In a surprise move today, the Federal Reserve has announced a new approach to handling the continuing economic malaise where the United States remains. In a vote of 11-1, the Board of Governors of the Federal Reserve System decided to discontinue their in-place programs developed under TARP, and instead to venture off into a new, unexplored approach to handling the credit crisis by directly going after the mortgages from which the recession began.
For the past few years, the Federal Reserve has engaged in a policy called by economists ”Quantitative Easing.” In layman terms, Quantitative Easing is the use of government securities to artificially increase bank reserves, forcing their credit interest rate down and hopefully increasing lending. This lending, in turn, should stimulate the economy according to some economic schools of thought. Normally, a central bank, such as the Federal Reserve, lowers its interest rate in order to create this phenomena. But when the central bank lending rate is at or near 0%, there literally is nowhere for it to go, which is when they turn to QE.
The Bush administration repeatedly forced this lending rate down throughout its administration. When Bush took office, the Federal Reserve overnight lending rate sat at 6.4%. Almost immediately, it began slashing that rate, down to 5, then to 4, and then it broke the bottom floor, the lowest rates seen in reserve history, 3%, and even dipping several times below 1%. At no point did it ever go above 5.5% during Bush’s time in office, although it did break 5% for a 13 month period of July ’06-August ’07. Historically this rate was above 8%, to prevent inflationary actions or runaway credit, with it nearly hitting 20% under the Reagan administration.
What this meant was, when the housing bubble burst, there was not enough margin in this rate to drop it far enough, fast enough or to prevent the credit markets from seizing up. The low rate caused a gigantic increase in lending, which artificially increased the price on homes, by several hundred percent from when Bush took office to when the bubble burst. As a result, the market needed a massive correction in prices, with the inevitable result.
When the reserve hit the 0% mark in 2008, it turned to the technique of QE to achieve the same results. QE is not as effective as slashing the interest rate, and costs far more to the government as a result. The reserve has gone through two rounds of QE to date, buying up assets as well as expanding bank reserves. However, rather than lending, the banks began to hoard their new reserves, with several trillion in assets being held, frozen, by these institutions and not being lent out. This is one of the main reasons why this recession’s effects are still lingering, long after it ended.
Since the increased capital reserves did not solve the issue, as the Federal Reserve Chairman had predicted, now the Federal Reserve has decided on taking a new approach to solving the crisis.
Instead of splitting the reserve’s efforts, by shoring up bank reserves as well as removing so-called toxic assets from their books, the Federal Reserve is now taking upon itself the mortgages upon which the crisis originated in the first place. As announced today, the Federal Reserve will begin purchasing $40 billion worth of securitized mortgages every month. This might look like a strange move, but in effect what they are doing is removing the credit crisis out of the market itself, and consolidating it into the Reserve. This would make the Reserve the mortgage holder.
Then chairman Bernanke made mention of something else, which is the key provision:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.
It is the “other policy tools” part which raises eyebrows. The Reserve has the right to re-evaluate asset value, although that provision has not been used since the 1960′s. Many economists have said that until the housing market bubble is corrected the economy will continue to remain soft. If the Reserve continues as its current pace of mortgage purchases, it could, in theory, re-evaluate the asset value, forcing a market correction directly instead of the meandering, slow correction we are currently going through.
That is only one possible tool, there are others, such as recombining securities, or even the elimination of them directly once all components of the securities are assembled. Right now, a securitized mortgage is effectively sliced up, so a single mortgage can be feeding a dozen or more securities. A single security might contain part of a dozen or more mortgages. This makes any corrections difficult, as the assets are split up among multiple groups. If the Reserve is able to reassemble these assets, they can engage directly to correct these assets. And they would not need all of them either. Even if only a small portion were corrected, it would force the marketplace in to the direction needed.
Is Ben Bernanke tired of the games that Wall Street is playing with our economic future? Or is he simply trying to save his own place in the history books? Only time will tell what “other policy tools” the Reserve will use. We should see first hand the evidence of it before the end of October.
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