Friday, February 8, 2008

Doom and Gloom: What Can the Federal Reserve Do?

The short answers- Quite a bit. Not enough.
This line of thought was triggered by a MarketWatch story from a couple days ago:

Bernanke committed to use all tools: Sen. Dodd

Federal Reserve chief Ben Bernanke reaffirmed his willingness to use all tools available to aid the economy, according to Sen. Chris Dodd, chairman of the Senate Banking Committee.

I was reminded of a Financial Times story from March 25, 2002:
Fed Considered Emergency Measures To Save Economy

Minutes which summarized the meeting were released last week. A full transcript will not be available for five years but a senior Fed official who attended the meeting said the reference to "unconventional means" was "commonly understood by academics."

The official, who asked not to be named, would not elaborate but mentioned "buying US equities" as an example of such possible measures, and later said the Fed "could theoretically buy anything to pump money into the system" including "state and local debt, real estate and gold mines – any asset"

I don't have the link but the the quote via my notebook is accurate, it struck me as important enough to jot down.
We now have the transcript,
Minutes of the Federal Open Market Committee

January 29-30, 2002
...At this meeting, members discussed staff background analyses of the implications for the conduct of policy if the economy were to deteriorate substantially in a period when nominal short-term interest rates were already at very low levels. Under such conditions, while unconventional policy measures might be available, their efficacy was uncertain, and it might be impossible to ease monetary policy sufficiently through the usual interest rate process to achieve System objectives. The members agreed that the potential for such an economic and policy scenario seemed highly remote, but it could not be dismissed altogether. If in the future such circumstances appeared to be in the process of materializing, a case could be made at that point for taking preemptive easing actions to help guard against the potential development of economic weakness and price declines that could be associated with the so-called "zero bound" policy constraint....
The question arises "Can the fed intervene in the Equities Markets?"
Again, two answers. 1) It's definitely something Central Bankers have thought about. 2) The Fed may need some enabling legislation which they would probably get if they requested it.
The FT reported February 21, 2002 "Japan Suspected of Stock Market Intervention".
A Google search finds 700 references to the "Stock Buying Body".
Here's a pungent one:
"We must halt this fall in shares. It's like diarrhea, we must stop it. The stock-buying body was set up precisely to absorb such selling (offloading of cross-shareholdings by banks). If February is such a month, there is no excuse for not functioning at that crucial time."
Finance Minister Masajuro Shiokaw – Feb 7
More relevant to the American markets are a couple Fed papers, the first of which is astounding for its frankness:

Monetary Policy When the Nominal Short-Term Interest Rate is Zero.
...This paper also examines the alternative policy tools that are available to the Federal Reserve in theory, and notes the practical limitations imposed by the Federal Reserve Act. The tools the Federal Reserve has at its disposal include open market purchases of Treasury bonds and private-sector credit instruments (at least those that may be purchased by the Federal Reserve); unsterilized and sterilized intervention in foreign exchange; lending through the discount window; and, in some circumstances, may include the use of options.

...8.1 Money Rains
Money rains are a clean way to study theoretically the effects of increases in the supply of money. In practice, it seems a bit difficult to envision how the Federal Reserve could literally implement a money rain that is give money away either through directly disbursing currency to the public or by disbursing it through the banking system. The political difficulties that are likely to arise from the Federal Reserve determining the distribution of this new wealth would be daunting. Even if the Federal Reserve were to and a way to physically conduct a money rain, the Federal Reserve Act does not appear to provide authorization for such activities. Under section 7 of the Federal Reserve Act, After all necessary expenses of a Federal reserve bank have been paid or provided for, the stockholders of the bank shall be entitled to receive an annual dividend of 6 percent on paid-in capital. That portion of net earnings of each Federal reserve bank which remains after dividend claims ... have been fully met shall be deposited in the surplus fund of the bank. Thus, any transfers to the public must either be claimed to be "expenses" or be transfers from the surplus fund.

But Section 7 of the Federal Reserve Act only provides for disposition of surplus in the event of dissolution or liquidation of the Federal Reserve Banks. A direct transfer of funds from the surplus account for any other reason and to the public in particular would appear to be beyond the authority of the Reserve Banks. Apparently, then, a money rain would have to be declared an expense" of the Federal Reserve. The legal foundation for doing so seems highly questionable.

A second way to distribute newly created money would be to use it to finance a federal tax cut. A money-financed tax cut could be brought about by the Treasury financing a tax cut by issuing debt, and the Federal Reserve purchasing that debt. If the stimulative effects of such open market purchases have already been exhausted by the Federal Reserve in its attempts to stimulate the economy, the total effect would come from the fiscal stimulus. Of course, if the fiscal stimulus were large enough to raise the nominal interest rate above zero, then standard open market operations would regain their stimulative impact. These are only two of many possible ways a central bank could attempt to increase private-sector wealth and thereby stimulate aggregate demand. Putting possible legal limitations aside, wealth could also be created by purchasing assets at above market prices or by extending loans at subsidized interest rates....

The market opens in two minutes, I'll have to continue this in a second post.