Bernanke and Fed Options

Many observers continue to clamor for a new round of asset purchases from the Federal Reserve. They were disappointed when the FOMC statement and press conference after last months meeting failed to provide fresh clues. They were disappointed again with the minutes from that meeting. They were disappointed again yesterday when Fed chairman Bernanke did not play up the likelihood of QE3.

This does not mean, however, that the Fed is content with the status quo. Indeed the Fed is reviewing its options. Bernanke listed several options for the Fed. These include purchasing Treasuries and mortgage backed securities, changing the Fed's guidance, cutting the interest on excessive reserves, and using the discount window for direct lending.

Bernanke seemed clear: "We haven't really come to a specific choice at this point, but we are looking for ways to address the weakness in the economy should more action be needed to promote a sustained recovery in the labor market." 

The problem is that the combination of Fed policy, the disappointing economic data and the European debt crisis have pushed US interest rates to historically low levels. It is not just Treasury yields that have fallen. The spread between corporate bonds and Treasuries has fallen for six consecutive weeks. The spread between commercial paper and T-bills has fallen. Mortgage rates have fallen.

Nevertheless, Bernanke identified still tight borrowing conditions for some market segments, which he believes are still a headwind on the economy. This suggests a subtle shift from reducing the cost of borrowing to increasing the availability of credit. 

On a couple of occasions now Bernanke has expressed interest in the UK's attempt to bolster lending through a new program "funding for lending scheme" (FLS). It is essentially a collateral swap. Banks can swap loans to households and businesses with the BOE for T-bills, which then can be used to secure cheaper funding in repos, for example. The program allows banks to draw on up to 5% of their loan book. For banks increasing their loan book, the FLS can reduce sterling borrowing costs considerably (from around 150 bp to closer to 50 bp Even if a bank reduces its loan book marginally, pays a modest penalty, there is still a savings to be had.

The Federal Reserve is engaged in Operation Twist. It is reducing its holdings of short-term securities. This means operationally it cannot duplicate the BOE's program, even if it wanted to. Hence, Bernanke's hint at the possible use of the discount window. 

As is widely appreciated, the discount window is neither a discount nor a window. The so-called discount rate is set 50 bp on top of Fed funds. Although Bernanke's comments have not been fleshed out, he may be considering lowering the discount rate penalty for banks expanding their loan book (perhaps in general or perhaps for household--including mortgage loans--and small businesses. The duration of discount window borrowings could be extended to a year (from 90 days). A wide range of collateral is also accepted.

US banks have about $6 trillion of household and business loans. If the program was the same size as the UK's, which can be as much as 5% of UK bank loan book, it would entail about $300 bln. This would boost the Fed's balance sheet but in a different way that the first two rounds of QE. It would link more closely lending and lower cost funding. 

There are some counter-arguments. For example, unlike in the UK (and the euro area), US bank lending is not contracting, but instead rising modestly (~5%). Interbank rates are also lower in the US than in the UK (and euro area). 

There are three take aways from this discussion. First, the key decision makers at the Fed (we have referred to them as the real Troika or BYD: Bernanke, Yellen and Dudley) are concerned about the faltering growth and the stalling out of the labor market improvement. Second, they are looking at existing tools and other options. Third, Bernanke himself seems to look sympathetically to what his one-time classmate and BOE Governor King is doing. Although it cannot be precisely duplicated in the US, it seems Bernanke believes it can be tailored to the US circumstances and may involve using the discount window. Some of the opposition to QE in the form of buying Treasuries is that it blurs the distinction between monetary and fiscal policy. Using of the discount window or other facilities tied closer to private sector lending, may overcome some of the objections.