Bernanke's Madman's Toolbox

Yesterday, I commented:

Bernanke better watch out with all these new financial "tools" he is creating. It's possible one of them won't be completely thought out and will result in all sorts of unintended consequences.

Today, my inbox contains two emails containing links to stories detailing how haywire events could develop from Bernanke's toolbox.

Nick sent along this link from NYT's Dealbook which warns about the Bernanke proposal for the Fed to issue their own debt:

The prospect of the Federal Reserve issuing its own bonds now that the United States Treasury has stopped borrowing on its behalf could paradoxically make the world a riskier place, according to Breakingviews. It threatens to reduce the effectiveness of Fed policy moves or, worse, influence them, the publication argues.

The tactic is only at the trial-balloon phase, and Congress may well reject it as an end run around its right to determine government borrowing. But lawmakers have blessed questionable strategies before, it notes.

If the Fed did issue traded debt, the market prices would act as a barometer of how investors viewed its policies, Breakingviews says.

Even if the debt were explicitly backed by the government, prices would probably still reflect market sentiment, it argues. After all, the publication says, bank-issued bonds insured by the Federal Deposit Insurance Corporation and the quasi-guaranteed debt of Fannie Mae and Freddie Mac trade with effective interest yields that exceed Treasury securities by notable, and in some cases volatile, margins.

It’s likely that rates on any Fed-issued bonds would diverge from Treasury bonds too, especially since the central bank lacks the power to raise tax revenue to pay interest, says Breakingviews. The market would probably look to the Fed’s own balance sheet, which has more than doubled in the last year, and weigh that against its ability to raise money by increasing reserves, when determining the risk of the bonds.

If the Fed pursues policies that could result in a loss — like its plan to lend to entities that buy packages of consumer loans — the risk premiums on its bonds should increase, it says.

Such snap judgments on policy moves could undermine the Fed’s effectiveness, Breakingviews says. If the bond market gave a thumbs-down to even a sensible policy, it would throw doubt on the Fed’s willingness to follow through, especially because the higher risk premium would increase the Fed’s future borrowing costs, the publication argues. Since monetary policy has a large psychological element, that could be a big problem.

Of course, there are already indicators of market sentiment about Fed policy, the publication notes. And the devil of any Fed debt would be in its details, it says. But with the Fed’s resources stretched and its mandate expanding, giving the markets another red flag to wave seems foolhardy, Breakingviews concludes.

Also this morning, Jeffrey Rogers Hummel emailed a link to his extensive analysis of the Bernanke decision by the Fed to pay interest on bank reserves. The JRH conclusion:

I predict that future economic historians will look back on this change as a major blunder during the current credit tightening, making traditional monetary policy less effective...Moreover, the paying of interest on reserves was motivated by the misguided focus on interest rates, rather than money supply measures, as an indicator and target of monetary policy...The irony is that the Fed is now less able to hit its interest rate target than ever before. It first adopted the corridor or channel system of the ECB, setting the interest rate on reserves below its Federal funds target, as a lower bound, with the discount rate above the target as an upper bound. But as the effective Federal funds rate fell not only below target but below the interest rate on reserves, the Fed on November 5 moved to the New Zealand system, where the interest rate on both required and excess reserves is set right at the target Federal funds rate. So far, this hasn't worked either.