Fed, in major shift, floods system with cash

The Fed's efforts to flood the financial system with cash are aimed at offsetting a massive destruction of capital — from consumers 401(k) accounts to banks' balance sheets.

The falling value of financial assets — from stocks to housing to mortgages backed by those houses — has wiped out trillions of dollars in wealth. If that deflation continues, along with the recent sharp drop in prices of commodities from oil to steel to paper, the downward spiral could become much more difficult to stop.

That threat was the subject of a 2002 speech by Bernanke, then a Fed governor, in which he described a “helicopter drop” of money as one of the Fed’s most powerful tools to fight deflation and earned him the nickname “Helicopter Ben."

Now that Bernanke is chairman, the Fed has distributed billions by a variety of ways, including buying up unwanted assets through programs with names like Term Auction Lending Facility, Term Securities Lending Facility and Asset Backed Commercial Paper Money Market Mutual Fund Lending Facility.

These efforts represents the unannounced creation one of the most powerful monetary tools the Fed has ever employed. Also known as “quantitative easing,” the zero interest rate policy is designed to reduce the cost of borrowing — even after the Fed cuts its benchmark rates to zero. Last used by the Bank of Japan to try to rescue that nation’s economy from a decadelong economic slump, the policy represents a fundamental shift for U.S. central bankers.

Though the Fed’s official overnight target rate still stands at 1 percent, the rapid buyback of bad assets has pumped more than $1 trillion in cash onto the financial system in a matter of weeks, forcing the effective rate below 0.25 percent early this month. The scope of the Fed’s buyback of bad debts has been as historic as the credit crunch the Fed is trying to overcome. Since early September, the value of assets held by the Fed has exploded from about $950 billion to more than $2.2 trillion — not including Tuesday’s announced purchases.

Though the Fed’s actions may head off further damage to the economic and financial markets, they carry their own risks.

For now, the Fed has had little trouble raising trillions of dollars to fund its buying spree. In theory, the central bank can raise as much cash as needed simply by issuing more of its own Federal Reserve notes — also known as dollars.

Much of the Fed’s spending money so far has been coming from “supplementary financing” from the Treasury, which continues to see strong demand for its own notes as investors around the world seek shelter from the financial storm. During the worst market turbulence, demand for Treasury notes has been so strong that interest rates on those notes have fallen below zero —which means investors are willing to lose a small amount of money in return for preventing bigger losses. That demand has also sent the value of the dollar soaring.

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“We have a lot more latitude in expanding the Fed's balance sheet now that the U.S. dollar —and six months ago it was not the case — today is the undisputed reserve currency of the world,” said Diane Swonk, chief economist at Mesirow Financial, a Chicago-based investment management firm.

For now, the dollar’s strength is a vote of confidence from global investors. If that confidence wavers, the Fed could find itself with a lot less room to maneuver.

Over the longer term, the Treasury and the Fed are trying to use the same leverage —essentially, using borrowed money — that got the financial system into trouble in the first place.

That credit, or liquidity, is supposed to fill the void created by the collapse in the credit bubble created by the private sector. For the time being the Fed and the Treasury may have no choice but to step in as “lender of last resort.”  But at some point, the Fed will have to drain that cash out of the system or risk creating another credit bubble. It’s far from clear what impact the unwinding process will have.

”When you look at the scope of what the Fed is doing, I think the market is much more concerned about the long-term effects right now,” said Atlanta-based investment adviser Scott Kays.

The other major risk of dropping trillions of dollars onto the economy from a helicopter is that all that money could sow the seeds of massive inflation when the global economy begins to recover. But at the moment, the rapid contraction in lending and economic growth is helping to push inflation fears farther into the future.

“When I look out five to 10 years, my gut tells me that there's got to be some sort of inflation payback as a consequence of all this money creation,” said Paul McCulley, a portfolio manager at PIMCO. “That's just a visceral feeling that I think we all have. But over the next year or two, I simply don't see it. It's further and further out on the horizon.”

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