Posts from — May 2009

The Federal Reserve released its combined 2008 Financial Statements on April 20, 2009. 2008 was stunning, with the balance sheet growing from $915 billion to $2.245 trillion. The major increases were in the commercial paper facility, foreign currency swaps, and term asset backed facility. Essentially - stabilizing mechanisms for short term market operations (both foreign and domestic) to continue.

The increase of $1.33 trillion is slightly larger than the gain in US GDP from $13.178 trillion to $14.264 trillion from 2006 to 2008. Essentially, the gains in US GDP from 2006 - when the Case-Shiller Composite Housing Index reached its peak - to 2008 are now sitting on the Fed’s books when they should be out in the private economy, on the balance sheets of companies, creating the next wave of products and services.

There are those who have argued the Fed’s actions will cause tremendous inflation. It is important to remember the major actions of the Fed are all preventing short term credit disruptions, which if not collectively implemented,  would have all lead to price declines, deflation.

Currency Swaps, worth roughly $553 billion or 1% of world GDP, are held against a basket of G-20 currencies, have most likely prevented an increasing demand for dollar. In the fall of 2008, the demand for the dollar reached a recent record high. Further appreciation would have further pressured US producers, unable to compete on price for various goods/services. The only solution would have been to cut costs to reduce prices.

Commercial Paper, worth $333 billion, is necessary to keep working capital afloat. Without it, the only solution to meet existing funding needs or return previously funded commercial paper would have been to liquidate existing inventory at reduced prices.

Term Asset-Backed Facility (TAF), worth roughly $450 billion, is further short term financing to allow banks to continue liquidity while suffering losses on their longest duration assets - CMOs. Without access to short term financing, again the only choice would be asset liquidation, further forcing price declines.

True, CPI did not increase in 2008. But added together, the Commercial Paper and TAF are roughly 5% of US GDP. As most companies were levered to the tilt, if the Federal Reserve funding was not there, the US price and consequentially unemployment situation would have been far worse.

As to worries of runaway inflation, the jury is still out. My belief is that the capital these facilities are replacing - in a sense - is now shoring up the balance sheets of various banks and companies. By increasing  equity ratios at companies and banks, future invested dollars from these newly shored up institutions will need higher returns on capital (all else equal), which is equivalent to the Fed raising fed funds rates to control inflation.

Until a recovery though, it is a good thing our economy has not faced deflation, certainly a real possibility in the fall of 2008.