The Fed's Powers and How We Got Here

by: Kimball Corson

The question of how the Fed can control longer term interest rates keeps cropping up. So let us start there. The question is sincere, I believe. The answer is largely simple. It is, in the same way it has been controlling those rates up to this point. But to understand that well, we also need to understand how we got to where we are in the economic scheme of things. I take up both intertwined issues.

For starters, consider this. There is nothing to prevent the Fed- if it chooses and as long as banks are not lending so as to create the problem of inflation- to initiate a $1 or even a $2 trillion dollar buy up program for 10- and 30-year Treasurys. It just completed a $300 billion dollar buy up program for longer term Treasurys over about 8 months which has worked just fine to this point. It also controls the Federal funds rate, now pegged at from 0% to .25%, and the reserve requirements of national banks.

The Fed will do something like that, too -- albeit more likely on a lesser and more incremental scale -- if it genuinely believes longer term interest rates will rise and (1) damage the recovery, (2) stall the housing sector and (3) increase unemployment, especially in 2010, an election year.

The Fed has almost unlimited muscle in these matters. If banks won't lend, it can buy as much debt as the U.S. government wants to float, without a problem of inflation. It can even work out a Fed-Treasury program to defer interest payments on Fed held treasurys if that is necessary. Of course, the Fed will have to mop up the reserves or high powered money out of the banking system at some point to avoid inflation, if banks begin to seriously lend and the economy really gets going. That can be easily and substantially done, in a pinch, by just increasing the reserve requirement of banks, say, for example, to 1 to 1, a ratio long recommended by Milton Friedman as one being more prudent than what we have had.

Those who believe that, in present circumstances, the Fed is powerless or lacks the necessary authority to control longer term rates are simply mistaken.The Fed will use as much of its power as it feels is necessary to protect the housing market, the recovery and employment. No one should really doubt that. We might be amazed to see it happen, but we were also amazed to see what the Fed proposed beginning in March of 2009.

In March of 2009, the Fed announced:

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

By November of 2009, the Fed had completed its purchase of $300 billion of longer term treasurys and said that it was continuing to purchase toward the $1.2 trillion of agency mortgage back securities, to support the housing market, and that it had scaled back its purchases of agency debt from $200 billion to $175 billion. The purchases of both are expected to be concluded by the end of Q1 2010. The purchase of the $300 billion in longer term treasurys was completed in the Q4 of 2009.

In November, 2009, the Fed also said, it will

continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

It is a mistake to underestimate the power of the Fed to control interest rates. The real limitation in the system is our government’s ability to pay the interest, but even the Fed has some considerable control there also, if it adopts an interest payment deferral program with the Treasury.

The Fed is not really to blame for the situation we are in, although some think so and believe we should have a second and worse Great Depression instead of being where we are now. If people want to blame someone for this less than optimal situation, don’t blame the Fed now for doing what it is. The blame lies elsewhere. The Fed did not push us to the brink of the disaster. It simply increased the money supply under Greenspan too much. Without more that would have led to some mild to middling inflation, nothing that much to worry about. However, the Republicans, Larry Summers and others blocked needed financial regulations in this time frame and some actually got repealed or were not enforced, especially in regard to mortgage loans, lending practices and derivatives. Also, Greenspan personally was a hindrance on getting some derivatives regulation. Republicans are still trying to block financial regulation, especially in the Senate Banking Committee!

Essentially unregulated, mortgage brokers nationwide knowingly began making bad mortgage loans to get the upfront commission fees. Loans were made to nominees, some pets; appraisals were a joke to non-existent, the lack of income qualification was overlooked and all these mortgage brokers and sales people cared about was grabbing the up-front money in fees and running. And grab and run they did, hundreds and thousands of them. The spirit of the times was unrestrained greed.

Also largely unregulated, Wall Street, which the FBI has said clearly knew better, began buying up, packaging and selling collateralized debt obligations (CDO's) made up from bundles of these (bad) mortgages and then later began heavy use of derivatives, including credit default swaps, and sometimes even packaged derivatives into CDO like bundles, to hedge against these bad mortgage CDO packages, also to sell, but without reserves set aside to pay off in the event of default on the underlying loans -- all the while seriously overstating and misrepresenting the credit worthiness of their products. But America bought Wall Street’s products and bought them big time. As long as housing prices rose, everything held together.

Wall Street was hawking these CDO bundles and derivatives in quantity throughout the financial world and especially to insurance companies, hedge funds, pension funds and banks. It was almost like selling air and the FBI has so claimed, but the FBI was and has been shoved into a corner and told to sit on its hands. Then, when the housing price bubble burst, the system came tumbling down. The huge fall in home prices seriously injured consumers who cut back on their spending and threw us into a recession at the same time Wall Street's house of cards came tumbling down and did the same thing. We dove into a depression at a faster rate than in the Great Depression just after 1929.

The truth is that the Fed under Bernanke and the Treasury did pull us back from the brink of a second Great Depression, with the programs I have identified and the TARP programs, and had the Treasury allowed the major banks to fail like it did Lehman Bros, the ensuing Depression would have been worse and more costly than the Great Depression and certainly much worse for us that the alternative situation that we are now in.

The Fed is now simply left to deal with the aftermath -- the result of massive criminal negligence throughout the country and on Wall Street, in my mind. The Fed is not doing a bad job presently and it will protect housing, the recovery and employment. Bet on it and the idea interest rate won’t rise by much, if at all, in 2010.

Disclosure: None relevant