This is a guest post by JP Koning:
Any central bank that wants to be Chuck Norris-like requires the legal authority to purchase a broad array and quantity of assets. Without the legal ability to conduct broad purchases, a central bank’s threat to enforce a new target will lack credibility. The Federal Reserve Act significantly limits the sorts of assets that the Federal Reserve is allowed to purchase and, given the politicization of all things Fed, is unlikely to be changed. Given the current scope of purchases allowed by the Federal Reserve Act, can the Fed be Chuck Norris?
Section 14 of the Federal Reserve Act sets out the rules governing Fed asset purchases. It currently limits the Fed’s purchases to gold (14.a) and US Federal government issued and guaranteed assets (14.b.1), including those of Federal agencies (14.b.2). Eligible government and agency securities include treasuries, agency debt, and agency-issued MBS. These purchases must be conducted in the open market, or secondary market. The open market stipulation prevents the Fed from purchasing Treasury or agency debt directly from the Federal government or its agencies. Such direct purchases would constitute monetary financing of the government.
The Fed is also permitted to purchase bankers acceptances and bills of exchange in the open market (14[para 1]). These are privately issued assets. But both are legacy instruments. Few American institutions use them much anymore.
The Fed is also allowed to purchase state and municipal debt with a term not exceeding six months. (14.b.1)
Lastly, it can purchase foreign government issued and guaranteed assets, as well as those of their agencies. (14.b.1)
Note that Small and Clouse claim that both municipal and foreign purchases can be made directly, and not via the secondary market. This precludes the need for an already-existing market in these assets to be present before the Fed can participate in it.
There is also a not-so-well known legal route by which the Fed has purchased assets in the past. The restrictions set by Section 14 clearly prohibited the massive Fed purchases of all sorts of private assets during the 2008 crisis, including private label RMBS (much of it subprime), CDOs, CMOs, ABS, swaps, whole commercial mortgage loans, and asset-backed and unsecured commercial paper. Furthermore, in many cases these purchases were often not made in the open market, but directly from distressed banks. (Bear Stearns and AIG)
In announcing its purchasing programs in 2008, the legal route taken by the Fed invariably drew on section 13.3 of the Federal Reserve Act. But oddly, Section 13 sets out the rules and regulations regarding Fed loans, not purchases. Section 13.3 is an incredibly open ended passage, allowing the Fed to lend to any individual, partnership, or corporation upon any collateral the Fed deems satisfactory.
Over the course of the crisis, the Fed mobilized 13.3’s lending powers so as to justify purchases by creating five separate Delaware limited liability companies: Maiden Lane LLCs I, II, and III, Commercial Paper Funding Facility LLC (CPFF), and Term Auction Lending Facility LLC (TALF). It lent to these corporations under the authority of Section 13.3. These LLCs proceeded to use these funds to purchase assets not specifically authorized by the Federal Reserve Act.
In short, the Federal Reserve attempted to get around the limitations concerning asset purchases found in Section 14 by lending under the much broader Section 13.3 to the five recently created LLCs it controlled, and ordering these LLCs to purchase whatever assets it deemed necessary. Presumably as long as the LLCs were doing the purchasing, and not the Federal Reserve itself, Fed lawyers felt that Section 14 was not being violated.
Dubious? It would take a court of law to determine how legal the entire range of transaction conducted though these LLCs was. Certainly it seems to have violated the spirit of the law, though perhaps not the letter. Nevertheless, there exists some sort of precedent, wholly legal or not, for large scale purchasing program of private assets.
So could the Fed incorporate, say, “NGDP Targeting LLC” or “QE3 LLC” and lend it an unlimited amount of dollars under Section 13.3 of the Federal Reserve Act? A stumbling point is that Section 13.3 only allows loans under unusual and exigent circumstances. Since targeting and quantitative easing are more than just emergency programs, but ways of conducting monetary policy on an ongoing basis, getting either through Section 13.3 sounds akin to passing an elephant through the eye of a pin. In sum, it seems unlikely that the Fed could ever purchase private label MBS, CDOs, stocks or corporate bonds on a regular basis.
Despite the difficulty of invoking 13.3 loans to fund “NGDP Targeting LLC” or “QE3 LLC”, purchases allowed under Section 14 are still significant. They amount to approximately:
Federal government debt: ~ $7.5 T
Agency debt: ~ $3 T
Agency guaranteed debt total: ~ $1.5 T?
Bankers acceptances: ~ minimal
Gold: ~ $10 T
Short term state/municipal debt and foreign government debt: theoretically infinite
While the existing market for acceptances is tiny, a Fed decision to enter the market as a large purchaser would lead to immediate growth in the acceptance market. Acceptances are short term credit instruments that in many ways serve the same purpose as commercial paper.
A short term municipal and/or state debt purchase program would also lead to a significant surge in the size of short term municipal/state debt markets. The fact that these securities can be purchased directly from municipalities/states rather than in the secondary market dramatically increases the scope for purchases, as a pre-existing stock of muni/state short term debt isn't necessary for the Fed to participate.
The gold market is a market in which the Fed could exercise significant purchasing power.
Lastly, the largest market through which purchases might be conducted is via foreign government debt markets. As in the case with states and municipalities, it would not be necessary to confine purchases to open market paper, since it seems that the Fed is allowed to directly negotiate with foreign governments to buy their paper.
If the Federal Reserve wants to become a credible Chuck Norris, it’s worth considering some of the costs involved in a decision to either re-enter the acceptance market or establish itself as a major player in municipal and foreign government finance. It would surely shape patterns of investment and liquidity in a very significant way, probably displacing existing financial instruments and market participants. Secondly, there is potential for abuse of the Fed’s power to purchase debt directly from municipalities/states and foreign governments. The traditional requirement to confine central bank purchases of government debt to the open market forces central banks to pay market rates rather than rates that might subsidize governments. Monetary financing of governments is not an accepted task of a central bank.
The above is by JP Koning.