February 15, 2011

The current Fed emphasizes communication policy and transparency more than any of its predecessors. Despite the emphasis, however, the Fed continues suffer communications problems and is less than transparent as it employs “talk” to shape expectations and perceptions about the economy and policy. The content of monetary policy pronouncements and also the Fed’s financial disclosure offer two cases in point that suggest deliberate obfuscation has become acceptable and, indeed, standard operating procedure at the Fed.

Shortly after Chairman Bernanke’s second 60 Minutes appearance on December 5, 2010, commentators from Caroline Baum. in a Bloomberg News article, to Jon Stewart. on the Daily Show. criticized Bernanke for reversing his position regarding QE and the “printing of money.” During his first appearance Bernanke equated QE and the printing of money while on the second appearance he said QE was unrelated to money creation. Baum also found it difficult to stomach Bernanke’s newly found 100% confidence in his ability to forestall inflation in the future despite the ballooning of the Fed balance sheet. Baum summarized her misgivings about Bernanke’s second 60 Minutes appearance: “What’s so troubling about the Sunday interview is that it wasn’t Bernanke, the media-shy economist, talking. It was a politician attempting to bolster confidence in his constituents and support for his policies. That’s not an ideal character trait for a central banker….”

However, Baum as well as many other observers are woefully behind the times. Under Chairman Bernanke and even before, the central bank has defined “Fed talk” as a policy tool, a decision that makes Fed officials indistinguishable from the other paid agents who operate in Washington. For at least the last five years, “Fed talk” has consciously, continuously and publicly been aimed at managing expectations about policy, the future course of the economy, interest rates and inflation. In short, “Fed talk” is and has been for some time exactly that to which Baum objects.

Further, in the collective mind of the Fed, doing what Baum objects to is exactly the optimal role of a policy maker. Central banks have changed levels set for targeted variables; they have changed the variables that that they target; they have changed their operating procedures. Central banks have been criticized (almost continuously by one party or another) for these changes in policy, but few would disagree with the premise that policy should adjust in response to at least some changes in the economic and financial environment. To the Fed, the relevant criteria to be used in evaluating “Fed talk” is the standard used to evaluate any policy tool, i.e. does it promote the goals of policy. In such a framework, the truth becomes irrelevant from time to time.

At earlier points in time, Fed reports, speeches by FOMC members might have been viewed as attempts at honest descriptions of the economic environment, policy and the future course of the economy. This is no longer the case. Given that the goal of “Fed talk” is expectations management, the Fed has added itself and monetary policy to the list of agencies and governmental activities wherein repeatedly “spinning’ the truth has become part and parcel of the policy process. Or as our friend Bob Feinberg likes to say, Washington is a city where 90 percent of what people say is false and the people saying it knowingly prevaricate.

Fed talk may affect the markets from time to time, but it is not a policy tool. A wide variety of things can affect markets. They include fiscal policy, non-Fed talk about policy and rumors about a range of topics from the geo-political to the salaciously scandalous, but they are not tools of monetary policy. The Fed has a series of targets, money market, (e.g. the Fed funds rate or quantity of reserves), intermediate targets (e.g. the structure of interest rates or the quantity of money) and longer run or ultimate targets (e.g. full employment and price stability). Open market operations on the other hand were viewed as tools of policy because, the Fed had complete controlled over them and hence controlled the money market targets with high degrees of precision.

Of course the Fed cannot control or anticipate the market reaction to Fed talk. Hence, “Fed talk” cannot be used to exercise control over expectations or any other target. The Fed clearly has a mandate to influence economic behavior through altering interest rates or measures of money and credit. At times, it may necessary or advantageous for the Fed to withhold information from the markets. The Fed should not reveal privileged or incomplete information especially if it might lead to an unnecessary market disruption. It is something very different, however, for a central bank in a democracy to manipulate the behavior of households and othe economic agents through disingenuous misrepresentations of the effectiveness of past and present policy or the state of the economy. Is it acceptable for other government agencies, e.g. the Defense Department, the CIA, the IRS, SEC, CTFC, the FDA, or the EPA to manipulate/spin the truth to pursue a policy path of its own choosing?

Such manipulation, even when effective in altering expectations, does not always produce net benefits. For example, post the recession of 2001and in order to reinforce the recovery, the Fed sought to influence expectations of economic growth, inflation and interest rates by arguing that it had conquered inflation and ushered in the Great Moderation. However to the extent that Fed increased belief in the existence of the Great Moderation, it contributed to economic agents’ willingness to increase leverage and exposure to low quality credit risks. If the Fed had not been successful in convincing those economic agents that the Great Moderation would continue indefinitely, then the crash and the recession would not have been so severe.

On the other hand, if the Fed succeeds in achieving its dual mandate via manipulation of the traditional tools of policy, “Fed talk” will be superfluous as economic and inflationary expectations will be both well behaved. While mutually contradictory presentations of policy such as Bernanke’s 60 Minute appearances are thankfully rare, the Fed continues the pattern of being deliberately disingenuous and opaque through omission as well as official statements.

Accounting Changes to Hide Bailout Losses: Fed GAAP

In the opening paragraphs of the January 6, 2011, Factors Affecting Reserves Balances (H.4.1) the Fed announced an accounting change in carefully crafted Fedspeak. The change in the accounting regime will “result in a more transparent presentation of each Federal Reserve Banks capital accounts and distribution of residual earnings to the U.S. Treasury.” Translated: As the Fed takes losses on its giant portfolio of RMBS acquired during round one of QE, the bank will decrease remittances to the Treasury, but will not take a capital loss.

Is the Fed’s presentation of its financial statements solely an accounting issue? What led to the change being made now? Does it have implications for policy or our understanding of the Fed’s balance sheet? How does one interpret this change in the absence of any context?

The change reflects the timing of when the Federal Reserve Banks adjust the balance in their surplus account to equate their surplus with their capital paid-in and at the same time also adjust their liability for the distribution of residual earnings to the Treasury. Previously these adjustments were made only at year-end. It is a question of timing. But why now? Because the Fed is about to recognize significant cash losses of some of these assets.

The balance sheet of the Federal Reserve System has recently ballooned in absolute terms as well as relative to paid-in capital of the Federal Reserve Banks. The asset side of the balance sheet also contains significant amounts of long duration debt instruments issued by parties other than the Federal government. This includes positions in mortgage back securities purchased as part of QEI and II and assets acquired as part of financial rescue packages, especially Bear, Stearns & Co. Many of these positions have substantial unrealized losses.  The Fed is litigating over the performance of some of these assets and is seeking repurchase of securities which have suffered defaults from the issuers and/or their successors.

As a result of (1) the larger balance sheet and the longer duration, lower quality assets held, and (2) the daily accrual of mark-to market gains and losses, the swings in the surplus of the Federal Banks may be significantly larger relative to paid in capital than in the past. The January 6 accounting rule change will permit the impact of losses in the value of assets to be offset on a daily basis by reductions in the Banks liabilities to the Treasury Department. The Fed remits the “seigniorage” or excess earnings from its assets less operating expenses to Treasury. The accounting change will do nothing to the size of the swings, but will stabilize the surplus/capital of the Reserve Banks as is the stated objective in the H.4.1.

However, the change also underscores a key governance issue, namely whether the Fed has the unilateral right absent the consent of Congress to essentially ignore the most basic principles of accounting. Strictly speaking, the Fed should charge the cash losses realized on the RMBS portfolio and other assets against capital, then retain earnings to replenish the capital account. This is a decision for the Board of Directors of the Federal Reserve Bank of New York. The economic effect is the same as is the impact on cash remittances to the Treasury, but the two methods of presentation of the financials and disclosure to the public and Congress are worlds apart. This decision is bad for Fed transparency and reflects a weak corporate governance and internal controls regime inside the central bank. Simply stated, neither the auditors nor the Board of Directors of the FRBNY should have accepted this treatment of realized cash losses.

The accounting rule change also masks the extent to which Fed has changed and entered the realm of executing fiscal as well as monetary policy. Prior to the crisis fiscal policy was designed executed and paid for via decisions made the by the Legislative and Executive branches of government. However, since the crisis started, the Fed unilaterally subsidized JPMorgans (NYSE:JPM /Q3 2010 Stress Rating: C) acquisition of Bear Stearns by taking on to the Fed’s balance sheet $29 billion of real estate loans JPM didn’t want.  The shareholders of Bear got $10 per share and the bondholders were paid in full, but now JPM must eat the legacy losses arising from the unliquidated claims against Bear for all manner of securities fraud.

The Fed took it upon itself to finance the de facto nationalization of American International Group (NYSE:AIG ) and eventually converted its creditor position into a 79.9% equity ownership interest, which thankfully the Treasury finally properly acquired from the central bank last month.  The Feds financing roles in the JPM acquisition of Bear and the AIG bailout, in which Fed illegally funded the Treasury’s acquisition of assets without prior Congressional approval, stand in direct contrast to the conservatorships create via legislated appropriations for the packages for Fannie and Freddie, as well as for General Motors (NYSE:GM ) and Chrysler. The Fed actions with respect to AIG and Bear Stearns were arguably unlawful, but neither Chairman Bernanke, former Treasury Secretary Hank Paulson. nor then-Fed of New York President Timothy Geithner have been truly called to account for this fact. See Greg Kaufman, The Nation ,  Geithners AIG Bailout.

By concealing the losses resulting from these bailouts, the Fed now seems to be engaged in a deliberate attempt to mislead the public regarding the cost of these unauthorized investments in subprime assets.  The Fed in the past held almost exclusively Federal government debt on its balance sheet. This was true for a number of reasons: the depth and liquidity of the Treasury market, a desire to avoid interfering with allocation of private capital, and a need to minimize possible losses. Hence the accounting change cited in the H.4.1, also reflects another aspect of Fed intrusion in to fiscal policy. The Fed has exposed the public purse to the risk of lossessmaller payments from the Fed to Treasury than otherwise would have been made. Losses that will realized should the MBS in the portfolio under-perform relative to the prices that the Fed paid for them. In that event Congress and the President will be faced with either reducing expenditures or running a larger fiscal deficit. This will occur despite the fact that there was no legislative roll in the decision to or the terms and conditions of the Fed participation in the AIG and Bear Stearns bailouts.  The Fed spent taxpayer dollars without the approval of Congress, then fought in the courts to avoid public disclosure of the information.

Other reasons notwithstanding, the announcement of the accounting change was quite disingenuous. Between the devious announcement and attempts to manipulate expectations and perceptions of policy, the Fed has journeyed far from both its legal mandate and the transparent institution that it purports to be. The duplicitous behavior of the central bank in its public communication strategy and financial disclosure only adds to the perception of a lack of accountability and transparency. This perception, in turn, gives the Fed’s opponents in Congress led by Rep. Ron Paul (R-TX) ammunition in their war to repeal the central bank. Chairman Bernanke and his colleagues may still think such an outcome is a remote possibility as the Fed nears its centennial, but it has happened before.