Swapping Risk

I promised more on Greece and that it wouldn't involve Greek drama. I'm following through on that below.

European leaders, especially in Germany, resisted initial clamor that they would bailout Greece before coordinated a 750 billion euro bailout plan. Now several Republican Congressmen are fighting against using IMF money funded by the United States to aid Greece.

The move puts them at odd with actions already being taken by the Federal Reserve. Just last week the Fed restarted swap lines with major central banks that allow them to access dollars. Of course the size of these swaps is miniscule. Total outstanding swaps were valued at less than $10 billion. Yet recognizing the chance of global contagion the move opens swap options to banks outside Europe, such as the Bank of Canada and Bank of Japan.

From swap size alone, Greece looks much more like Bear Stearns than Lehman or AIG, when swap lines grew to over $500 billion.

But looking simply at the size of the swaps is misguided. Before responding last week to the Greek crisis, swaps had been out of use since February. The haste by American officials to respond signaled a willingness to forestall a crisis, or more accurately to stand ready should the crisis spread. Lawmakers have both derided the Fed for acting with little authority and benefited by not having to approve any funding the Fed did provide. Moves to reduce American involvement in IMF plans are more likely to drive American involvement to places like the Fed, and outside of Congressional oversight, rather than reducing the overall burden.

Enterprise: Bernanke's Room is Ready

I've got a post this afternoon over at The Enterprise blog on the Fed's release of financial data from all three Maiden Lane facilities.

I've already been told it's outrageous that the regional Fed banks spend all this taxpayer money on conferences. The cost maybe outrageous but it's not technically taxpayer money. The regional Fed banks are not actually government agencies. The Federal Reserve Board is but the banks are funded by commercial banks in their districts. We could call the fees that commerical banks pay an indirect tax on consumers but they are not directly your money. Plus the commerical banks get to sit on the Regional Feds' boards in exchange for their fees.

A bit of this could change under Charmain Dodd's bill. More on that later.

Balancing Act

The Federal Open Market Committee just released its policy statement. No major surprises here. The Federal Funds Rate is staying in its 0 to .25 range. For some time I’ve been using the compare function of MS Word to track the changes in the FOMC’s statements. The function which is meant to find revisions in updated versions of the same document works surprisingly well for the FOMC. In other words, there are not a whole lot of changes between statements. The minimalist approach means that I’m going to each change got Joyciean attention (James Joyce was rumored to have ceased writing for days simply to fixate on one word that he wanted to get right).

So here are this month’s changes. The Fed is
1. Shifting the winding down of the MBS purchases into the present tense.
2. Says firms are “reluctant to hire” rather than the active cut backs from last month.
3. Eliminates the phrase “the fed is monitoring the size and composition of its balance sheet”
4. Has reaffirmed its commitment to end most of its special programs by February 1, 2010.

I’m still watching the balance sheet, given that, as the chart above shows it’s still double the size that it was before the crisis began. Additionally, it's the red section of the chart, direct asset, purchases that is growing and likely carries the most risk. Just as Treasury has called the Capital Purchase Program closed even while sitting on nearly $100 billion of potentially toxic assets, the Fed may be stuck with a good deal of garbage for a long time.

Depression Fatigue?

I wrote over the summer about the manic consumer mood during recessions. My argument then was that by calling a recession, policymakers could send consumer confidence into a tailspin.

With the current recession creeping toward it's second full year (even if NBER calls June the end of the downturn, as some predict, that will make the recession 18 months), this is the longest contraction since the Great Depression. Calling a recessions is academic for this instance. Today, I want to know what happens in long recessions. The figure below charts the unemployment rate (the BLS' headline U-3) and the ICS (the University of Michigan and Reuters confidence index that I used before.The model that I provide is hyperbolic, allowing it to take the curved shape in the blue regression line. The model, which accurately predicts the current ICS from the September unemployment rate, indicates that small changes in the unemployment rate drag on confidence more than at high levels.


The model is far from perfect because unemployment is one of the last indicators to recover form a recession. Yet unemployment tends to peak at the end, or just after the end of a recession. So we can use high unemployment levels as as a proxy for the length of a recession.

People appear to be most respond emotionally to the beginning of a contraction. We're seeing this now. Chairman Bernanke called the recession "officially over" recently and the Fed said in it's FOMC statement yesterday that consumer spending is "expanding."


Oh for the wonks, the model specificaiton is:
ICS=187 (1/unemployment rate)+54
R2=.25
*The model outperforms ln, linear, or quadradic specifications
Data from 1978 to present

The Legacy Continues to Build

Sometime early this year the Administration stopped calling unsalable assets "toxic," as Secretary Paulson had done, and began calling them "legacy assets." Even that rhetoric has evaporated or just been ignored more as of late. That's unfortunate because the Fed's big moves from early last year have mostly evaporated as the true legacy assets are still accruing.

The figure below shows several Federal Reserve programs that began last year.

The two that were most prominent in 2008, central bank liquidity swap lines and the commercial paper program were sensible, short-term program. The liquidity swap lines were extended to other central banks so that they could obtain US dollars. The commercial paper facility allowed firms to trade on their own short-term debt obligations. The move was important because firms rely on the commercial paper market to manage their day-to-day finances.

The other two programs both show a different view of the bailout. The green Maiden Lane line is the sum total of funds given to bailout and purchases assets from Bear Stearns and AIG. These assets are definitely legacy assets. You can see that after the levels only jump when the Fed picked up Bear and then Later AIG. Since then the Fed has been unable to unload these assets. Much unlike the central bank swaps and commercial paper programs where private markets have stepped into resolve the issue, no one wants to touch Maiden Lane.

Also, it's clear that Maiden Lane is simply a small portion of bailout efforts. While the Bear and AIG episodes have lots of other costs, as you can see that the central bank swap lines become much more important once Bear fails, they are not themselves the big cost.

The real cost and the one most likely to resemble Maiden Lane is the Fed's purchases of mortgage-backed securities (MBS). The Fed has continued buying these up in an effort to cleanse financial markets. These are the quintessential "toxic" assets. The Fed will be unable to sell most of this stuff and have to hold it until the underlying liabilities are paid back. Given that a lot of those are home loans, the Fed could have a good deal of these assets for 20 to 30 years. The recession rhetoric may be over but the legacy will be with us for some time.

Who's the Pig's Head?

Typically, I'd just tweet a funny link but this one really deserves a bit more attention. A comic over at Abstuse Goose combines The Lord of the Flies with a fictive history of the Federal Reserve. The joke takes the expense that with a Federal Reserve system the lost boys could fund elaborate weapons production and make the ensuing madness more "civilized."

Sure the error in the this comic, which I often make mentally, is to equate the Fed as an established institution. The first panel purports to create a "government and Federal Reserve Banking System" all in one stroke. In reality, Treasury came along with the Washington Presidency but we don't get the Federal Reserve Act until 1913. Even then the structure of Fed Independence that we know today isn't enshrined until the Fed and Treasury reached The Accord in 1951 over who would manage debt.

More than a historical lesson, the Fed faces revision today. The Administration's financial regulatory reform plan would turn the Fed into a systemic regulator. The comic doesn't assume such a role for the Fed, in large part because the intuition already has important goals: price stability and full employment.

Volcker and Greenspan shaped a mysterious Fed. One that appears to have always existed. It hasn't. The current crisis could make the current Fed structure as ephemeral as we have believed it permanent.

Are Negative Fed rates really possible?

Harvard Economics Professor Gregory Mankiw thinks so. In this morning's New York Times, Mankiw proposes having the Federal Reserve decrease the Federal Funds rate below 0 percent. The zero bound has been considered binding because reducing it further would make potential lenders better off simply holding cash than lending. Mankiw, who is well aware of the problem of hording cash provides two unlikely solutions.

The first would be a "tax" on money. Likely by dissolving all money ending in a randomly selected serial number a year from now.  Of course such a move would require some enforcement. Someone would actually have to check serial numbers in a way that would discourages businesses from accepting the now worthless bills. Not to mention the way such a move could strain both domestic and international trust in the US dollar.

Mankiw's simpler solution is to simply have the Fed promise future inflation. He writes:

Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Yet commitments from the government are difficult to obtain and even more difficult to keep and have people trust. Mankiw mentions that Bernanke seems well equipped to make such a commitment. Bernanke’s term as chairman expires at the start of 2011. The possibility of President Obama appointing an new chairman could be enough to break faith in an inflation promise. More importantly, while inflation helps borrowers, it hurts anyone whose wages are not adjusting upward to meet the new price level. While many employees have contracts that include inflation-based cost of living adjustments, non-contract, hourly workers are likely to be negatively impacted; a situation that the Fed would be pressured to avoid.

Fed press Confernces?

The snarky blog LoLFed scans a report from Reuters saying that the Federal Reserve is considering holding more regular press conferences. While such press meetings seek to improve communications with the general public, I'm not convinced they will add a lot. The Federal Reserve, for all it's opacity, has already added a great deal to the information it releases this year. It even put out an extensive web overview of how it conducts monetary policy and its host of new liquidity facilities.

Besides today is Beige Book day. At 2pm, the Fed will release an almost 50 page document on regional economic activity across the country. The total number of readers, probably about a dozen. I'm not sure that Fed press conferences would be any more popular.