Submitted by Geoffrey Batt.
May 2004
Ben Bernanke and Vincent Reinhart (who until 2007 was Director of the Division of Monetary Affairs for the Board of Governors of the Federal Reserve System) publish “Conducting Monetary Policy at Very Low Short-Term Interest Rates” in The American Economic Review. How, they ask, can a central bank effectively move beyond conventional policy measures when short term rates are at or approaching zero? Bernanke and Reinhart suggest three strategies:
- Convince market participants rates will stay low for a period beyond current expectations
- Change the composition of the central bank’s balance sheet (credit easing)
- Increase the size of the central bank’s balance sheet to a level exceeding what is necessary to achieve zero short term rates (quantitative easing)
Strategy #2 is radically aggressive insofar as it contemplates altering the composition of a central bank’s assets- which, in non-crisis conditions, consists almost entirely of Treasuries of various maturities- to include other, perhaps even riskier assets. For instance:
As an important participant in the Treasury market, the Federal Reserve might be able to influence term premiums, and thus overall yields, by shifting the composition of its holdings, say, from shorter-to longer- dated maturities. In simple terms, if the liquidity or risk characteristics of securities differ, so that investors do not treat all securities as perfect substitutes, then changes in the relative demands by a large purchaser have the potential to alter relative security prices. The same logic might lead the central bank to consider purchasing assets other than government securities, such as corporate bonds or stocks or foreign government bonds. (The Federal Reserve is currently authorized to purchase some foreign government bonds but not most private-sector assets, such as corporate bonds or stocks.)1
October 31, 2008
In the context of rapidly deteriorating market conditions, Jan Hatzius, Chief US Economist for none other than Goldman Sachs publishes “Getting to the End of the Rate Cut Road” in US Economics Analyst. With overnight Fed Funds at 1%, Hatzius argues the time for more aggressive monetary policy may be at hand. Specifically:
…Fed officials could start to purchase risky asset[s] such as corporate bonds and even equities. At present, such an aggressive approach is legally quite problematic, as the Federal Reserve must not take on a material amount of default risk. Thus, the purchase of risky assets would probably require an explicit stamp of Congressional approval. Should the economic and financial environment continue to deteriorate, however, it would be foolish to rule out such a more radical approach.2
November 14, 2008
Hatzius publishes “Marco Policy in a Liquidity Trap” in US Economics Analyst, advocating still more radical policy measures. In his words:
The most radical step would be debt- or even money- financed purchases of risky assets such as nonconforming mortgages, corporate bonds, or equities… Policy makers could focus specifically on the mortgage market, buying up mortgages or entire mortgage-backed securities in size, restructuring the terms on a loan-by-loan basis, and then holding the loans to maturity. Alternatively, they could target risky assets more generally- private-label mortgages as well as corporate bonds, equities, and potentially a whole host of more exotic securities. Especially, if such a program were financed by money creation, it would be considerably more radical than anything seen previously. Hence, the hurdle for adoption is high one, and the political scrutiny in Congress would likely be intense. Nevertheless, we believe it could become a serious possibility should the economic and financial slump deepen in 2009.3
November 21, 2008
Hatzius publishes “What’s Needed to Stop the Rot?” in US Economics Analyst reiterating his call for unconventional policy action even while noting that it currently sits on shaky legal ground. That is:
…the Congress should consider providing explicit authority to either agency [Treasury or Fed] to buy a broader range of risky assets, including corporate debt and even equities. Although many politicians have difficulty swallowing this on philosophical grounds, this week’s market action should convince them that the risks of inaction are serious. However, such a more radical step is unlikely until sometime in 2009.4
March 13, 2009
Chaos reigns globally. Respected academics and high ranking politicians call for bank nationalization. CNBC reports of “secret” meetings at Goldman Sachs amid fears Geithner cannot get the job done. US equity indices are down more from their highs than the corresponding period in The Great Depression. Pension funds, 401k plans, endowments, insurance companies, etc., are fully exposed, taking heretofore unimagined losses. With nearly everyone in the country exposed to equities in one way or another, the unthinkable begins to seem increasingly plausible. Insurance companies cannot pay claims; pension funds cannot meet their obligations; universities suspend session; Mr. and Mrs. Smith, told just months earlier an unprecedented $700 billion bank bailout was designed to save them and their neighbors on Main St., stand to lose everything. The Fed, having thrown just about everything in its arsenal at the crisis, appears to be losing control. In the most desperate of times, Hatzius calls for the most desperate of measures:
…Fed officials might need to expand their balance sheet by as much as $10 trillion to make policy appropriately accommodative (pg. 2)…To be sure, “quantitative easing”- an increase in base money beyond what is needed to keep the funds rate at zero- by itself may not be sufficient on its own because Treasury bills become perfect substitutes for base money once short-term interest rates have fallen to zero. But the Fed can engage in “credit easing” by purchasing assets whose yields are still positive, including longer-term Treasuries, commercial paper, mortgages, corporate bonds, and perhaps even equities.5
Five days later, the Fed shocks the world (though not, it seems, Goldman Sachs) with its most aggressive policy action yet, expanding both the size and composition of its balance sheet via increased purchases of mortgaged-back securities, agency debt, and long-dated Treasuries. Spreads immediately tighten; Bonds- both IG and HY- scream higher; equities stage one of the most explosive rallies in history; the debate shifts from bank nationalization to record bank profits and excessive pay; financial collapse, along with the terrifying social, political, and economic consequences associated with it, is averted. The war, we are confidently told, is over.
Mission accomplished.
Questions, however, still remain:
- Forget the "Paulson Bazooka," if Lehman’s collapse was a financial Pearl Harbor, was the Fed’s policy response on March 18, 2009 the financial equivalent of Fat Man and Little Boy? (The direct purchase of equities?)
- In the face of the unthinkable, did the Fed exceed its policy statement by directly buying assets not contemplated therein?
- Did Bernanke, encouraged by Goldman’s Hatzius, heed his own advice and monetize the equity markets?
At best, the evidence offered here is circumstantial. This is not, to be sure, conclusive proof the Fed bought equities- nor is it intended to be. All I have endeavored to do is raise a rational doubt, one that could easily be done away with if Bernanke answered (finally) under oath direct questions as to the Fed's purchase of equities at any point during his tenure as Chairman. Perhaps Alan Grayson might put his worries about foreign currency swaps to the side, and ask Chairman Bernanke about equities.
(The author would like to acknowledge the generous help of Zero Hedge's Marla Singer in the production of this article).
- 1. The American Economic Review, Vol. 94, No. 2., p. 86. (Emphasis ours).
- 2. "US Economics Analyst," Vol 08, Number 44, Goldman Sachs, October 31, 2008, p. 6.
- 3. "Macro Policy in a Liquidity Trap," US Economics Analyst Issue 8 Number 46, Goldman Sachs, p. 6. (Emphasis ours)
- 4. "What's Needed to Stop the Rot?" US Economics Analyst, Issue 08, Number 47, Goldman Sachs, p. 3.
- 5. "The Specter of Deflation," US Economic Analysis, Issue 09, Number 10, Goldman Sachs, March 13, 2009, pg.3. (Emphasis ours)
