Fed package may be spitting in wind

Bloomberg

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The U.S. Federal Reserve’s new $800 billion effort to combat the financial crisis is designed to make credit more accessible to shaken consumers who aren’t sure they want more debt.

Households and lenders may not respond much because of the wealth destruction from plunging property and stock values, and the deepening economic slump, economists say. That means banks may end up returning the Fed’s new liquidity through deposits at the central bank.

"We are sort of spitting in the wind," said Michael Darda, chief economist at MKM Partners. "Banks won’t be throwing a lot of loans out there when they fear - rationally - those loans may not be paid back."

Policymakers aim to kick-start markets for loans to students, car buyers, credit-card borrowers and small businesses with a new $200 billion program. Backed in part by the Treasury, the Fed will become a new buyer in the market for consumer loans at a time when many traditional holders of the assets, such as off-balance sheet bank units, have collapsed or been dissolved.

The announcement of the new efforts Tuesday came amid criticism that officials were only focused on saving Wall Street firms, with the Citigroup rescue Nov. 23 the latest example.

President-elect Barack Obama and congressional Democrats have pushed for a stronger response to the housing crisis. The Fed responded Tuesday, invoking authority first granted in 1966 to buy $500 billion of mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae.

Along with a $100 billion plan to buy the corporate debt of Fannie, Freddie and federal home loan banks, the step marks the central bank’s biggest foray into a type of quantitative easing. That’s an unorthodox monetary policy tool that goes beyond setting short-term interest rates. The central bank has cut its benchmark rate to 1 percent.

"Rates are going to be kept down for a long time, the Fed’s balance sheet is going to be expanded for a long time," said John Ryding, chief economist at RDQ Economics. "It does represent a very significant quantitative easing."

Expansion of balance sheet
The question remains whether the lower rates will have much impact on the flow of credit and the economy. While the Fed has expanded its balance sheet by $1.3 trillion so far, banks have left much of the liquidity on deposit at the central bank itself, as so-called excess reserves. The surplus stood at $604 billion on Nov. 19.

Bank regulators have tried to cajole lenders, saying they "expect" them to lend, in a guidance letter issued Nov. 12. The Fed’s most recent quarterly survey of bank loan officers showed that 70 percent of domestic firms had tightened lending standards for their best mortgage borrowers in the third quarter, and 60 percent had raised standards on credit-card loans.

"The root of the problem is our securitization markets are non-functioning," said Josh Rosner, managing director at New York research firm Graham Fisher. "We have capital problems at the banks so they can’t take over."

While officials contested claims that the Fed is undertaking quantitative easing, they acknowledged that the central bank’s new actions will result in another injection of funds into the system. Officials said their objective is to affect credit markets rather than to target money supply.

The Bank of Japan is the only major central bank to deploy quantitative easing in modern times, from 2001 to 2006. Current Governor Masaaki Shirakawa said in May that the policy "was very effective in stabilizing financial markets," while at the same time it had "limited impact" in resolving Japan’s economic stagnation because banks wouldn’t lend and companies wouldn’t borrow.

Fed officials next meet on Dec. 16-17, when economists anticipate they will cut their target rate for overnight loans between banks to 0.5 percent. The central bank expanded the meeting to two days, making it likely that the Federal Open Market Committee will explore the options for conducting policy with rates near zero percent.