(Revised) The Fed in Stock and Bond markets.

I think that the meaning of the Quantitative Easing can also be found in functioning of financial markets and monetary policy channel. As we know, current monetary policy mechanism heavily depends on well-functioning of financial markets. For example, the interest rate channel mainly works through interactions between the short term interest rates and the long term interest rates. If the Fed changes the Federal Funds rate, then short term interests rates and long term interest rates change, and eventually its effects reach economic activity.

If the financial markets function normally, lowering the short term interest rates can lead to stimulate the economy. As the Fed lowers the Federal Funds rates, short term interest rates fall and long term interest rates fall consecutively. Financial institutions will borrow short term money and invest them in long term assets such as corporate bonds. This leads to decrease of borrowing costs of companies and eventually increases investments.

But, this time financial markets stopped functioning normally because financial institutions suffered from heavy loss, and credibility of long term assets got severely damaged. These financial markets situations cause monetary channel not to work properly. Therefore, malfunctioning of monetary policy channel caused by the extremely strained financial markets conditions can be regarded as one of the reasons that make the Fed enter into this new monetary policy territory, balance sheet monetary policy. In that sense, the Fed’s decision to buy MBS seems to be very sound in terms of stimulating economy.

Big credit events like the collapse of the Lehman Brothers greatly increased the counterparty risk in the financial transactions, and money does not flow properly in the financial markets. Financial institutions worried about creditworthiness of financial transaction counterparts. Due to the development of financial engineering, complex financial techniques like asset securitizations makes financial institutions harder to estimate credit risk of counter party.

As a result, financial flow to credit markets such as stocks and corporate bonds decreased sharply and money stayed in the safe markets like treasury bill markets. Even though the Fed provided excess money in the markets, money might not flow to credit risk markets properly. This lack of financial flow to credit markets hurt real economic activities and eventually resulted in the Great Recession. In that sense, I think that if the Fed had directly bought stocks and corporate bonds, financial markets could have returned to its normal functioning more quickly, and economy could have shown more rapid recovery.

I think there are three major concerns about the Fed’s participating in those credit risk markets. First concern is about causing inflation, but this concern is not a big deal in this economic situation of lower than natural outputs as Professor Kimball well explained in his blog, “Balance Sheet Monetary Policy: A Primer”. Other concerns are increase of credit risks in the Fed balance sheet and moral hazard problems in the financial markets.

In regard to increase of credit risks at the Fed, which will result from buying credit risk assets like stocks and corporate bonds, I cannot think of any serious trouble in the Fed’s monetary policy implementation. Even though corporate bonds or stocks that the Fed buys go bankrupt, it does not have any serious impact on the Fed ability to conduct monetary policy. That’s because the Fed ability to conduct monetary policy comes from its authority to provide money and the Fed does not rely on any other financial resources to conduct monetary policy. So, the loss in the Fed balance sheet does not any substantial effects on its monetary operations.

Certainly, however, deficit of the Fed would be embarrassing to the Fed. The Fed may worry that deficit would cause any unnecessary intervention of monetary policy from the Government or the Congress. The Fed would also worry about any stigma from its deficit. I think that we can approach this credit problem by adopting a new accounting principle for central bank profit and loss. Specifically, we can separate the Fed’s loss originated from monetary policy implementation from its operating profit and loss, and treat the loss in special accounts. By doing so, I think we can avoid misunderstanding of the Fed’s loss as bad investment. This special treatment for the Fed’s loss can be justified in the sense that the Fed is intentionally taking credit risk for economic recovery.

Another problem is the increase of moral hazard in the financial markets. As the Fed is ready to rescue the plummeting financial markets, then financial institutions are more likely to bear more credit risks and to take aggressive investment behaviors which might cause financial crisis. But I think that this moral hazard problem is indispensable when dealing with financial crisis. Without taking the risk of increase of moral hazard, the Fed cannot revive financial markets. And the way to minimize the related moral hazard is another policy task to deal with.

I think one way to reduce the moral hazard is that the Fed does not buy individual company’s stock or bonds but buy market index products, which are made to keep track of market index like Dow Jones Industrial Average Index, S&P 500 Index or other bond market index. By investing in market index products, the Fed can reduce unnecessary suspicions and interference from other stakeholders.

As the economy recovers from the Great Recession, we need to retrospect the past, and to think about how to deal with the future crisis. I think that one possible solution for financial crisis is the Fed’s direct involvement in stock and corporate bonds market. If there is any legal restrictions for the Fed’s operation in those credit risk markets, legislature think about change of the law to allow the Fed to participate in stock and corporate bonds markets.