Is the Fed Doing a Good Job Ensuring the Credit Flow

Modern economies have become too much credit-, or lending-, driven probably due to the ever evolving of all the interdependency and intertwining inside a society as a whole. Smooth flow of credit through all facets of an economy not only promotes it into good times, but also saves it from bad days. Any disruption to both the credit availability--the amount available for lending, and the credit liquidity--the amount ready to be lent, paralyzes the whole body of economic activities, of which credit lending is the central nerve. As the ultimate CEO managing our nation's economy, the Federal Reserve is solely charged with overseeing that critical money supply. As for now, there appears to be both the credit availability problem and the credit liquidity concern. The two words availability and liquidity, we sometimes use them interchangeably, with maybe a higher preference on the more technical sounding liquidity. But think it twice--they really point at two different aspects of a credit problem. Simply put, having funds available doesn't necessarily mean that whoever controls the funds is ready or willing to lend them out just yet; there could be a host of concerns that might prompt a state of illiquid lending activities, such as: the level of interest rate, the prospect of being paid back, the worry of self-emergency use down the road... However, having ample funds available at hands certainly helps pave a smoother path for a more liquid changing hands of credit. Maybe that is the one magical thing that the Fed ought to make happen--if banks are first loaded with more available funds, then, once the silver bullet is fired from there, it will penetrate through the sluggishness of the illiquid credit market.

Coming out of its last FOMC meeting this December, the Fed once again had levered all the three tools handily at its disposal--the discount window, the open market operations security transactions with banks, and the federal funds rate. When was the last time the Fed discount window was all dressed up? While it's been always the distant cousin bearing the "Government" surname, it's now being given the close sibling status of the federal funds market, private in its nature consisting of participating banks. For a 10-year period in the recent past, the federal discount rate was changed only 29 times, but it's been a full percentage drop in 4 months since August. The story line here is that when banks are out of shopping choices in their inter-bank federal funds market, unable to make up any reserve shortages because others are not willing to release out their reserve excesses in anticipation of their own future needs, the Fed will leave the discount window open to provide government loans to banks as their last shopping resort.

Therefor, unless absolutely needed, the government is going to first let the markets play out on their own for the most part. In that regard, open market operations and federal funds rate are perfect in making ongoing adjustments to banks' lending capacities when deemed temporarily off track from time to time, but not nearly enough for any credit crisis of current scale that surely will take longer time to reverse the damage accumulated over too long a period. Boosting banks' reserve level for only a few days by means of Fed's open market operations, where banks sell securities to the Fed but with the promise to buy it back shortly in exchange for an accounting credit increase to their reserve account on the Fed balance sheet, is too little too late for now. Nothing is wrong with the idea that an increase in a bank's reserve account with the Fed expands the bank's lending capacity. But with only such a temporary relief, when banks are in need of funds for much longer time, sustainable lending activities from banks are just a hard-reaching goal for the Fed. And the Fed's intention, to keep the federal funds market float by making it less costly for anyone who needs to make up their reserve accounts, is not at the moment translating into any actions in that market, unless banks holding onto their excess reserves are free of worries of their own lending operations back home. No wonder there wasn't any rate-cut magic this time; the normal ripple effect of banks paying low will for sure very slowly come to the business and consumer end, if ever. The Dow's dropping nearly 300 points on the very day reflected exactly that perception.

When private money is stuck in the cycling process, government money is supposed to provide the rolling power. However in reality, taking federal loans out of the Fed discount window has never been a prevailing practice. The reason? Well, banks, like no others, are at their core running on reputations and unfortunately the Fed discount window by design openly exposes a bank's failure. Should a credit-stripped bank decide to use some government's money, everything else it still has might get all stripped off along the way, as such a loan has too much strings attached to it. So, as easily as an outrage can happen at any time, banks are still holding onto their own weak power--the Fed discount window gives them only a window dressing effect. I wouldn't suggest that the rescue mission of the discount window should be abandoned altogether, as it still serves the public interest; but I am suggesting for a more effective dissemination of credit by the Fed to counteract the currently widely-spread credit crunch. But hen, where is the Fed going to fire such a silver bullet from? There isn't any out of its current ammunition in storage.

Out of monetary policy options, the Fed has just in time established this temporary Term Auction Facility. What this new tool does is that it can free some of the banks' most illiquid assets, including investments such as mortgage-backed-securities, as the Fed allows a wide range of collateral to be used against the term-loan advances under the program. The Fed intends to make the temporary program permanent, if outcomes are positive, to expand its current monetary policy tools.