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James Hamilton on the Federal Reserve's Term Auction Facility

20071208_delong_micro.jpg It is not clear to me what the Fed expects banks to do with the $40 billion that it will lend fore one month next Tuesday and Thursday. Does it expect them to rollover loans they would otherwise refuse to renew? I understand how lowering the Fed Funds rate works. I understand how forcing banks to increase their capital would work. I understand how making long-term loans to banks that won't come due until after this slow-moving crisis is resolved would work.

I don't understand how $40 billion of one-month loans are supposed to work.

But maybe I am just being unusually (or usually) slow today...

James Hamilton writes:

Econbrowser: Term auction facility: Will a new, improved discount window solve our problems? [U]nquestionably the Fed does see the strains in the money market as a significant risk. Evidently there are those who entertain the hope that the Fed could find two separate tools to achieve two separate ends. The first tool--the traditional instrument of monetary policy--is to adjust the total quantity of reserves available to the banking system so as to achieve a particular target value for the fed funds rate, the rate at which one bank lends to another overnight. When one describes a traditional monetary policy action as "providing liquidity," this is what we are discussing.

But there appears to be a widespread belief that the Fed needs a second tool... to achieve a second policy objective... eliminate the gridlock... from huge holdings of assets that no one seems willing to buy.... The basic idea is that the Fed will specify a certain maximum amount that it would like banks to borrow. It intends... to lend up to $20 billion for a 28-day term on Monday, and lend up to an additional $20 billion for a 35-day period on December 20. Potential borrowers will bid an interest rate to receive this loan, with I presume each $20 billion going to the highest bidders. Banks must also provide collateral for these loans.

The objective is clearly not just to get $40 billion more in reserves into the banking system next week--an open market operation could accomplish that just fine. The objective must be to get the reserves into the hands of those particular banks that want them most. Of course, those same banks could be getting them right now through the discount window, but choose not to, perhaps because of the stigma, or perhaps because of the financial penalty charged for discount borrowing.... The other thing the facility accomplishes is allow the Fed to accept lower-quality collateral from borrowers than its rules require for open market operations conducted through repurchase agreements. If there is an effect of the facility, I would think that this would be the mechanism....

I hope that Bernanke has also pondered.... [that T]here certainly is plenty of historical precedent for financial crises you can't inflate your way out of--southeast Asia in 1997 comes to mind as one recent example...

The only reason southeast Asia couldn't inflate its way out of 1997 was that it's banking system had lots of debts denominated in dollars. If that debt had been denominated in local currencies, inflating your way out of it would have worked fine.