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The weary world
received confirmation this morning that Federal Reserve Chairman Ben
Bernanke’s monetary helicopter has filed flight plans for a new
monetary drop. Perhaps we should start calling Bernanke’s flying
apparatus a B-1 Bomber as some of you have suggested. In any case, I had
hoped to finish my detailed analysis of the previous helicopter (oops, sorry,
B-1 Bomber) operation by now but this latest aerial maneuvering deserves
immediate attention. I hinted yesterday in the comments section that the Fed
would likely have to target the commercial paper market, and lo and behold,
the Fed announced this morning that it is in fact doing just that. The new Commercial Paper Funding Facility involves setting up a
Special Purpose Vehicle (SPV), which many of you will recall is what got
Enron in trouble (we called these things special purpose entities or SPEs
back then). This SPV will buy commercial paper at a slight discount (the Fed
innocently calls it a “spread”) using funds “loaned”
to it by the Fed at the Federal Funds Rate.
The question of the
day is, of course, where will the Fed get the funds to loan to the SPV under
this new bombing operation? If it is the U.S. Treasury Department’s
Supplementary Financing Program (see my previous essay),
we’ll have to watch and see just how much of it will actually translate
to new Reserve Balances, representing the Fed issuing new money, as opposed
to it being a “sterilized” operation in which existing money is
merely being recirculated. Perhaps I might not have made this very clear in
my prior essay, but the various Fed credit facilities to date, which the
Supplementary Financing Program (”Treasury SFP”) has been funding
for several weeks because the Fed is now bankrupt, represent a swap of assets
and not actual money creation. In other words, these facilities are just
exchanges of liquid Fed assets (Treasury securities) for illiquid bank
assets. There is one facility, however, that I have yet to mention and this
one does not appear to operate in the same manner. Indeed, it appears to be
the target of the first $150 billion helicopter drop as I will soon explain
in yet another essay.
Specifically in the
case of funding provided under the Treasury SFP, approximately $180 billion
of the $344 billion that has been provided to date was acquired through
public auction of securities by the Treasury. This $180 billion was merely
re-distributed from those buying the Treasury securities to participants in
the Fed’s credit (asset swap) facilities. The balance of $160 billion,
however, did actually represent new money creation in the form of Reserve
Balances. To accomplish this, I believe the Fed essentially purchased
Treasury securities in a similar manner that it conducts Open Market operation [PDF], except for the “open
market” part. [As an aside, I know many of you have been asking why
Open Market operations would have been an unstable method for the Fed to
address this credit crisis. The Open Market operation [PDF] paper from the Fed explains
this quite well.] Exactly how
Reserve Balances were created under the Treasury SFP from a mechanical
standpoint is something that deserves further analysis. But first, my next
paper will tackle precisely how the resulting Reserve Balances are being used.
Returning to the
latest bombing raid, we find that the Fed does have strong precedent to play
a role in the commercial paper market. In fact, as I previously mentioned,
the Fed started out in 1913 as a newborn central bank with limited ability to
create money through purchases of rediscounted commercial paper backed with
40% gold. The idea of limiting the Fed’s monetary influence to the
commercial paper market was sound monetary policy. Simply put, the Fed could
not bring more money into existence than was actually required to finance the
needs of commercial enterprises who were in the process of bringing goods or
services to market within the next 90 days. When the money supply equals the
sum total of goods and services in the economy, the result is stable prices.
Minus the gold part (which, by the way, would be a good idea for Mr. Bernanke
to consider instituting again as it would be a huge confidence boost for the
markets), it appears the newly-formed SPV will also buy rediscounted
commercial paper just like the Fed did when it was a largely harmless (and
consequently not large) central bank.
And that brings us to
the strong possibility that the new commercial paper facility will not be
financed using Treasury auctions under the Treasury SFP after all but will
rather be monetized with commercial paper serving as collateral. By doing so,
the Fed would be injecting liquidity at the Monetary Base level in the form of
Reserve Balances. Since the commercial paper is being discounted only by a
small amount, banking capital destruction is largely avoided (see the
Appendix to my prior essay in which I discuss the problem of creating banking
reserves using collateral that is deeply discounted). If this in fact proves
to be the case, it will be a pure helicopter/B-1 Bomber drop in the sense
that it will be the functional equivalent of the historical Open Market
operations that have been responsible for nearly 100% of the inflation of the
Monetary Base, and in turn the money supply, during the last few decades.
The reason I believe
this will be a monetization of commercial paper instead of a sterilized asset
swap like the other Fed credit facilities is that the banking system is not a
direct recipient of the credit (the SPV is). Setting up a special purpose
entity to hold the commercial paper allows the banks to get some of this
stuff completely off their books. Since the SPV will hold the commercial
paper until maturity that means either (1) the banks will have to be willing
to lend on commercial paper again by then or (2) the Fed will have
effectively provided permanent commercial paper financing. Clearly the latter
will result in a permanent jump in the Monetary Base. In other words, the
money generously dropped from the helicopter/B-1 Bomber will not be returned
to Mr. Bernanke.
Yet even if banks do
start lending on commercial paper again, they will still need funds to lend.
Should, in the meantime, the Reserve Balances they have received from the SPV
get withdrawn from the banking system in the form of Federal Reserve Notes
stuffed under the mattress or exported offshore, the monetary injection would
need to become permanent. And as I controversially claim in my updated version
of the Fed is Bankrupt essay, the primary reason for the inflation of the
U.S. dollar Monetary Base in the past few decades is the result of Federal
Reserve Notes being sent offshore. And the reason for that is the U.S. trade deficit. As a result of the above, we may very well see export control over the
U.S. dollar as one of the next steps in this increasingly desperate attempt
to fight deflation by hyperinflating our monetary troubles away.
Tom Szabo
Silveraxis.com
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