The Federal Reserve is being stretched to its limits, in the range of problems it is being asked to fix and in its financial firepower.
WASHINGTON — The Federal Reserve is being stretched to its limits, in the range of problems it is being asked to fix and in its financial firepower.
The central bank has also transformed itself almost overnight into The Fed Inc. by essentially taking over American International Group (AIG), after already taking on hundreds of billions of dollars in mortgage securities to help ailing financial institutions.
Instead of setting monetary policy, the Fed now must wear several hats, those of insurance conglomerate, investment banker and hedge-fund manager.
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“This is unique, and the Fed has never done something like this before,” said Allan Meltzer, a professor of economics at Carnegie Mellon University and author of a history of the Federal Reserve. “If you go all the way back to 1921, when farms were failing and Congress was leaning on the Fed to bail them out, the Fed always said, ‘It’s not our business.’ It never regarded itself as an all-purpose agency.”
The Fed has often been described as the nation’s lender of last resort, the one institution that would lend money when everything else had failed. But by acquiring almost 80 percent of AIG in exchange for lending it $85 billion and holding $29 billion in securities once owned by Bear Stearns, the Fed also is becoming the investor of last resort.
That could put the central bank in an increasingly complicated and contradictory position. It will be responsible for stabilizing the financial system but also for minimizing losses to taxpayers. Those responsibilities are likely to conflict even more than the traditional tension between the Fed’s dual mandate to control inflation and to promote full employment.
The Fed’s balance sheet, moreover, is being stretched in ways that seemed unimaginable one year ago. As recently as last summer, the central bank’s entire vault of reserves — about $800 billion at the time — was in Treasury securities.
By last week, the Fed’s holdings of unencumbered Treasurys had dwindled to just over $300 billion. Much of the rest of its assets were in the form of loans to banks and investment banks, which have pledged riskier securities as collateral.
In a sign of how short the Fed’s available reserves are, the Treasury on Wednesday sold tens of billions of dollars of special “supplementary” Treasury bills to provide the Fed with extra cash. The Treasury sold $40 billion of the new securities Wednesday morning and will sell an additional $60 billion today. More money-raising is sure to follow.
“The Fed is very stretched, and that’s why they’ve asked the Treasury to go ahead with these proposals,” said Lou Crandall, chief economist at Wrightson ICAP and a longtime analyst of the Fed’s market operations. “You don’t want the market wondering whether the Fed has enough reserves to handle the next supplicant.”
Indeed, Fed chairman Ben Bernanke’s expansive new role almost seemed to unnerve a leading House Democrat. “He can make any loan he wants under any terms to any entity or individual in America that he thinks is economically justified,” said Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee.
Fed officials contend they have ample resources to handle all their new obligations. Unlike a company or a household, the Fed can raise as much cash as it wants by printing money and buying up Treasurys and other securities at will.
But in the past few months, the central bank has transformed itself from a regulator of the money supply to a white knight for troubled financial institutions.
“He can make any loan he wants under any terms to any entity or individual in America that he thinks is economically justified.”