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.

 In a speech today, Fed Chairman Ben Bernanke discusses the central bank’s policy initiatives and the impact it has on it’s balance sheet.  In recent months, there has been quite a bit of discussion on the explosive growth of the Federal Reserve’s balance sheet during the financial crisis. 

Finally, the expansion of the Federal Reserve’s balance sheet has raised some concerns–and led to some misconceptions–about the credit risk being taken by the Fed. I will address the issue of credit risk today. And I would also like to talk about steps that the Fed is taking to improve the transparency of its programs to the public, consistent with our obligations in a democracy.

It does seem that the Fed has taken a much smaller profile since the start of the year, perhaps to give the new administration a chance to coordinate policy goals and agree on a concerted plan of action to deal with the current crisis.  That being said, the Fed today also released the minutes of it’s most recent FOMC meeting in an effort to become more transparent to the public.

The Fed has taken extraordinary steps in trying to deal with the worst financial crisis since the Great Depression.  It has been estimated that the Fed has pumped in over $8 trillion in liquidity so far into the money supply which has raised concern over the increased credit risk the central bank has opened itself to as well as the prospect of inflation in the future.

Bernanke sought to calm some of those fears today, explaining that Fed’s assets are mostly short term in nature and that they can be quickly reduced as the economy normalizes.  According to the recently released economic forecasts reveal that the Fed is estimating long term inflation at a modest 2%.

This is of course a far cry from estimates over the summer, commodity prices started to take a nosedive.  However, a major reason for the decline in long term inflation estimates has to do with credit creation.

Although the Fed has sought to expand the monetary base of the economy, there is not the corresponding growth in credit that we would have seen in years pasts.  You can think of credit creation as a multiplier of the money supply and that number has shrunk significantly since the financial crisis began.

In fact, without the Fed’s balance sheet actions, we could very well be talking about the risk of deflation right about now.

The Fed’s balance sheet has ballooned over the past year as they attempt to pump trillions of dollars in liquidity into credit markets.  With the financial crisis intensifying in October in the wake of the Lehman Brothers collapse they have announced that they are extending the life span of three key lending facilities.

In light of continuing strains in financial markets, the Federal Reserve on Tuesday announced the extension through April 30, 2009, of three liquidity facilities: the Primary Dealer Credit Facility (PDCF), the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), and the Term Securities Lending Facility (TSLF).  These facilities had previously been authorized through January 30, 2009. 

This will be the second time that they have extended these programs, which were initially created after credit markets tightened up after the Bear Stearns fire sale to JP Morgan back in March.  Despite their best efforts, credit markets have continued to deteriorate as private sources of investment have dried up.

In the beginning, many institution may have been wary of borrowing from the Fed because of the perception of weakness that this would entail.  Now for many, this source of liquidity is their means for survival.

Still, the alarming growth of the Fed’s balance sheet has many economists concerned as the Fed has opened themselves up to considerable risk by taking on illiquid securities as collateral.  The amount of liquidity the Fed has committed to the banking system, dwarfs the $700 billion financial rescue package by comparison.

With the country facing the worst economic downturn since the Great Depression you can’t blame the Fed for taking these extraordinary steps.  A major reason why the Fed is able to expand the money supply this much is due to the free fall in the price of oil, which has fallen more than $100 off it’s July high.

Whether these steps will forestall the rapid decline in spending remains to be seen.