First exit for the Fed

June 23, 2009

Call it a battle for beginnings and endings, and the Federal Reserve is smack in the middle.

As Fed policymakers convene for a two-day meeting starting on Tuesday, the lines are growing more defined between those who want the Fed to do more to stimulate a still fragile economy, and those who are calling for a defined exit strategy to prevent the global economy from going into an inflation-inducing overdrive.

There’s a way to placate both camps, at least in the near-term, and that’s for Ben Bernanke and his colleagues to retire some of the temporary short-term lending facilities put in place at the height of the financial meltdown last year.

It would show good faith that the U.S. is serious about exiting some of those emergency facilities, and it would give the central bank breathing room to keep its ultra-easy monetary policy in place until it’s ready to call the all clear.

Bernanke, as a scholar of the Depression, is all too aware of what can happen should the central bank move too quickly and forcefully in removing stimulus.

One program in particular is a ripe candidate – the Commercial Paper Funding Facility.

Introduced last year, the CPFF made sure that highly-rated companies could get access to short-term funding at a time when traditional commercial paper lenders like money market funds, spooked by losses caused by the Lehman Brothers bankruptcy, shunned such borrowing. By the end of 2008, the Fed’s commercial paper lending added $334.1 billion to its balance sheet.

Since then, the demand for short-term government financing has waned. For one, the program bought companies precious time to cut their dependence on short-term markets as they found financing elsewhere, such as the longer-term corporate bond market. The sharp slowdown in the economy also curbed companies’ need for short-term borrowing, which was often used to cover payrolls, rent or other basic expenditures.

In the latest week, the Fed reported that its facility had shrunk by $6 billion to $132.1 billion in a sign that companies were choosing to pay down their debt before next July when a good portion of the loans begin to mature.

Barclays Capital money-market strategist Joseph Abate expects the commercial paper facility, along with another facility that gives loans to banks so they’ll buy certain types of commercial paper from money market mutual funds, could fall below $50 billion by the time the programs are due to expire in October.

These programs have already been extended once, so they are still in play despite the stated end date.

While practically speaking there would be no harm in keeping facilities like the CPFF open indefinitely just in case financial markets should swoon again, there are pragmatic considerations that should be taken into account.

It’s better to show a commitment to exit strategies with a program that has largely run its course than to start tinkering with interest rates and quantitative easing that can have an outsized impact on the U.S. and global economy, which are still by no means out of the woods.

The World Bank reiterated on Monday its forecast for world economic slump this year, with output contracting by 2.9 percent rather than the 1.7 percent decline predicted in March.

The rise in Treasury yields earlier this month and the quashing effect they had on mortgage lending activity also should be a reminder that the Fed needs to stay flexible when it comes to its unorthodox policies. But it’s time to show the world that it’s also ready to put aside some weapons in its arsenal when the time is right.

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