Since October, 2009, the Federal Reserve has increasingly hyped the inflation meme by publicly touting the more than $1 trillion in excess reserves (held by banks with the Fed) which, as the theory goes, could come flying out into the economy in an HFT-New York second, in one hyperinflationary swoop. If all the world’s a stage, then Bernanke will be winning an Oscar for this performance, because the futures and currency markets are pricing in a Fed rate hike in the second half of 2010 and a robust US economy. Rather, we have postulated that this tightening theatre is mere preparation for QE 2.0, which has been confirmed today (at least with respect to more Agency MBS purchases by the Fed). We suspect the Fed will wait until the US Dollar index rallies to at least 81 or 82 before announcing the next round of long term Treasury purchases. Make no mistake, however, those pesky excess reserve dollars will eventually get itchy to rejoin their friends in the economy (perhaps when they amount to $3 trillion sometime in 2011), and the Fed will need all the tools it can strap around its bloated waist to reign them in.
Through the Emergency Stabilization Act of 2009, passed shortly after the Lehman bankruptcy, Congress accelerated the effective date to October 1, 2008 of an amendment to the Federal Reserve Act that would give the Fed the authority to pay interest on excess reserves. The pros and cons were best expressed by the manager of the world’s largest hedge fund (the FOMC’s System Open Market Account) in a speech on December 2, 2009 to the Money Marketeers of New York University:
A key part of the framework is the ability to pay interest on excess reserves. This authority alone may allow the FOMC to control short-term interest rates to its satisfaction, even if the banking system is saturated with a large amount of excess reserves. Indeed, the interest rate on excess reserves should act as a magnet for other short-term interest rates, keeping them relatively close together. In the current environment, the federal funds rate has remained modestly below the rate paid on reserves, typically by 10 to 15 basis points. If that spread were to remain steady near those levels even as the interest rate on excess reserves was increased, then policymakers would have sufficient control over short-term interest rates without the use of additional instruments. They could still choose a target level of the federal funds rate and could hit it by adjusting the interest rate on excess reserves.
However, policymakers face some uncertainty about how stable that spread will remain as short-term interest rates increase. The behavior of the spread today might not be that informative in this regard, as the proximity of short-term interest rates to the zero bound prevents the spread from getting much larger. In my view, the most likely outcome is that the spread will not widen substantially as short-term interest rates increase. However, if the spread does become large and variable, then policymakers will need other tools for strengthening their control of short-term interest rates.
With that in mind, monetary policymakers have asked the Federal Reserve staff to develop the ability to offer term deposits to depository institutions and to conduct reverse repos with other firms. These tools are similar in nature, as they both absorb excess reserves by replacing them with a term investment at the Fed. By removing reserves that would have otherwise been available for overnight lending, these tools could pull the federal funds rate and other short-term interest rates up toward the interest rate on excess reserves, providing the Fed with more effective control over the policy rate.
The development of both of these tools has made considerable progress…
We end there because the only sizable test of the triparty reverse repo system was perported to be an unmitigated disaster. So, on the one hand, paying interest on excess reserves has worked so far, but may cease as short term interest spreads increase (and they undoubtedly will). This could be solved by locking up reserves for a period of time a la reverse repos, but those do not appear to be doing the trick either (and with the all out assault on the money markets, it’s dubious they ever will). Selling the Fed’s accumulated Treasury and Agency stash to drain reserves is completely out of the question as it would put a quick end to deficit spending and the housing refi bubble. Enter the new Term Deposit Facility, but first, a bit of background.
Common knowledge holds that the Fed does not have authority to issue its own debt. The very thought of the Fed competing with Treasury at auction does not seem kosher. Yet, little more than a year ago, with a balance sheet that had recently exploded several orders of magnitude, the Fed was seriously contemplating the issue and exploring it publicly. A WSJ article from December, 2008 had this to say:
The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.
Government debt issuance is largely the province of the Treasury Department, and the Fed already can print as much money as it wants. But as the credit crisis drags on and the economy suffers from recession, Fed officials are looking broadly for new financial tools.
The Federal Reserve drained $25 billion in temporary reserves from the banking system when it arranged overnight reverse repurchase agreements.
Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.
It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency.
Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.
With Treasury-bill rates now near zero, it seems unlikely that Fed debt would push Treasury rates much higher, but it could some day become an issue.
There are also questions about the Fed's authority.
"I had always worked under the assumption that the Federal Reserve couldn't issue debt," said Vincent Reinhart, a former senior Fed staffer who is now an economist at the American Enterprise Institute. He says it is an action better suited to the Treasury Department, which has clear congressional authority to borrow on behalf of the government.
Even current high ranking Fed staff hold this to be true, as San Francisco Federal Reserve Bank President and CEO Janet Yellen stated on May 6, 2009:
The simplest approach—the one that we have used traditionally—would be to shrink our balance sheet by selling the Treasuries, agency debt, and agency MBS we accumulated during the crisis. Many of the special liquidity and credit facilities we have developed will be phased out as financial markets recover. But it is conceivable that, even with the economy rebounding nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. In this case, we could increase the interest rate we pay on bank reserves. This would induce banks to remove funds from the federal funds market and lend them to us, thereby increasing the federal funds rate and longer-term interest rates that are more relevant to private borrowers. Importantly, this approach provides us with the flexibility to tighten monetary policy in response to an improving macroeconomic picture without shrinking the size of our balance sheet or our support to financial markets. It is the main method employed by many central banks to influence financial conditions. An alternative approach that could accomplish the same goal, and perhaps do it better, would be something completely new for the Federal Reserve—that’s to issue interest-bearing debt broadly to private investors. Let’s call this debt Fed bills. Congress would have to authorize this, but it too is a tool available to many central banks. The sale of Fed bills would reduce the reserves of the banking system, as in a typical contractionary open-market operation. As with interest on reserves, we could accomplish a tightening of policy while maintaining our support of credit markets. But Fed bills would have an advantage over interest on reserves. The loans to the Fed would come from investors throughout the economy, not just from banks. [More on this later.] At a time when we need banks to lend to the private sector to fight a credit crunch, this is a decided plus.
Clearly, the Fed cannot issue its own debt.
However, on December 28, 2009, amid the eggnog-sloshed holidays, the Fed solicited comments on a proposed amendment to Regulation D that would combine the features of two of its other excess reserves handling facilities to create a new Term Deposit Facility (TDF). As we will soon demonstrate, the innocuously sounding facility is nothing more than a de facto debt issuance mechanism that once again pushes the envelope of the Fed’s statutory (not to mention Constitutional) authority.
And, lest we ask you to suspend disbelief any longer, consider the following. If Treasury decided to become a bit more opportunistic and issued a new series of bills of multiple short term durations that (i) were auctioned competitively, (ii) paid interest, (iii) carried a zero risk weighting, (iv) were not directly transferrable, but (v) did allow for a temporary return of principal for a premium–would we not hesitate to call it a new debt instrument of the US Government? That is exactly what the Federal Reserve will achieve with the TDF.
So what of the fact that only banks can participate? First, a developing story here is the filing for bank holding companies by hedge fund affiliates and private equity underwriters, which further blurs the line between banks and nonbanks. Witness the recent grant of bank holding company status to Alcar, LLC, an affiliate of West Side Advisors. Though the “conservative leverage of 2-3 times” was enough to bring down at least one hedge fund, one wonders what leverage will be employed with the ability to borrow at 0.12%.
Secondly, it is not difficult to imagine JPM setting up a new Fed Bills bespoke derivatives desk to overcome any transferability hurdles. One of the interesting features of the Fed bills is that they may be used as collateral at the discount window so that, in a pinch, a bank could regain access to the supposedly locked up funds. This is functionally no different than a bank pledging a T-Bill at the window; however, as we witnessed last fall, the hoarding and dumping of T-Bills made for some spectacular fluctuations in short term interest rates.
The Fed is only statutorily bound in terms of the interest rate it pays, that it does not “exceed the general level of short-term interest rates.” In the proposed Regulation D amendment, the Fed writes:
For these purposes, ‘‘short-term interest rates’’ would be defined as the primary credit rate and rates on obligations with maturities of up to one year in which eligible institutions may invest, such as rates on term Federal funds, term repurchase agreements, commercial paper, term Eurodollar deposits, and other [Treasury? No don’t mention Treasury] similar rates.
Conceivably, even an average over several weeks would do. What premium or discount would Fed Bills command with respect to Treasury Bills? With hundreds of billions (or trillions) in excess reserves locked up in durations of up to one year, would the Fed not have the ability to directly influence a broader spectrum of the yield curve? Once Treasury QE 2.0 is announced, would the Fed not be the entire yield curve? Consider too, it would take but a one sentence revision in a ramrodded Congressional bill circa the next crisis to allow the Fed to pay interest at any rate, thus introducing Fed Notes and Fed Bonds.
No doubt, the Fed has considered this, but there is no precedent for the actions of the world’s largest central bank engaging in these types of activities. By President Yellen’s own admission, the Fed did not have the authority to issue its own debt in May, 2009, so why does it now? A simple question posed, but unlikely to get a response, just prior to Mr. Bernanke’s reappointment vote.