The Fed doubles its balance sheet - above $2 trillion in just 5 weeks

Think about that. If any commercial or investment bank had been seen to do that, it would become an instant leper in the credit markets. It is a truism that banks go bust by writing business that wiser banks rejected, and so grow their balance sheets faster. As a young bank supervisor I was told that the surest way to spot a potential bank failure was to look for outliers in asset growth.

Had anyone at the Fed or FSA been brought up in the old school, they would have seen Countrywide and Northern Rock coming a mile off. Perhaps they did, but in the new Friedmanite culture of forbearance and free markets, and Basle II risk models, they decided to let capitalism run its disastrous course rather than take unpopular decisions about constraining the prerogatives of over-compensated executives and shareholders.

And now we have the Fed doubling its balance sheet in just five weeks. It is exactly by taking on the assets of the banking sector that are otherwise unmarketable that the Fed has grown its balance sheet. And it is by doing this while indulging the banks in continued oversized dividends and executive bonuses that leads me to believe the policy must ultimately fail to either correct the problems in the US banking sector or sustain the credibility of the Federal Reseve as a prudential supervisor and lender of last resort.

Dallas Fed President Richard W. Fisher has speculated that the balance sheet could expand to $3 trillion by January:

“You can see the size and breadth of the Fed’s efforts to counter the collapse of the credit mechanism in our balance sheet. At the beginning of this year, the assets on the books of the Fed totaled $960 billion. Today, our assets exceed $1.9 trillion. I would not be surprised to see them aggregate to $3 trillion—roughly 20 percent of GDP—by the time we ring in the New Year.”

At the same time the Fed has equalised the interest it pays on reserves deposited in the Fed and the Fed Funds target rate. That undermines any incentive to interbank lending, virtually ensuring that banks will prefer to hold their cash as reserves at the Fed rather than as lending exposures to one another. On the other hand, according to a Fed research note from August, it allows the Fed to supply greater liquidity for market needs without the risk of pushing lending rates below target rates.
In contemplating the anomalies of this policy, it occurred to me that it might be aimed at reinforcing the dollar by drawing reserve balances to the Fed in preference to other central banks as they follow the Fed by cutting rates this week. Perhaps the Fed is pre-emptively combating dollar capital flight, or perhaps it is a further extension of the "ring fence" tactic of drawing assets to the US in contemplation of future insolvencies to secure advantage for US creditors over global peers.

As Sam Jones at FTAlphaVille commented yesterday:

There’s a big danger here for the Fed: that it is trying to catch a falling knife. The Fed is risking things it’s never risked before. That’s not to say we’re in apocalyptic territory at all; consider the firepower the Fed has behind it. It is though, to use a hackneyed, but apt phrase, paradigm shifting.

In Japan, where quantitative easing failed, the central bank’s balance sheet swelled to a size equivalent to 30 per cent of GDP. The Fed’s balance sheet is currently equivalent to 12 per cent of GDP.

This is uncharted territory for a central bank of a reserve currency. I suspect, however, that these moves play into the strategy of the Paulson Plan survivor bias. As someone reminded me recently, Mr Paulson's primary objective at Goldman Sachs was to outperform peers in both good times and bad times. If profits were to be made, he wanted Goldman to have more of them. If losses must be booked, he wanted Goldman to have less of them. He seems to have taken the peer outperformance strategy global with the Paulson Plan.

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Hat tip to FTAlphaVille for posting relevant Fed insights yesterday and today:

The mother of all balance sheets

Fed capitulates: the central bank is broken