Fed Minutes Show Confusion

Now just how do Ben Bernanke's new tools work, and should the Fed really use them?

Most will focus on the minor changes in 2010 GDP forecasts that are made in the just released Fed minutes, but the real story continues to be Bernanke's new tools. The Fed simply doesn't know what tools will work and how those tools will work, if huge amounts of reserves need to be drained from the system. Reserves that are hanging like a dark cloud over the Federal Reserve building. Here is the commentary directly from the minutes:

Participants expressed a range of views about how the Committee might use its various tools in combination to foster most effectively its dual objectives of maximum employment and price stability. As part of the Committee's strategy for eventual exit from the period of extraordinary policy accommodation, several participants thought that asset sales could be a useful tool to reduce the size of the Federal Reserve's balance sheet and lower the level of reserve balances, either prior to or concurrently with increasing the policy rate. In their view, such sales would help reinforce the effectiveness of paying interest on excess reserves as an instrument for firming policy at the appropriate time and would help quicken the restoration of a balance sheet composition in which Treasury securities were the predominant asset. Other participants had reservations about asset sales--especially in advance of a decision to raise policy interest rates--and noted that such sales might elicit sharp increases in longer-term interest rates that could undermine attainment of the Committee's goals. Furthermore, they believed that other reserve management tools such as reverse RPs and term deposits would likely be sufficient to implement an appropriate exit strategy and that assets could be allowed to run off over time, reflecting prepayments and the maturation of issues. Participants agreed to continue to evaluate various potential policy-implementation tools and the possible combinations and sequences in which they might be used. They also agreed that it would be important to develop communication approaches for clearly explaining to the public the use of these tools and the Committee's exit strategy more broadly.

Does this in anyway indicate a Fed that even knows if Bernanke's tools will work? And what assets are they talking about selling? They have been taking on junk mortgage securities. Who the hell is going to buy them?

And what the hell is this comment in the minutes? :

M2 appeared to have expanded at a moderate rate in September and October.

The only reason the M2 number is positive at all is because of the huge dip in money supply in August. The October money supply number is essentially flat with where money supply stood in July and still down versus June. Take a look for yourself.

One fact that can not be argued is that banks aren't making loans, and the Fed does know that:

Bank credit declined in September and in the first half of October, as the contraction in C&I loans contributed importantly to a further decline in total loans over the period. According to the SLOOS, bank lending standards and terms tightened further and demand continued to decline, on net, for most types of loans in the third quarter. Commercial real estate (CRE) loans also continued to decrease, reportedly because of widespread paydowns and charge-offs. In addition, residential mortgage loans on banks' books fell, and revolving home equity loans and consumer loans also contracted. The pace of decline in total loans at large banks continued to exceed that at smaller banks. The allowance for loan and lease losses rose further at large banks in September, but it was about unchanged at small banks.

However, if they start making loans, it means that they are using some of the excess reserves. What if they get carried away? How exactly is the Fed going to drain reserves? And won't that whack the economy?

Bottom line: The economy is in a very precarious state, and it is not clear if the Fed would be able to effectively withdraw reserves quickly if the need arose.

It would probably take a perfect storm of events, but it is not impossible for the Fed to lose control of money making activities, and the money supply could then take on a life of its own. How so? Step 1. Banks start loaning out against their excess reserves. Step 2. The Fed finds it impossible to sell the mortgage backed securities it owns. to drain reserves. Step 3. It tries the third-party reverse-repo tool, but this jacks interest rates sky high (as envisioned by some Fed members in the minutes). This forces the Fed to halt third-party reverse-repos and causes the Fed to just watch as a trillion in excess reserves are loaned out.

Now, as i said, it would take a perfect storm for this scenario to unfold, but it is not out of the question. And, even under this scenario, the Fed would likely create emergency new lending restrictions to prevent further lending of excess reserves. But, wouldn't speculation that such restrictions were about to be implemented simply cause banks to try and make loans even quicker?

We do live in interesting times. Don't die now, you really need to see how all this plays out.