Federal Reserve & Interest Rates

Although, China announced that it wouldn’t be making any changes at this time to it’s foreign exchange policy at this time, more and more countries are questioning the role of the U.S. Dollar as a global currency reserve.  China’s influence can’t be overstated, since they are the largest holder of U.S. Treasury Securities and hold over $2 trillion in currency reserves.

While they freely admit that the Dollar currently dominates global trade, there is also no question they and other countries would like to seek an alternative if possible.  We’ve also seen many petroleum producing countries, whose output is pegged to the dollar, also raise questions on having so much of their economic livelihood tied to the our currency.

With it’s fast growing economy, many expect China to become a global powerhouse in a few years and they will most likely remain the central figure on any attempts to change the status quo.  Unfortunately any attempts they make to change the Dollar’s role may not be for purely economic reasons.

China’s substantial Dollar and Treasury holdings gives it added political power when dealing with Washington and everyone knows this.  Unfortunately, there is not much the U.S. can do in the short term to undo decades of trade imbalances and deficit spending.

While we can expect further rumbling from different circles in the near future, the current fragility of the global financial system will probably make any changes in the short term unlikely.  However once the global economy does recover, we can probably expect some countries to move quickly in order to prevent future disruption to the U.S. economy to have such a far reaching effect on the rest of the world.

Federal Reserve Chairman Ben Bernanke gave testimony before Congress on it’s role over the merger of Bank of America(BOA) and Merrill Lynch.  As we have seen many BOA shareholders sharply questioned the transaction after the fact, once major losses came to light in ensuing quarters.

As you know, the period encompassing Bank of America’s decision to acquire Merrill Lynch through the consummation of the merger was one of extreme stress in financial markets. The government-sponsored enterprises, Fannie Mae and Freddie Mac, were taken into conservatorship a week before the Bank of America deal was announced. That same week, Lehman Brothers failed, and American International Group was prevented from failing only by extraordinary government action. Later that month, Wachovia faced intense liquidity pressures which threatened its viability and resulted in its acquisition by Wells Fargo. In mid-October, an aggressive international response was required to avert a global banking meltdown. In November, the possible destabilization of Citigroup was prevented by government action. In short, the period was one of extraordinary risk for the financial system and the global economy, as well as for Bank of America and Merrill Lynch.

Obviously the Fed didn’t want to see another episode of what happened in the aftermath of the Lehman collapse when financial market froze up and at the time the financial system was and is still on shaky ground.  Until the financial system can gain firmer ground, one of the main goals of the Fed is preventing any additional shocks that would undo much of the massive intervention the government has already undertaken.

In hindsight maybe they wished they had done more to prevent the Lehman Brothers collapse but at the time the Fed was unwilling to take on the substantial risks that would have imposed on them.  Even now, you can’t say they made the wrong decision since Lehman’s liabilities far outstripped it’s assets because they were so heavily leveraged.

In the case of Merrill Lynch at least they had a party in BOA that they could share some of the risk with.  For the time being it appears that the Fed made the right decision in supporting the transaction even though some parties don’t agree with it.

While in some ways the current global recession began with the collapse of the U.S. housing market and the subprime mortgage meltdown, much of the ensuing damage was amplified because of the explosive growth of the over-the-counter(OTC) derivatives market.  It will also be exceedingly difficult for the Federal Reserve to develop a regulatory structure for this complex and unwieldy market that many observers have called a ticking time bomb for the financial system.

The government has been holding hearings recently on revamping the entire regulatory structure of the entire financial system in order to prevent the kind of shocks that nearly brought it to it’s knees over the past year.  A major concern for the Fed is the currently unregulated OTC derivatives market and some of it’s members gave their views before Capitol Hill today, on ways to finally regulate a market that is pretty much a festering wound waiting to happen.

The events of the last two years have demonstrated the potential for difficulties in one part of the financial system to create problems in other sectors and in the macroeconomy more broadly. OTC derivatives appear to have amplified or transmitted shocks. An important objective of regulatory initiatives related to OTC derivatives is to ensure that improvements to the infrastructure supporting these products reduce the likelihood of such transmissions and make the financial system as a whole more resilient to future shocks.

The key goal of any of the changes to the financial regulatory structure will be to dampen systemic risk and the derivatives market as it currently stands poses a grave threat to future global financial stability.  Unfortunately the task ahead at this point may be akin to closing the barn door after all the animals have already left.

Because the market has grown so large in such a short time, it will take a global effort from central banks around the world to realize any significant changes in the short term for it to be effective.  At this point acting on it’s own, the Fed’s can only realistically try to mitigate any possible shocks to the financial system as opposed to attempting to prevent them entirely.