Is the Fed taper too little too late?

By December 2007, the economy officially entered a balance sheet recession awash with massive deleveraging. The population became less creditworthy and less confident in future income, and balance sheets contracted as loans were closed out and minimal new credit was issued.

By the end of 2008, the Fed had lowered the Fed Funds target rate to zero. The Fed hoped that driving down interest rates would make outstanding loans less expensive and new credit creation more attractive (see Figure 1), resulting in new money that could be used to stabilize crashing asset prices.

The Fed set out to achieve its target rate using open market operations, which is the Feds traditional method of manipulating interest rates. [Using open market operations, the Fed creates money out of thin air and uses the newly created money to buy Federal government bonds (i.e., Treasuries) via repos from the Feds Primary Dealers (see Figure 2). With this process, the Fed swaps treasuries on bank balance sheets with cash reserves, which lowers the inter-bank lending rate because a greater supply of reserves available reduces the “market price” of banks borrowing reserves from each other.]

Figure 2 – The Federal Reserve’s Primary Dealers as of February 2014

In addition to regular open market operations, in October 2008 the Fed entered a new territory of stimulus as it began paying banks interest on reserves held at the Fed for the first time in history. The Fed hoped that this interest income would help recapitalize banks, and would also give the Fed another tool to use when targeting the Fed Funds rate. The thinking being that banks would not lend out reserves for less than what the Fed is paying them, in this case 0.25%. Paying banks interest on reserves held at the Fed was an important development of the current stimulus program given that the Fed’s open market operations, and later QE, were effectively based on building up bank reserves held at the Fed.

When the Fed’s target zero interest rate level was realized in December 2008, deleveraging of the economy was still accelerating and asset and stock prices were far from normalized. The Fed had a mission to continue with stimulus, but having already taken rates to the floor, the Fed chose to experiment with a more targeted asset purchase program referred to as Quantitative Easing.

[The mechanics of QE are similar to open market operations, in that the Fed again creates money out of thin air, but instead of using the money to buy Treasuries, the Fed buys mortgage backed securities (MBS) and government bonds with longer maturities than treasuries. This process swaps toxic MBS with cash reserves, leaving private balance sheets cleaner. QE significantly benefits banks as the Fed not only takes these unwanted assets off of their balance sheets, but pays them a premium to do so, the difference essentially equating to a cash infusion. In addition, the Feds Primary Dealers (see Figure 2) also receive cash commissions from the Fed for these transactions.]

QE1 was the first time the Fed ever bought mortgage bonds, and it was the most aggressive stimulus program initiated in the Fed’s 100 year history, buying $1.55 trillion worth of assets in 12 months. Andrew Huszar, a Fed official that oversaw QE implementation described the execution as “buying so many (mortgage bonds) each day through active, unscripted trading that we constantly risked driving bond prices too high and crashing global confidence.”

By the time QE1 was complete, the cost of bank lending had decreased as planned, but it did not matter because banks were still not lending (see Figures 3-8). Creditworthiness and confidence, essential for credit creation, had still not returned to the U.S economy. Even though QE1 delivered lackluster results, the Fed proceeded with QE2 only seven months after QE1 purchases were complete. QE2 was a continuation of QE1 targeting MBS and long bonds, buying $600 billion worth of securities over six months.

Figure 3 – C&I Loans by Large Banks, 2003-Present

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