The New Federal Reserve

By Dr. William W. Woolsey, Special Economic Correspondent of The Free Enterprise Foundation

Over the last year, the Federal Reserve has fundamentally changed. For decades, the Fed created money by purchasing short-term government bonds with funds created out of thin air. The banking system would multiply those funds, creating a money supply made up of the currency and checkable deposits that ordinary households and firms use to make purchases. In June of 2007, the Fed had purchased $790 billion worth of government bonds and created a monetary base of $826 billion, the banking system multiplied that to create a $1.4 trillion money supply.

The Fed targeted the federal funds rate, the interest rates banks charge one another for overnight loans. It influenced that interest rate by creating or destroying money to manipulate supply and demand in credit markets. In recent years, the goal of the Fed has been to maintain growth in total spending in the economy so that firms will be able to sell the increasing volumes of products generated by a growing labor force and rising productivity, at modestly higher prices - a planned inflation rate of 2% a year.

The Fed has traditionally let market forces direct the flows of credit between and among households and firms. During the last decade, much borrowing and lending has been through the “shadow banking system.” Commercial banks, thrifts, finance companies and mortgage banks make loans. The loans are bundled and securities are created that are claims to the interest and principle. Investment banks held many of these securitized loans, funded with commercial paper. Money center commercial banks did the same thing, but used off-balance sheet “Structured Investment Vehicles” to hold the securitized loans and issue asset-backed commercial paper. Traditionally, the money that people deposited in banks would be used to finance the loans made by banks. Now, it was those investing in commercial paper that was financing the loans.

With the drop in home prices starting two years ago, serious problems developed. If homeowners cannot make payments, and the home is repossessed and sold, the proceeds might not be enough to repay the loan. Worse, speculators borrowed money to purchase homes and when prices fell, they simply walked away from their failed investments - and the money they owed. The rising default rate and falling value of the collateral caused ratings agencies to write down the value of the securities.

The shadow banking system has suffered serious problems since 2006, but the real panic began with the failure of Lehman Brothers in September. Outstanding commercial paper decreased by $200 billion and interest rates on commercial paper backed by securitized loans rose from 2.5% to a peak of slightly more than 6%. Investors fled to government bonds as well as traditional bank deposits. Bank deposits expanded from $6.8 to $7.1 trillion between August and the end of November. And banks have expanded their traditional “on balance sheet,” lending, including $100 billion in new business lending, $40 billion in additional consumer lending, and $80 billion in residential lending.

Rather than accept that market forces were moving funds back to the traditional banking system, the Fed has made direct loans to banks and financial institutions centered on Wall Street. A year ago, loans made by the Federal Reserve to banks were less than one billion dollars - in June of 2007 the Fed lent only about $150 million to banks. Over the last year, the Federal Reserve has reduced holdings of government bonds to $476 billion and is now lending huge amounts to banks and other financial institutions. Its traditional primary credit lending is now up to $90 billion. But that is dwarfed by the $447 billion in term loans to banks. Since the spring, the Fed has begun lending to a variety of other financial institutions as well. There is the $50 billion loan for the Bear Sterns rescue, and another $50 billion to AIG. And there is $300 billion for the asset-backed commercial paper facility. Hardly a month passes without the Fed introducing an unprecedented avenue of direct lending.

For most of the last year, the Federal Reserve created little new money. Where did it get the money to make all those loans? Along with lending less to the government, it began to borrow from the Treasury. Fed borrowing from the Treasury was up to $440 billion in December.

However, during September, the Federal Reserve began expanding the monetary base. It was at $847 billion in August, little changed from a year before. It had increased to $1.4 trillion by November. Currency remained little changed at about $800 billion, but bank reserves increased from $40 billion to $609 billion. The M1 measure of the money supply has increased to nearly $1.6 trillion.

In October, the Federal Reserve began paying interest to banks for just leaving money in their reserve accounts at the Fed. At the same time many were saying that credit was frozen, that banks weren’t making enough loans, and that soon no one could get car loans, the Federal Reserve was paying banks to leave their funds idle and not lend them out. Why? The Fed explained what it was doing. Funds that the banks leave in reserve accounts allow the Fed, rather than the banks, to direct the lending.

Also in December, the Federal Reserve began discussions with Congress about the power to issue its own bonds. Why would the Federal Reserve sell bonds? Again, the answer is simple. The Fed is seeking more money for direct lending.

The Fed’s new target for the Federal Funds rate somewhere between ¼ percent and zero, along with a commitment to expand its balance sheet shows that it remains committed creating money in quantities sufficient to keep total spending growing. However, there is little reason to believe that the Fed will again let the market direct the flow of credit between and among households and firms. The Fed remains committed to its new approach of direct lending and directing the flow of credit through the economy.

Copyright © 2009 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey as a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.

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