This last week, the US Federal Reserve cut its target rate more than expected to an unprecedented level close to zero. A few days later, the Bank of Japan sought to move in tandem and go on to Act 2 of its nineties? quantitative easing (QE). What were the motives, why a shift in stance now, and what will be the consequences?
It might seem an academic exercise to analyse the Federal Reserve?s monetary policy actions last week, but it is not. It will have a deep impact on India?s economic future in the next year, even more than the measures now being taken by India?s policy authorities. A back-of-the-envelope calculation shows that India?s exposure to global markets (exports of goods and services) in 2007-08 was $223 billion (or about Rs 11 lakh crore; India?s GDP was Rs 47 lakh crore, for reference). A fall of 20 percentage points in exports growth in 2008-09 means a drop of Rs 2 lakh crore in potential income, far beyond anything that our stimulus packages envision. So what the Federal Reserve manages to do will have significant implications for India?s economy. If we accept this, we need to understand the implications of the measures announced by the Federal Reserve in much greater detail.
Recall the string of interventions by the Fed since September 2007. The chart shows that despite the significant liquidity that had been injected since then, the Fed had managed to keep the effective federal funds rate close to the relevant Target till the markets blew up in mid-September, after the collapse of Fannie Mae, Lehman Bros and AIG. After that, the Fed has effectively been in a quantitative easing mode and the effective rates have been close to zero since November.
How had the Fed managed to control rates in the past? The funds that had been lent to banks and other intermediaries was effectively neutralised through the sale of securities from its system open market operations portfolio, inducing liquidity neutrality. After it ran out of securities to sell, it signed an agreement with the Treasury (supplementary financing program, SPF) in mid-September, whereby the latter would issue treasury bills, in excess of market borrowing requirements. From 5 November, in addition, the Fed started paying banks interest on excess reserves at the target rate to ensure that liquidity infusion operations were aligned to monetary policy objectives signaled by the target rate. Obviously, none of this worked. Cutting its target rates to zero and earlier discontinuing the SPF were patent signals acknowledging this reality.
The array of refinancing facilities that have been progressively added to the liquidity enhancing operations also show the ?mission creep? of policy interventions, and that the Fed had in effect been running a quantitative easing programme much before its formal announcement in December. These have been three characteristics of these operations: (1) a rapid widening of acceptable securities as collateral against the Fed?s loans (2) expansion of the range of institutions eligible for refinancing and support and (3) an increase in the tenor and maturity of the financing.
The granddaddy of its interventions was the term auction facility, followed by the term securities lending facility (both confined to banks), then expanded to the primary dealer credit facility (to broker dealers, investment bankers and the like). A change in stance in these liquidity facilities (and a willingness to essentially lend directly to borrowers) was in the commercial paper funding facility in early October. One reason for the shift was the OMOs had virtually doubled the high power money base (M0) without achieving the goal of making banks increase their lending. The CPFF allowed the Fed to target the term funding markets more directly; investors had earlier been dumping commercial paper and increasingly shifting to bank deposits. CPs are a vital component of corporate credit in the US and had been particularly affected in the crisis. This was followed by the money markets investors funding facility. Now comes a term asset-backed securities loan facility to facilitate the extension of credit to households and small businesses.
Is what the Fed doing, then, the best way to go? Is an expansion of direct lending to various funding instrument classes a better option than bloating its balance sheet with purchases of ?large quantities of agency debt and mortgage-backed securities and?longer-term treasury securities?? Probably. Even if longer-term Treasury yields are brought down (and thereby mortgage rates), there is no guarantee of increased availability of funds. The fear is that, in taking credit exposure directly, the Fed is not equipped to pick one corporate or lending line versus another. In the meantime, the Fed?s balance sheet has ballooned from $900 billion before the meltdown in mid-September to over $2.2 trillion now.
The effect of these, and of the Treasury Tarp, Talf and other bailout programmes will continue to reverberate in the global financial system for a long time. We wait and watch to see the immediate effects.
?The author is vice-president, business and economic research, Axis Bank. These are his personal views