The London Telegraph reported on Sunday that central bankers are quietly reviewing a 2004 U.S. Federal Reserve Bank study on how far the Fed’s powers can be extended in an emergency. In the Introduction to the study, the authors state:
We examine the limits imposed by the Federal Reserve Act along two dimensions: those types of counterparties and financial instruments with which the Federal Reserve may conduct monetary policy. In doing so, we develop a theme not commonly pursued in the literature -- the ways and extent to which the Federal Reserve Act limits the Federal Reserve from taking credit risk onto its balance sheet.
The study is entitled The Scope of Monetary Policy Actions Authorized under the Federal Reserve Act and was written in July 2004 by David H. Small, of the Federal Reserve Board’s Monetary Studies Section, and James A. Clouse, of the Fed Board of Governors’ Monetary and Financial Market Analysis Section. Downloads of the study are available here.
The gist of the Telegraph article is that the world’s central banks are running out of time to stop the collapse of the credit and derivatives markets before economies are pushed into depression. The remaining window of time mentioned is about two months. The article includes some very notable quotes from various central bankers around the world:
The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. "We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other," he says.
New York's Federal Reserve chief Tim Geithner echoed the words, warning of an "adverse self-reinforcing dynamic", banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.
SNIP
"The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history," says Thomas Jordan, a Swiss central bank governor.
"The sub-prime mortgage crisis hit a vital nerve of the international financial system," he says.
The Telegraph article, which is entitled, Crisis may make 1929 look a 'walk in the park', also points out that the most vulnerable point of the world's financial system now may not be the United States, but the United Kingdom and the relatively new Euro zone:
The ECB's little secret is that it must never allow a Northern Rock failure in the eurozone because this would expose the reality that there is no EU treasury and no EU lender of last resort behind the system.
The article also notes the role played by British Prime Minister Gordon Brown, in the late 1990s, when Brown was Chancellor of the Exchequer, and pushed further deregulation of the financial system by giving the Bank of England operational independence in monetary policy.
Worse, changes pushed through by Gordon Brown in 1998 have caused the de facto cash and liquid assets ratio to collapse from post-war levels above 30 per cent to near zero. "Brown hadn't got a clue what he was doing," he says.