Federal Reserves Big Cash Injection

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In allowing Lehman to go under, in September, Bernanke, along with former Treasury Secretary Henry Paulson and his successor, Tim Geithner, who was then head of the New York Fed, unleashed a global financial panic that terrified many Americans, who responded by clamping their wallets shut. The stock market slumped, and the economy went into free fall, leaving Bernanke no choice but to inject more money into the financial system. Had the Fed failed to act, the system would have seized up completely.

The monetary transfusion kept the patient alive, but it wasn’t enough to prevent a dangerous drop in spending, output, and prices. If a deflationary psychology takes hold, consumers will scale back their outlays even further, while borrowers—credit-card users, homeowners, businesses—will find the deflation-adjusted cost of their debts rising. Based on what happened to Japan in the 1990s and this country in the 1930s, we know what this scenario yields: economic stagnation that lasts for years.

It was against this backdrop that the Fed announced in December that it would deploy “all available tools” to revive the economy, including the maintenance of exceptionally low interest rates and the provision of yet more liquidity.

Almost all of the expansion in the monetary base has come in the form of additional bank reserves at the Fed, which aren’t necessarily inflationary. Just like you and me, big banks maintain bank accounts, but theirs are at the Fed. Deposits in these accounts are known as reserves, and banks use them to settle transactions with one another. (If Chase owes Bank of America $50 million, rather than sending a check or wiring the money, it can simply instruct the Fed to debit its account and credit B of A’s account.)

What has happened in recent months is that the Fed, in seeking to keep credit flowing, has greatly expanded its lending programs, allowing banks and other financial institutions to exchange yet more illiquid assets, such as mortgage securities, for dollars. Before the onset of the subprime crisis, the Fed demanded ultrasafe securities like Treasurys as collateral when it extended loans to banks. Today, it has greatly broadened the range of collateral it accepts. The result has been a massive increase in bank reserves. At the end of August 2008, they totaled about $100 billion; by the end of December, they had grown to more than $820 billion.

The Fed isn’t finished yet, not by a long shot. On January 5, in an effort to ease the credit crunch and bring down mortgage rates, it launched a program to buy up to $500 billion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, with the aim of encouraging those institutions to make home loans again. It has committed another $200 billion to supporting the purchase of securities backed by student, auto, and credit-card loans, along with loans guaranteed by the Small Business Administration. The Fed said it intended to finance both of these initiatives by creating more new reserves. (Speaking in London in January, Bernanke said this policy should be thought of as “credit easing,” rather than “quantitative easing,” but that is just a matter of labeling.)

One result of all this activity is clear: The Fed and the taxpayers, who provide the central bank’s capital, have been taking on additional credit risk. (As Wall Street cynics like to say, the Fed has been exchanging “cash for trash.”) The inflationary implications are less obvious. When the Fed credits a bank with, say, $100 million in new reserves, the bank faces a choice: It can leave the money at the Fed, earning a modest rate of interest; it can ask the Fed to send over the cash in an armored car; or it can use the money to make additional loans.

The second and especially the third option raise the prospect of the new dollars being used to bid up prices, but so far there is no sign that banks are extending more credit. To the contrary, as anybody who has spoken to a loan officer recently will testify, bank money is harder to get. Since the end of October, the total value of commercial and industrial bank loans outstanding has been falling steadily. This may well lengthen the recession, but from the perspective of individual banks, it is a rational response to the deteriorating economy. Rather than risk making new loans that may never be repaid, they prefer to maintain a high level of reserves at the Fed and pocket the interest.

The reserves also offer a bit of reassurance to bank shareholders, who have been spooked by the long credit crisis.

The fall in bank lending underscores the scale of the task facing Bernanke. The good news is that some of the Fed’s new initiatives are working: Interbank lending rates have fallen significantly, the commercial paper market has revived, and mortgage rates have come down to 5 percent or even lower. Eventually, this improvement in financial conditions should help the economy. Once that happens and the threat of a downward deflationary spiral is removed, the Fed can mop up any excess liquidity in the economy by raising interest rates and scaling back its lending programs.

It would be a major policy error if the Fed were to abandon its newfound radicalism out of a misplaced fear of inflation. Fortunately, this is unlikely to occur. In a recent interview with the Financial Times, Bernanke said, “One of my conclusions from my study of the Great Depression is that people tend to think of orthodoxy as safe. But strategy should depend on the situation. In a severe crisis, orthodoxy can prove to be a very bad strategy.” At various points in the past 18 months, I have criticized the Fed chairman’s actions. Now he is right on the money—in every sense of the phrase.

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