fed accepts as collateral.

3) Let the Fed issue its own debt. The Fed would use the funds to purchase securities or make loans. A new entry would appear in the list of Federal Reserve’s liabilities:

Changes in the Fed's balance sheet after issuing $1,000M worth of its own debt
Assets	US government securities	0
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	+1,000
	PDCF loan	0
	TSLF loan	0
	Other assets	0
Liabilities	Currency in circulation	0
	Reserve balances	0
	Federal Reserve bonds	+1,000

4) Remunerate reserves. Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

This reviews my review of the Fed's new monetary policy. Will these new tools make it to the textbooks? It’s hard to tell whether the particular facilities (TAF, TSLF, etc.) will survive. But I think that some standardized form of loans to non-depository institutions will stay, and that the Fed will become willing to accept dodgier collateral than it traditionally has.



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The Fed's new tools (I)

By popular demand, I improved and expanded the notes I published a couple of weeks ago about the new tools of the Federal Reserve. I have added instruments that are not in place yet but the Fed considers using. I have ended up with a very long post, so I have broken it down into two parts. The second part will come out next week.

(I thought somebody would like to use these posts as a refresher, a summary, or even class notes. Jim Hamilton has a few great posts on the subject: September 23, December 14, December 16, March 15. The New York Federal Reserve made its own pocket version. And Greg Ip wrote a rather educational piece. Enjoy.)

UPDATE (4/13/2008): The link to the New York Fed's pocket version does not work any more. But you can find that document here now. Sorry about that.

* * *

The central bank has a balance sheet, as any other bank. As assets, it holds primarily securities issued by the government and loans to banks. As liabilities, it has currency (the cash in your pockets) and reserve balances. Reserves are deposits that regular banks keep at the central bank. When a bank needs currency it withdraws from its deposit, effectively turning it into notes and coins that you and I can use. As you will see in a minute, reserves are a key element in monetary policy.

This was the balance sheet of the Federal Reserve on August 15, 2007:

Federal Reserve's balance sheet, $ millions (Aug. 15, 2007)
Assets	US government securities	789,601
	Repurchase agreements	24,000
	Reverse repurchase agreements	-31,941
	Direct loans	264
	Other assets	37,058
Liabilities	Currency in circulation	813,085
	Reserve balances	5,897

Source: Federal Reserve, H.4.1 release.

(For the moment, regard “repurchase agreements” as loans to banks.)

The sum of currency in circulation and reserve balances is the monetary base (M0). The Federal Reserve’s target, however, is not M0 but the federal funds rate.

Banks keep deposits at the Fed to meet reserve minimums required by the Fed and to clear financial transactions. Institutions with balances in excess of reserve requirements lend reserves to institutions that don't have enough. The interest rate on those loans, typically overnight, is called the federal funds rate. That’s a market rate, determined by the supply and demand of such funds. The more reserves, the lower the fed funds rate, and vice versa.

Source: Federal Reserve Bank of New York
The Fed does not set the federal funds rate. When you read in the newspapers that “the Fed cut interest rates by 25 basis points,” what they mean is that the Fed reduced its target for the federal funds interest rate by 0.25%, not the actual rate. But the Federal Reserve can push the actual rate close to its desired target by affecting the amount of reserves available.

Until now, macroeconomics textbooks have been telling us that central banks use two tools to affect the federal funds rate. Looking at them through the balance sheet will help us understand what the U.S. central bank has been up to recently:

• Open market operations (OMO). This is an outright purchase of Treasurys (government securities): the Fed takes securities from banks and credits the banks’ reserve balances. A higher level of loanable reserve balances mean lower interest rates. Voilà: the Fed just "cut" interest rates. Eventually, banks withdraw from their reserves at the central bank and turn them into cash. So an open market operation amounts to withdrawing Treasurys from the hands of banks and replacing them with cash. That would be an expansionary move of monetary policy. The central bank can also reduce the amount of cash in circulation, by doing just the opposite: selling government securities and absorbing cash.

Suppose that the Fed pumps $1,000 million in the banking system through an open market operation. The Fed’s balance sheet would experience the following changes, once banks have withdrawn the new funds from their reserve accounts:

Changes in the Fed's balance sheet after a $1,000M open market operation
Assets	US government securities	+1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	+1,000
	Reserve balances	0

• Direct loan. We usually refer to this tool as the discount window. The central bank simply lends money to a bank, at a set interest rate. The central bank increases its balance of loans, and simultaneously credits the reserves that the borrowing bank holds at the Fed.

The loan is secured by collateral, i.e. the Fed would seize assets in the event of default. But there is no flow of securities from the bank to the Fed or vice versa —just cash from the Fed to the bank. There is a long list of assets that banks can use as collateral. The term of the loan is generally one day, but sometimes it’s longer for small banks.

This is what happens to the Fed’s balance sheet when it extends a loan through the discount window (and once the borrower has withdrawn its new reserves):

Changes in the Fed's balance sheet after a $1,000M discount window loan
Assets	US government securities	0
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	+1,000
	Other assets	0
Liabilities	Currency in circulation	+1,000
	Reserve balances	0

Even though the price of a such loan is set by the Fed, not the market, a discount-window loan can affect the federal funds interest rate by increasing the amount of available reserves.

Asking for a direct loan usually means that the bank was not able to obtain liquidity any other way. For that reason banks that request discount window loans are subject to scrutiny by the central bank, and watched closely by other banks. And the interest rate charged for direct loans is higher than the federal funds rate. For those reasons, the discount window is used rarely and in small amounts.

A tool that is more frequently used than OMOs but that textbooks often don't mention is:

• Repurchase agreements (or “repos”). A repurchase agreement is a loan from the Fed to a bank. The Fed credits the bank’s reserves and increases its entry of repo claims on banks.

This is what happens to the Fed’s balance sheet:

Changes in the Fed's balance sheet after a $1,000M repurchase agreement
Assets	US government securities	0
	Repurchase agreements	+1,000
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	+1,000
	Reserve balances	0

From a financial point of view a repo is not that different from a discount window loan.

The effect of a repo loan on reserves is “self-reversing.” Unlike open market operations, repos automatically restore reserve balances to their original level: at the maturity of the loan, the Fed debits reserve balances and removes the repo loan from its assets.

The loan is guaranteed by assets pledged by the borrower. The set of acceptable collateral is called General Collateral. It includes things other than US government securities (agency obligations and mortgage-backed securities) but not as many as the list of discount window collateral .

Many textbooks don’t mention repos because they are considered a type of open market operation (OMO). The New York Federal Reserve itself calls them “temporary OMOs” sometimes. By nature, however, a repo is a collateralized loan, not a purchase or sale of Treasurys.

Sometimes the Fed does not want to increase the amount of reserves in the banking system, because it estimates that the amount available is appropriate. Still, for some reason, banks can’t get enough liquidity from their peers in the federal funds market and keep coming to the Fed for loans.

As an example, last summer some U.S. banks started experiencing losses from their portfolios of mortgage-related securities. Nobody knew who those banks were, or how large those losses could be. So banks started hoarding reserve balances rather than lending them out. Some institutions were unable to find as much liquidity as they wanted because nobody would lend it to them (at a reasonable price).

In those situations the Fed conducts moneyless monetary policy, acting as counterparty without actually changing the amount of cash in the economy. How? It enters repurchase agreements, which create new reserves. Then it offsets those new reserves by selling some of its own government securities (or letting them mature without purchasing more), and thus withdraws cash from the banking system.

Here’s how a repurchase agreement would change the Fed’s balance sheet, after offsetting it with an open market operation:

Changes in the Fed's balance sheet after a $1,000M repurchase agreement, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	+1,000
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	0 (-1,000 + 1,000)
	Reserve balances	0

In that case the repos don’t have any bottom-line effect on liquidity: they merely change the composition of the Fed’s assets and provide temporary cash to the borrowing banks.

In the second half of 2007 these offsetting operations became more frequent, and his is why Jim Hamilton writes that the Fed has been doing monetary policy using the asset side of the balance sheet. Another way to see it is that the Fed took the money out of monetary policy, because its actions barely affected the monetary base (reserves plus currency in circulation).

Also in the summer the Fed introduced the first of its new tools:

• Term Discount Window Program (TDWP). The first innovation introduced by the Fed doesn’t really deserve a name of its own. Under the TDWP, announced on August 17, the Fed makes discount-window loans for as long as 30 days. On March 16 it prolonged the maximum maturity to 90 days. The range of collateral at this facility is exactly the same as at the discount window, and so are the changes in the Fed's balance sheet. These loans are restricted to institutions eligible for primary discount-window credit —basically, banks with a strong balance sheet.

Many institutions didn’t want to use the discount window or its sister the TDWP because of the stigma that it carries. But liquidity was still dear, so on December 12 the Fed stepped up to the plate, with the

• Term Auction Facility (TAF). The TAF represents an improvement with respect to repos in their capacity to provide liquidity. First, it widens the range of collateral it accepts, from General Collateral to discount window collateral. Second, it provides funds for a longer term, eliminating the need to roll over the loans every day or every week. And third, unlike discount window loans, the interest rate is determined in the marketplace, so the money goes to the institutions that value it most.

By themselves, TAF loans would increase both assets and liabilities of the Fed, just like open market operations and repos. But once again the Fed offset those loans by selling securities and withdrawing cash from the system. Example:

Changes in the Fed's balance sheet after a $1,000M TAF loan, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	TAF loans	+1,000
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	0 (-1,000 + 1,000)
	Reserve balances	0

The Fed extends the loan, which is an asset for the lender, and credits the bank's reserve account. (In the table I assume that the borrower withdraws the funds from the reserve account, so they're turned into currency in circulation.) Just like a repo, loans through the new facility require borrowers to use assets as collateral for the duration of the loan. But the collateral doesn't show up in the balance sheet, because the Fed does not take ownership of it. At the same time, the Fed sells $1,000M worth of government securities, absorbing that same amount of cash from the banking system.

And here’s the simplified balance sheet on December 26 and August 15:

Federal Reserve's balance sheet, $ millions
Assets		Aug. 15, 2007	Dec. 26, 2007
	US government securities	789,601	754,612
	Repurchase agreements	24,000	42,500
	Reverse repurchase agreements	-31,941	-40,542
	Term Auction Facility loans	0	20,000
	Direct loans	264	4,535
	Other assets	37,058	52,869
Liabilities	Currency in circulation	813,085	829,193
	Reserve balances	5,897	4,781

Source: Federal Reserve, H.4.1 release.

The balance of TAF loans grew from $20bn to $100bn between December 26 and April 9.

To be continued...

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How the Fed took the money out of monetary policy

UPDATE: I wrote an expanded, better version of this post, in two parts: Part I and Part II.

The Federal Reserve used to have only a few tools to do its job —that is, until it got the genie out of the bottle. Sometimes quietly, other times conspicuously, the Fed is surely changing the way it creates liquidity.

(Jim Hamilton has been narrating these changes since the summer. Part of this post is my one-stop account. Jim’s posts, which are much better, are here: September 23, December 14, December 16, March 15.)

The central bank has a balance sheet, just like any other bank. As assets, it holds government securities, loans to depository institutions (banks), and other assets. As liabilities, it has currency (the cash in your pockets) and reserve balances. Reserves are deposits that banks keep at the central bank. When a bank needs currency it withdraws from its deposit, effectively turning it into bills and coins that you and I can use.

Until now, macroeconomics textbooks have been telling us that central banks use three tools to control the amount of currency in circulation. Looking at them from an accounting perspective will help us understand what the Federal Reserve has been up to recently:

1) Open market operation. This is an outright purchase of government securities from banks. When conducting this operation, the central bank increases its assets and credits banks’ reserve balances. Eventually, banks withdraw from their reserves at the central bank and turn them into cash. So an open market operation amounts to withdrawing government securities from the economy and replacing them with cash. The central bank can also reduce the amount of cash in circulation, by doing just the opposite: selling government securities and absorbing cash. By far, an open market operation is the best-know of the central bank’s tools.
This is a simplified version of the U.S. Federal Reserve’s balance sheet on August 15, 2007:

Federal Reserve's balance sheet, $ millions (Aug. 15, 2007)
Assets	US government securities	789,601
	Repurchase agreements	24,000
	Reverse repurchase agreements	-31,941
	Direct loans	264
	Other assets	37,058
Liabilities	Currency in circulation	813,085
	Reserve balances	5,897

Source: Federal Reserve, H.4.1 release.

(For the moment, regard “repurchase agreements” as government securities.)
Suppose that on August 16, 2007, the Fed pumped $1,000 million in the system through an open market operation. The Fed’s balance sheet would experience the following changes, once banks have withdrawn the new funds from their reserve accounts:

Changes in the Fed's balance sheet after a $1,000M open market operation
Assets	US government securities	+1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	+1,000
	Reserve balances	0

2) Direct loan. This tool is usually referred to as the “discount window.” The central bank simply lends money to a bank. The borrower must pledge collateral with a value that exceeds that of the direct loan. The central bank increases its balance of loans, and simultaneously credits the reserves of the borrowing bank. Then the bank withdraws from its reserves, effectively turning them into currency in circulation. Asking for a direct loan usually means that the bank was not able to obtain liquidity in the inter-bank market. Moreover, borrowers are also subject to scrutiny by the central bank, and watched by other banks. And the interest rate charged for direct loans is higher than the inter-bank rate. For those reasons, the discount window is used rarely and in small amounts.

3) Reserve requirements. Banks are required to keep a certain amount of reserves at the central bank. If the central bank increases that requirement, banks are forced to withdraw currency from the economy and put it in their reserve account. The central bank can also do the opposite, i.e. increase the amount of currency in circulation by lowering the reserve requirement. This tool is the least often used.

Normally banks obtain liquidity for their daily operations in the inter-bank market, where they borrow from and lend to each other at the going interest rate. Last summer some U.S. banks started experiencing losses from their portfolios of mortgages and securitized mortgages. Nobody knew which banks would suffer losses in the future, or how large they could be. So banks starting growing wary of lending to each other, and it became more expensive—or just plain impossible—to raise as much liquidity as needed.

The Fed stepped in to help. Instead of providing liquidity through outright open market operations, it increased the use of an operation that is more frequently used, yet less well known: repurchase agreements. These are short-term loans, usually overnight, extended by the Fed to banks. As collateral, banks transfer high-quality securities to the central bank for the duration of the loan. At expiration, the loan is repaid and the bank takes back its securities.

From an accounting perspective, the repo increases the central bank’s assets and potential currency in circulation, much like an open market operation does. This, for example, is what happened between August 8 and August 15.

Soon after, the Fed decided that it didn’t want to increase the potential amount of liquidity in the system, which affects short-term interest rates and inflation. So it offset the repurchase agreements by selling some of its own government securities (or letting them expire without purchasing more), and thus withdrawing cash from the system. So the repos didn’t have any bottom-line effect on liquidity: they merely changed the composition of the Fed’s assets and provided temporary cash to the borrowing banks. This is why Jim Hamilton writes that the Fed has been doing monetary policy using the asset side of the balance sheet. Another way to see it is that the Fed has been conducting money-less monetary policy, because its actions barely affect the monetary base (reserves plus currency in circulation).

Here’s how a repurchase agreement would change the Fed’s balance sheet, after offsetting it with an open market operation:

Changes in the Fed's balance sheet after a $1,000M repurchase agreement, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	+1,000
	Reverse repurchase agreements	0
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	0 (-1,000 + 1,000)
	Reserve balances	0

After doing this for months, and aware that banks were not getting as much liquidity as they wanted, in December the Fed unveiled the Term Auction Facility (TAF). As its name suggests, this is an auction for a limited amount of Fed’s loans. Just like a repo, loans through the new facility require borrowers to use assets as collateral to the Fed for the duration of the loan. But the TAF represents an improvement with respect to repos in their capacity to provide liquidity. First, it lowers the bar for the type of assets that the Fed accepts, which are the same as those for the discount window. Second, it is more targeted than repos: the bidding system ensures that the limited loans go to the banks that value them most.

By themselves, TAF loans would increase both assets and liabilities of the Fed, just like open market operations and repos. But, once again, the Fed partially offset those loans by selling securities and withdrawing cash from the system. Here’s the simplified balance sheet on December 26 and August 15:

Federal Reserve's balance sheet, $ millions
Assets		Aug. 15, 2007	Dec. 26, 2007
	US government securities	789,601	754,612
	Repurchase agreements	24,000	42,500
	Reverse repurchase agreements	-31,941	-40,542
	Term Auction Facility loans	0	20,000
	Direct loans	264	4,535
	Other assets	37,058	52,869
Liabilities	Currency in circulation	813,085	829,193
	Reserve balances	5,897	4,781

Source: Federal Reserve, H.4.1 release.

The balance of TAF loans grew from $20bn to $60bn between December 26 and March 12.

Still, all these liquidity venues are available only to members of the Federal Reserve system, which I have been calling “banks” and whose proper name is “depository institutions.” There is another set of financial intermediaries and investors, such as Bear Stearns or Lehman Brothers. They have been as affected by the liquidity crisis as much as banks have, but don’t have direct access to neither the discount window nor TAF.

So the Fed has announced two new facilities for those institutions. The first one is the Term Securities Lending Facility (TSLF), to open on March 27. At this new window, all primary dealers -all banks and brokers that trade in government securities with the Fed- are allowed to borrow up to $200bn of government securities for 28 days. The minimum quality of the assets seems to be the same as those for than for the TAF (they include federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS). But in contrast with TAF this new facility lends government securities, not cash. Through the TSLF the Federal Reserve will be temporarily swapping safe government securities for risky assets. This is how these loans would look like on the balance sheet:

Changes in the Fed's balance sheet after a $1,000M TSLF loan
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	TSLF loan	+1,000
	Other assets	0
Liabilities	Currency in circulation	0
	Reserve balances	0

The second institution is the Primary Dealer Credit Facility (PDCF), which started operating on March 17. This venue provides overnight cash loans to all primary dealers, at the discount window interest rate, and accepts even riskier the same type of collateral. they accept all collateral eligible for repos, plus investment-grade corporate securities, municipal securities, MBS and asset-backed securities. With the PDCF, all primary dealers have de facto access to the discount window, from which only depository institutions could borrow before. The loan will increase the monetary base (read the PDCF FAQ). To offset the increase, the Fed will utilize "a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements, redemptions of Treasury securities, and changes in the sizes of conventional RP transactions." Here's what a PDCF loan looks like, after it has been offset:

Changes in the Fed's balance sheet after a $1,000M PDCF loan, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	PDCF loan	+1,000
	TSLF loan	0
	Other assets	0
Liabilities	Currency in circulation	-1,000 + 1,000
	Reserve balances	0

In fact, the Federal Reserve has included PDCF as a sub-entry within "Other loans" in the balance sheet, next to the discount window loans, because PDCF and discount window are in fact one and the same facility.

Unlike the TAF, neither TSLF nor PDCF will increase the assets of the Fed. It will temporarily decrease balances of government securities, and increase those of sketchy securities. And because participant institutions don’t have Fed reserves, TSLF loans don’t affect the monetary base. These two venues circumvent the necessity to conduct open market operations so that the monetary base doesn’t change.

Here’s the balance Fed again, in December and after the PDCF opened:

Federal Reserve's balance sheet, $ millions
Assets		Dec. 26, 2007	Mar. 19, 2008
	US government securities	754,612	660,484
	Repurchase agreements	42,500	62,000
	Reverse repurchase agreements	-40,542	-46,143
	Term Auction Facility loans	20,000	80,000
	Primary Dealers Credit Facility	0	28,800
	Direct loans	4,535	125
	Other assets	52,869	36,603
Liabilities	Currency in circulation	829,193	818,362
	Reserve balances	4,781	3,507

Source: Federal Reserve, H.4.1 release.

With its new tools, the Fed has provided liquidity without printing much money. It has temporarily absorbed risky and illiquid securities, and supplied government securities, which are risk-free. So instead of monetary policy, in the sense we traditionally have thought about it, the Fed has become a risk-absorber (temporarily, we hope). Or, to put it less kindly, a pawnbroker.

Will these new tools make it to the textbooks? It’s hard to tell whether the particular facilities (TAF, TSLF, etc.) will survive. I think that some unified, generalized form of credit to non-depository institutions will stay. But I’ll have to write about that another time.

Addendum:

Somebody asked me how the Fed conducts an "offsetting" open market operation when the Fed extends a TAF loan. This table summarizes it:

Changes in the Fed's balance sheet after a $1,000M TAF loan with an offsetting open market operation
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Teerm Auction Facility loans	+1,000
	Direct loans	0
	Other assets	0
Liabilities	Currency in circulation	(-1,000 + 1,000)
	Reserve balances	0

The Fed extends the loan, which is an asset for the lender, and credits the bank's reserve account. (In the table I assume that the borrower withdraws the funds from the reserve account, so they're turned into currency in circulation.) The collateral doesn't show up in the balance sheet, because the Fed does not take ownership of it. At the same time, the Fed sells $1,000M worth of government securities, absorbing that same amount of cash from the banking system.

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Productivity trends

Productivity is the main determinant of long-run growth. In the United States, between 1958 and 2007, the average growth of output per capita has been 2% per year, whereas the average growth of productivity —output produced in one hour of work— has been 2.1%. But productivity growth fluctuates a lot, and the latest changes are uncomfortable to look at.

At the end of 2007 trend productivity growth was 1.7%, 1.3 percentage points down from the fourth quarter of 2001. Now productivity increases at the same pace as it did before the information revolution of the 1990s (see Chart 1). Why?

My story is one of sectoral shifts. The second half of the 1990s was marked by technological improvements in telecommunications. Cell-phones, e-mail, software and, above all, the internet, did two things: they lowered the cost of gathering information, and facilitated interactions among workers, both within and between firms. Both boosted productivity in knowledge-based industries. Not only that: those technologies created new jobs and even entire sub-industries.

Over time those technologies became well established. Investment in equipment slowed down. New job openings were filled by people coming from other industries, who were less productive than incumbent workers. To put it in two sentences: 1995-2001 was a period of technological deepening and creation of new services and industries; 2001-2007 were years of re-allocation of workers towards services.

The data are suggestive: during the business cycle of July 1990 to March 2001, the decrease in payrolls in the manufacturing sector accounted for just 4% of the total change in jobs in the private economy (see Chart 2). Since March 2001, the bleed of manufacturing accounted for 76% of the change in employment.



But another change is in the works. During the current business cycle, most jobs have been created in industries where it is difficult to increase productivity. Health services are a notorious example: 62% of the increase in non-farm payrolls happened in the health care industry. (Hat tip to Michael Mandel, from BusinessWeek.) It is hard to increase the value of services per hour in that sector, because we still rely on a large number of doctors, nurses, orderlies and administrative personnel to deliver one unit of output. Without having done an in-depth analysis, I would say that we have made enormous technological progress in diagnosing and treating health conditions, but that those technologies don’t save any labor.

A similar argument applies to the leisure and hospitality industry (hotels, restaurants, etc.), which absorbed 39% of the change in employment. Until we teach a robot to fry your eggs and make your bed, productivity will increase slowly.

* * *

Productivity is the most important, but not the only driver of growth. An economy produces more output per capita by: employing a higher fraction of the population, working longer hours, or squeezing more output per hour. Chart 3 shows the trend growth rates of each of those components. (I call them “trend” because they are constructed using smoothed time series. Technical details below.) The sum of the three series is equal to the growth rate of output per capita.

Increased participation in the labor force (top panel in chart 3) has grown by less than 0.5% in most decades. Hours per worker (middle panel) have declined decade after decade, reducing the growth of output per capita. But output per hour (bottom panel), also known as productivity, has grown routinely at annual rates well over 1%, and in some decades 2%.

Going forward, there are reasons to believe that productivity gains will become even more important. In a nutshell: the fraction of people who work is going to decrease. The fall of the participation rate already subtracted 0.12 percentage points from the growth rate of output per capita between 1998 and 2007 (see chart 3, top panel). Historically, the employment-population ratio has increased thanks to women, whose participation has increased since WWII. That trend has probably played out. The female participation rate reached a historical maximum of 58% in 1999, and since then it has stayed roughly constant.



More importantly, the large generation of baby-boomers born between 1946 and 1964 will gradually retire from 2011 through 2030. That will push the participation rate down because their descendants, the X and Y generations, are not numerous enough to replace them. And immigrants don’t improve the employment-population ratio much because they add to both the numerator and the denominator.

Adding to those demographic trends, men in prime working age (25-54) have continued their slow, secular exit from the labor force. Their participation has declined from a maximum of 95% in 1969 down to 87% in 2007. Where did those men go? Some of them just replaced women as homemakers, but that cannot be the whole story. The New York Times published a story by David Leonhardt this week (hat tip: Vox Baby). He thinks that “these nonemployed workers tend to be those who have been left behind by the economic changes of the last generation. Their jobs have been replaced by technology or have gone overseas, and they can no longer find work that pays as well.”

Now let’s put together these pieces: the economy is re-allocating resources towards health and labor-intensive services; population aging will increase the demand for those services and reduce the number of people who provide them; and the information technologies of the “e-era” raise productivity at decreasing rates. Can the U.S. economy continue to deliver a growth rate of 2% in output per capita? And, if so, what will be the next driver of productivity?

Technical details: I use time series on hours, employment and non-farm business output (from BLS productivity data base), and on the employment-population ratio (from the CPS data base). First of all, I calculate quarter-over-quarter growth rates for each time series, by taking differences in logarithms, and then I annualize them by multiplying by four. Then I apply the Hodrick-Prescott filter to each growth rate series, with smoothing parameter equal to 5000. Finally, the growth rate of productivity is the smoothed growth rate of output minus the smoothed growth rate of hours; the growth rate of hours per worker is the smoothed growth rate of hours minus the smoothed growth rate of employment. The growth rate of output per capita (displayed on chart 2) is the sum of the growth rate of participation and the constructed growth rates of hours per worker and productivity.


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The fiscal stimulus: ineffective or wrong?

The latest economic data show that output growth has weakened and unemployment is creeping up. The government is worried, with good reason, that the economy is going through a pronounced slowdown, perhaps even a recession. To limit the damage, Congress yesterday approved a battery of fiscal measures. By my reckoning, however, the plan will at best provide a short-lived nudge to consumption, but not employment; at worst, it’ll do nothing.

Starting in May, the government will send $600 checks to individuals ($1,200 for couples and an extra $300 for each child). People who earn too little to pay income taxes, but make more than $3,000, will receive a $300 payment. Payments will total $106 billion and will add to the budget deficit.

Cash outlays are supposed to boost private consumption expenditures and accelerate overall growth. $106b may seem a small stimulus for a $14 trillion economy, but the payments are expected to have a “multiplier effect”: higher demand will prompt businesses to hire more workers, and increased employment will further stimulate private consumption, which in turn will induce more hiring. The process continues ad infinitum. The outlays, therefore, can have a final effect on aggregate demand that is many times bigger than the initial stimulus —hence the name “multiplier.”

The effectiveness of the measure hinges on two factors. First, the fraction of the government outlays that will be spent immediately. According to Bruce Bartlett, previous experiences with tax rebates in 1975 and 2001 indicate that it's small. The recent study by Elmendorf and Furman indicates that it's a 50 percent.

The second requirement, which has received less attention, is that businesses will respond to the initial surge in demand by hiring new workers. If they don’t, then the fiscal package will have no second-round impact on demand, and the stimulus to consumption will total just $50b.

Because the first two quarters of 2008 will be marked by considerable uncertainty about the course of the economy in the medium term, the announcement of the fiscal plan will not have an immediate effect on hiring. Manufacturers may ratchet up their inventories, in anticipation of the small jolt of demand in May, but they will do so by using overtime and temp workers, rather than hiring permanent employees. In the services sector, we won’t see any change in employment until the late spring, and even then employers will similarly meet spikes in demand with overtime hours and temp workers, at least initially. If, come June, forecasts have improved, we may see employment pick up over the fall. But by then the effect of the government checks will have played out. In conclusion, the fiscal package won’t provide any significant boost to employment.

A less obvious reason to reject the stimulus is that the slowdown in aggregate demand is necessary, even healthy. Most of the growth experienced between 2002 and 2006 was based on low interest rates, over-valued real estate, and loose lending standards.

Chart 1, from a story by Michael Mandel at BusinessWeek, tells it all. Mandel estimates that, “if consumer spending had tracked the overall economy over the past decade as it has in the past, Americans today would be spending about $600 billion less a year. The extra spending has amounted to a total of about $3 trillion since 2001.” That extra spending was financed with debt. Quite literally, Americans were borrowing their prosperity from the future —not exactly a sustainable growth path.

Chart 1 (left) and 2 (right). Click to enlarge.

The growth of productivity, the value of output per hour worked, confirms the hypothesis that consumer expenditures were out of line with real income gains, at least over the last five years. Robert Gordon of Northwestern University estimates that trend productivity growth peaked in 2002, and has slowed down ever since (see Chart 2, via Michael Mandel’s blog). The gap between long-term growth of GDP and consumption, on the other hand, has widened over the same period.

So, if the recent growth rate of expenditures was excessive, why is Congress rushing to prop it up? More importantly given that the stimulus will be financed with future tax increases: why are legislators borrowing even more from future prosperity? The answers to these questions have a lot to do with politics and very little with economics.

Notice the hodgepodge of enigmatic measures included in the fiscal package. Congress grants payments of $300 to low-income seniors and disabled veterans, but not to other disabled people. It allows federal housing agencies to insure jumbo mortgages, as if subsidies to the purchase of expensive homes was going to parachute the economy. And it includes specific provisions to prevent illegal immigrants from claiming payments, precluding illegals from contributing to the consumption surge, however small that may be. So, if you think about it for a minute, what Congress did is give itself a votes-buying package, which does stimulate something: re-election.

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The burden of spending

Over the 12 months to October 2007, home prices in the 20 largest metropolitan areas declined by 6.1 percent. And they have fallen every month since January. With less equity to borrow from, homeowners could cut their spending. As a second whammy, a large volume of adjustable rate mortgages are scheduled to reset to higher interest rates between 2008 and 2012. The burden of higher monthly payments could force households to reduce their expenditures too.

Economic growth and consumer debt are inextricably connected in the U.S. And it’s been that way for so long that it’s easy to forget why and what that implies.

Spending has outpaced personal income since the mid 1980s. Households saved ten percent of disposable income in 1985, five percent in the mid 1990s, and then nothing in 2005. (See chart 1, maroon series, scale on the left axis.)

Chart 1 (click to enlarge)

Low interest rates motivated the consumption ramp-up. Loose monetary policy played its part, but it would be incorrect to blame it all on the Fed. The massive accumulation of wealth by developing countries lowered the opportunity cost of spending, as Alan Greenspan has explained.

Interest rates motivated it, but the borrowing spree was made possible by innovations in the financial sector that increased the supply of debt. The introduction of the FICO score in the early 1990s improved the assessment of a borrower’s creditworthiness – or at least lenders believe so. By pegging interest rates to an index, instead of offering fixed rates, lenders transferred some financial risk to borrowers. Securitization of debt balances shifted some more of that risk off the lenders’ balance sheets.

The problem with a growth path based on borrowing and spending is that it has a natural end. An individual’s debt limit is determined by her creditworthiness, income capacity and collateral. That limit may be high relative to current income, and it may even be unknown to the borrower — after all, it’s up to the lender to draw the line. But once debt balances reach that limit, spending can grow only as fast as income (minus debt payments). Consumption is pinned to the vagaries of income. At the aggregate level, that means that economic growth is more vulnerable to unemployment and to the swings of the stock and real estate markets.

For instance, back in 2001 unemployment was rising, investment fell sharply, and share prices crashed. But overall the economy held up better than expected. Why? One explanation lies in real estate wealth. That year house prices rose by nine percent and consumers borrowed against home equity.

As a gauge of the current level of indebtedness, households now spend almost 15 percent of their disposable income on interest payments, including mortgages. (See chart 1, blue series, scale on the right axis.) If you include repayment of principal, the fraction of debt payments is much larger. Debt repayments are linked to interest rates, and hence subject to unforeseeable increases. Hence the worry about mortgage resets.

The main variables that determine spending and access to debt are outside the policymaker’s control. The cost of borrowing depends on the world level and distribution of savings. Lenders will continue to improve their assessment and management of risk, thus reducing the cost of credit. And central banks are capable of controlling inflation, but not of preventing asset bubbles or stimulating long-run growth.

But don’t despair: tax policy can mend our spending ways. First of all, do no harm. Tax laws can distort the cost of borrowing. The Tax Reform Act of 1986 partially addressed this issue by getting rid of the deduction for interest paid on consumer debt (credit card and uncollateralized loans). The deduction for mortgage interest should go next. I concede that there’s a (weak) case for subsidizing home ownership. But these days a house is much more than a place to live: it’s a piggy bank to draw from. There is no reason why the government should subsidize that.

Second, replace the personal income tax with a tax on consumption. A basic tenet of economics is that if you tax something you get less of it. An income tax punishes work. Instead, the government could levy a tax on the difference between income and contributions to savings. The new tax could be progressive, rather than flat, and could include personal deductions, just like the current personal income tax.

The main obstacle to those tax policies is political. The mortgage interest deduction is popular, and a consumption tax is still regarded as an oddity. No presidential candidate who actually cares about being elected would make such proposals. Perhaps in 2012, if the then incumbent president can afford it. Changing the nature of American economic growth is a cause worthy of spending political capital on.

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The WSJ follows my call

The Wall Street Journal is warming up to my idea that the Federal Reserve should stop caring about growth. In an editorial today, the newspaper says that “the Full Employment and Balanced Growth Act of 1978 deserves to be repealed. Also known as the Humphrey-Hawkins, this is the law that mandates that the Fed consider both price stability and full employment in making monetary policy decisions. […] this dual mandate makes it impossible for the Fed to target only inflation the way, say, the European Central Bank is mandated to do.” The WSJ wraps up with these words "setting monetary policy by a genuine price rule would be better." (Read the editorial here.)

The editorial comments on yesterday’s speech by Ben Bernanke. The Fed's chairman brought up the virtues of inflation targeting, but was very careful to point out that the Fed should continue to put equal weight on growth and inflation.

It's nice to hear, though, that an American mainstream paper supports the idea of a more hawkish, ECB-style central bank.

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Macro slack

This month will mark the sixth anniversary of the current economic cycle in the United States. Although it might be too early for an obituary –the chances of a recession by year-end are slim— a mid-life review of the expansion is surely due. The story, I warn you, may strike you as uninspiring: “The 21st century economy: A solid slacker” would make a fitting title.

Most people hold the notion that expansions are times of normal or fast growth. A few economists would say that they are periods when the primary factor limiting how much the economy produces is its physical capabilities --how many people are willing to work, the quality of their skills and technology, and the physical capital available for them to use. (Read this blog post by professor James Hamilton on Econbrowser.) On the flip side, a recession is an episode of slow or no growth, and slack capacity. By historical standards, the economy has been in a grey area between recession and “normal times” since 2001.

Chart 1 (click to enlarge)
Exhibit number one: The Labor Participation Rate –the ratio of employed people to the potential labor force— is low and out of course. Normally, the rate goes up during times of expansion as better job prospects entice students to get a job, fifty- and sixty-somethings are kept in the payrolls until their normal retirement age, and stay-at-home mommies and daddies find it harder to pass up job opportunities. This time around, however, more and more people have stayed away from the labor market throughout the recovery and the expansion (chart 1).

Chart 2 (click to enlarge)
Exhibit number two: Total Capacity Utilization –a ratio of actual to potential production in the industrial sector– has recovered all the ground that it lost during the 2001 recession, but it has failed to increase after that (chart 2). At one point or another during each of the three previous expansions, capacity utilization topped the 85 percent mark; now, after 23 quarters of expansion, it hovers around 81-82 percent.

Chart 3 (click to enlarge)
Exhibit number three: For too long has the Gross Domestic Product (GDP) stayed below its potential, defined as the maximum level of output the economy can produce without increasing inflation. The output gap has stayed between one and two percent, instead of falling to zero and beyond, as it always has done in the past (chart 3).

Since the three statistics discussed reflect the same reality, I have taken the liberty of merging them into a single indicator. The Slack Index, as I have called the cocktail, is the average of the output gap, unused industrial capacity (100 minus Total Capacity Utilization), and the non-participation rate (100 minus the Labor Participation Rate). I normalize the series to be equal to 100 in 1992. A higher value of the index indicates more spare productive capacity.

The index has remained for quite some time around a value of 96, which would be fine for a recovering economy, but too high for an expanding one (chart 4).

Chart 4 (click to enlarge)

Turning to evidence on growth, GDP has averaged an annualized growth rate of 2.8 percent, lower than in any other expansion in the post-war era. For example, in the 23 quarters following the 1991 recession, the average growth rate was 3.3 percent, and 4.9 percent in the same period after the 1981-82 recession.

It seems pretty clear that the economy is unusually far below its possibility frontier. The good news is that if we are able to shake off the threats from the housing slump, the sub-prime mortgage crisis, and soaring oil prices, the economy should be able to grow much faster without stoking inflation.

The job market appears to be tight. The unemployment rate, at 4.7 percent, remains low. But this time around we have a large pool of potential workers who so far have chosen to stay off the payrolls. If the macroeconomic threats evaporate, those people may return to the market, increasing the supply of labor and pushing wages down.

So if the economy comes out of the slums and you’re looking for a job you’d better not play hard-to-get; if you already have one, don’t bug your boss to cut you some slack.

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When the heat is not in the core

Prices rose 2.4 percent in the year to September 2007, using the monthly price index for personal consumption expenditures (PCE); the reading was 0.6 percentage points higher than in August. Core inflation on the other hand, which doesn’t include the prices of food and energy, was 1.8 percent in the year to September 2007, and the reading stayed unchanged from the previous month.

Over the entire history of the two time series, the average difference between core and overall inflation has been close to nil (0.12 percentage points between 1960 and 2007). But the gap between the two does not necessarily have to be small and indeed has not been small for prolonged periods, sometimes lasting several years. (See chart 1.)


Most recently, between November of 2002 and August of 2006, overall inflation stayed above core inflation for 46 consecutive months. The average (and median) difference was 0.7 percentage points, a large one considering that core inflation ranged between 1.3 and 2.5 percent. (See chart 2.)


Most central banks including the Federal Reserve follow core prices, which means that many times their gauge of inflation is below the increase in the cost of living. Whether the Fed likes the prices of food and energy or not, wages are implicitly pegged to overall, not core inflation.

Suppose that the Fed has a target core inflation rate of two percent. If the public expects an overall inflation of, say, three percent next year, wages will increase accordingly, and so will nominal consumption expenditures. Monetary theory tells us that this will push actual overall inflation up to around three percent. Unless the prices of food and energy change relative to the rest of the prices, core inflation will also be around 3 percent, above the Fed’s target.


Conducting monetary policy by tracking core inflation is tantamount to assuming that the average gap between core and overall prices won’t get too far for too long (and that workers and employers have the same expectations). The US experience between 2002 and 2007 indicates otherwise (see chart 2). Given that economic conditions during those years have been “normal” --as opposed to the extraordinary oil shocks of the 1970s and early 1980s-- the premise that food and energy prices won’t stray too far from core prices doesn’t seem adequate as the default hypothesis for the rest of the century (barred a major technological breakthrough).

The main reason why central banks track core inflation, rather than overall inflation, is that the prices of foodstuffs and energy are notoriously volatile. Short-run changes in the price of those goods reflect variations in weather conditions, geopolitical climate, commodity markets, and discoveries of new oil reserves, for example. Central banks assume that those phenomena have a zero-mean effect on inflation in the long-run, so their effect on prices in the short-run can be safely ignored.

There is no question that inflation should be stripped out of its most volatile components. But it’s worth exploring alternatives to what we now know as core inflation. One possibility would be to use the prices of all goods and services, but then adjust their weights to reflect their volatility –prices with high volatility and low correlation with overall inflation would receive low weights. Those weights would evolve as new data are incorporated to the time series.

Another possibility is to leave out all goods and services with volatilities above a certain threshold. Those goods would not necessarily be food and energy, and would not necessarily be the same every month or every quarter. The Federal Reserve banks in Dallas and Cleveland have been calculating a trimmed index of inflation for a while. (Robert Rich and Charles Steindel of the Federal Reserve Bank of New York explore three alternatives to “ex-food-and-energy” inflation.)

A more radical approach would consist of targeting wages or labor costs directly, instead of the price of goods. (Knzn, over at “Economics and…” has been advocating this policy. Start by reading this post and this one.)

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