Guest Post: The Federal Reserve Still Doesn't Know How To Get Rid Of Excess Liquidity

Tyler Durden's picture

Submitted by James Bianco of Bianco Research

•    The Wall Street Journal - Fed Proposes Tool to Drain Extra Cash
The Federal Reserve on Monday proposed selling interest-bearing term deposits to banks, a move the U.S. central bank would make when it decides to drain some of the liquidity it pumped into the economy during the financial crisis. The new facility is intended to help ensure that the Fed can implement an exit strategy before a banking system awash with Fed money triggers inflation. Fed Chairman Ben Bernanke has described term deposits as “roughly analogous to the certificates of deposit that banks offer to their customers.” Under the plan, the Fed would issue the term deposits to banks, potentially at several maturities up to one year. That would encourage banks to park reserves at the Fed rather than lending them out, taking money out of the lending stream.The central bank said the proposal “has no implications for monetary policy decisions in the near term.” “The Federal Reserve has addressed the financial market turmoil of the past two years in part by greatly expanding its balance sheet and by supplying an unprecedented volume of reserves to the banking system,” it said. “Term deposits could be part of the Federal Reserve’s tool kit to drain reserves, if necessary, and thus support the implementation of monetary policy.” Michael Feroli, an economist at J.P. Morgan Chase, said “it’s another step forward in the exit-strategy infrastructure, but it’s been well flagged in advance, so it’s not a surprise.” When Fed officials decide to tighten credit, they would likely use the term-deposits program ahead of — or in conjunction with — adjusting their traditional policy lever, the target for the federal funds interest rate at which banks lend to each other overnight. The Fed also said Monday that its balance sheet rose slightly to $2.2 trillion in the week ending Dec. 23. The Fed’s total portfolio of loans and securities has more than doubled since the beginning of the financial crisis. As part of its efforts to fight the downturn, the central bank is buying $1.25 trillion in mortgage-backed securities, a program it says will end in March. The Fed now holds $910.43 billion in mortgage-backed securities, it said Monday.

•    Bloomberg.com - Fed Proposes Term-Deposit Program to Drain Reserves
The Federal Reserve today proposed a program to sell term deposits to banks to help mop up some of the $1 trillion in excess reserves in the U.S. banking system.  The plan, subject to a 30-day comment period, “has no implications for monetary policy decisions in the near term,” the central bank said in a statement released in Washington. Fed Chairman Ben S. Bernanke is preparing tools and strategies to shrink or neutralize the inflationary impact from the biggest monetary expansion in U.S. history. Central bankers are also conducting tests of reverse repurchase agreements and discussing the possibility of asset sales. Term deposits may help the central bank “assert operational control over the federal funds rate” once officials decide to lift the overnight bank lending rate from the current range of zero to 0.25 percent, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. Excess cash “would be locked up” rather than put downward pressure on the federal funds rate, he said.The Fed won’t begin raising interest rates until the third quarter of 2010, according to the median estimate of 62 economists surveyed by Bloomberg News in the first week of December.

•    The Financial Times - Fed to offer term deposits to banks
The US Federal Reserve plans to offer term deposits to banks as part of its “exit strategy” from the exceptionally loose monetary policy used to fight the recession. In a consultation paper released on Monday the Fed said it planned to change its rules so that it could pay interest on money locked up at the central bank for a defined period. The Fed added that the well-flagged rule change - designed to allow it more influence over the $1,100bn in excess reserves held by banks - was part of “prudent planning. . . and has no implications for monetary policy decisions in the near term”. It is one of a number of measures that has been outlined over the past few months by Ben Bernanke, chairman of the Fed, as an option to drain liquidity from the financial system in a manner that protects the economic recovery while heading off the threat of inflation.

•    The Federal Reserve - Notice of proposed rulemaking; request for public comment.
The Board is requesting public comment on proposed amendments to Regulation D, Reserve Requirements of Depository Institutions, to authorize the establishment of term deposits. Term deposits are intended to facilitate the conduct of monetary policy by providing a tool for managing the aggregate quantity of reserve balances. Institutions eligible to receive earnings on their balances in accounts at Federal Reserve Banks (”eligible institutions”) could hold term deposits and receive earnings at a rate that would not exceed the general level of short-term interest rates. Term deposits would be separate and distinct from those maintained in an institution’s master account at a Reserve Bank (”master account”) as well as from those maintained in an excess balance account. Term deposits would not satisfy required reserve balances or contractual clearing balances and would not be available to clear payments or to cover daylight or overnight overdrafts. The proposal also would make minor amendments to the posting rules for intraday debits and credits to master accounts as set forth in the Board’s Policy on Payment System Risk to address transactions associated with term deposits.

Comment

We believe the proposal of this new tool signals the Federal Reserve is still flailing around trying to look busy so everyone is assured they have a plan.  The fact is they have no plan and are still throwing everything on the wall to see what sticks. From the November 4 FOMC minutes:

Participants expressed a range of views about how the Committee might use its various tools in combination to foster most effectively its dual objectives of maximum employment and price stability. As part of the Committee’s strategy for eventual exit from the period of extraordinary policy accommodation, several participants thought that asset sales could be a useful tool to reduce the size of the Federal Reserve’s balance sheet and lower the level of reserve balances, either prior to or concurrently with increasing the policy rate. In their view, such sales would help reinforce the effectiveness of paying interest on excess reserves as an instrument for firming policy at the appropriate time and would help quicken the restoration of a balance sheet composition in which Treasury securities were the predominant asset. Other participants had reservations about asset sales–especially in advance of a decision to raise policy interest rates–and noted that such sales might elicit sharp increases in longer-term interest rates that could undermine attainment of the Committee’s goals. Furthermore, they believed that other reserve management tools such as reverse RPs and term deposits would likely be sufficient to implement an appropriate exit strategy and that assets could be allowed to run off over time, reflecting prepayments and the maturation of issues. Participants agreed to continue to evaluate various potential policy-implementation tools and the possible combinations and sequences in which they might be used. They also agreed that it would be important to develop communication approaches for clearly explaining to the public the use of these tools and the Committee’s exit strategy more broadly.

The Federal Reserve first hinted at term deposits almost two months ago, although exactly what they were talking about was left vague until now.

Remember that the Federal Reserve has to withdraw over a trillion dollars of excess liquidity.  The easiest way to do this is to sell hundreds of billions of MBS, Treasuries and agencies.   As the bold highlighted passage above implies, they are scared to death of doing this, so they propose complicated schemes to withdraw liquidity like reverse repos and now term deposits.

We have argued that these schemes will not work.  They cannot be done in the sizes necessary or enough to even matter.  The Federal Reserve could possibly drain tens of billions of dollars via these schemes, but collectively that will amount to a rounding error when the goal is to withdraw over a trillion in excess reserves.

The Federal Reserve does not want to admit defeat, so they continue pursuing these strategies that will not make a difference.  We believe they also do it to “look busy” as they are taking measurements and notes as to how to withdraw all the liquidity they have pumped in.  They think this will give the market comfort that someone is on the case and that inflation expectations will not get out of control.  The market is not buying this.  Inflation expectations, s measured by TIPS inflation breakeven rates, are going vertical.

Reinvestment Risk

As to term deposits, the Federal Reserve is proposing an illiquid short term instrument for banks to invest in.  Banks would buy these instruments and “lock up” the excess reserves they now have.  This would have the same effect as draining excess reverses.  The maturities of these instruments would be as long as one year.

It is unclear if there will be a secondary market for these instruments, and if so, how liquid it will be.
Without a secondary market, buyers of these instruments face huge reinvestment risk.  The future course of short term interest rates is arguably to the most uncertain it has been in decades.  Will the Federal Reserve stay near zero until 2012 or will they be forced to raise rates in the first half of 2010?  Given all this uncertainty, who wants to lock up money in something that cannot be sold before maturity?  This is especially true given the Federal Reserve’s statement that the “maximum-allowable rate for each auction of term deposits would be no higher than the general level of short- term interest rates.”

The general level of short-term interest rates is set on known instruments that have generations of history and active secondary markets.  If the Federal Reserve wants to introduce a new, and wholly unknown instrument with an uncertain secondary market and offer no interest rate premium, then we cannot see how this will work beyond a token amount after some arm twisting to get them sold.  The Federal Reserve will have to offer a premium for uncertainty and illiquidy to make this fly in any major way, something they said they will not do.

Complicated Is Simple

The Federal Reserve owns 80% of AIG.  With each passing day it looks like the Federal Reserve is adopting AIG Financial Product’s business practices.  That is, when faced with a financial problem, they create complicated tools (like CDS).  When critics says these new products will not work, tell them they do not know what they are talking about and create even more complicated tools to dazzle everyone.  Once the tools are so complicated that no one understands them, you will be hailed as an expert with no peer.  You might even be named TIME’s Person of the Year.

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Stevm30's picture

UMMM - it's called a TREASURY BILL Bernanke you dumbass!  You want to go head to head with Timmay G. and the US Government?... LOL! That's a fight I'd like to see.

VegasBD's picture

Yes. Please. So we can end this third central bank already.

JACOB5CD's picture

HOW WAS TODAYS BOND AUCTION

Cursive's picture

Enough with all this talk of "tools" that the FBR uses.  The toilet is still backed up and shit is raining from the 13th floor.  Many thanks to Jim Bianco for this excellent analysis.  At the end of the day, the Wizard is just a little man hiding behind a curtain.

Segestan's picture

That is really a naive view. The little man behind the curtain is a global network. A network that has human science down to an art. Good luck with that Yellow brick road idea.

Crime of the Century's picture

Interesting - so the blanched faces in Sep '08 were just an act?

Cursive's picture

@Segestan

My sentiments are the same as that posted by "Crime of the Century".  I love your mangled metaphors.  "Human science"?  Is English your second language?  I don't doubt that there are powerful and dark forces at work here, but I doubt their eventual success.  Goebbels knew a lot about using human behavior to consolidate power.  How'd that work out for him?  Listen, it is a more naive view to deny the existence of gravity or to think that a man or a group of men can prevent the inevitable.  The central banks of the world cannot keep the lid on this pressure cooker.  God help us all.

Rusty_Shackleford's picture

Agreed.  There is no one smart enough or with a big enough network to make a system of non-redeemable paper-ticket currency sustainable.  Whether you look at it from the standpoint of Triffen's Dilemma, or just plain common sense, it just can't work.  It will destroy itself.

 

 

As it will be in the future, it was at the birth of Man
There are only four things certain since Social Progress began.
That the Dog returns to his Vomit and the Sow returns to her Mire,
And the burnt Fool's bandaged finger goes wabbling back to the Fire;

And that after this is accomplished, and the brave new world begins
When all men are paid for existing and no man must pay for his sins,
As surely as Water will wet us, as surely as Fire will burn,
The Gods of the Copybook Headings with terror and slaughter return!

gookempucky's picture

Knew I should not have sent him that package of BEDAZZLER's for Xmas

Brett in Manhattan's picture

Why doesn't the Fed just sell all the MBSs they bought? That should drain a few hundred bucks out of the system.

Anonymous's picture

now that's funny!

Cognitive Dissonance's picture

"That should drain a few hundred bucks out of the system."

That had me laughing. But I've read other comments from people trying to apply common sense to the situation by offering reasonable ideas for draining liquidity from the system and then lamenting on when the Fed doesn't do it. There is a simple reason why it's not done.

Because the Fed doesn't wish to drain liquidity from the market. Period!

Brett in Manhattan's picture

Exactly, the Fed could hold a Dutch Auction and sell the trillion plus MBSs on their books, but, that would expose those assets for what they're really worth.

B9K9's picture

The Fed is trying to keep everyone honest with these periodic feints regarding 'draining liquidity'. I mean, talk about false flag operations; the Fed talks up one strategy while covertly pursuing exactly the opposite through one of its many proxies. Monkey see, monkey do - they learned well from their squidly masters.

At the risk of losing $trillions in housing values, there is no way either the Fed, Treasury or FanMac can allow interest rates to climb even a fraction from where they are right now. It turns out that the math is actually quite simple; dollars must be printed in such vast quantities that new keyboards will probably have to be ordered. Of course, with the dollar driven to new lows, it's only a matter of time before a formal devaluation (effective default) is announced

Ultimately, all these fun & games don't do anything other than allow us to continue "eating our see corn". (See: FanMac obviates all loss limits in preparation for principal reductions.) What we really need is some type of productivity break-through in order to be able to pyramid a new layer of debt. That's why I expect to see some type of Nuremberg rally where the PTB will get everyone worked up over the next big gov't sponsored initiative. (An expanded ME war just doesn't do it for me - we'd need to draft around 10-15m guys and place them over there as occupational forces to get even small ROI.) So it might be something like the moon shot of the 60s - cold fusion? (Cap 'n trade only works as a wealth siphon.)

It doesn't matter what it is as long as people believe there is an opportunity, and are willing to spend/invest capital they don't have, but will borrow/lend, in order to get in on the "ground floor". This is neo-Keynesian 'functional finance' to a T.

The big winners are of course banks, and surprisingly, investors, if any of the concepts actually take hold. Of course, nationalized cum directed economies rarely ever achieve those types of gains, so the big play might be gold if all we end up doing is pissing away a few $trillion more before we default.

It's a tough game knowing the possible outcomes; it sure looks like disaster, but you never know if something won't come up. It's probably preferable to be a clueless ignoramus who either scores big if things turn out OK, or becomes canon fodder if the SHTF. In either case, you have no idea what just happened.

Anonymous's picture

Because the Fed lives in fantasyland where somehow Timmy's half-witted ideas to bailout the housing market indefinitely will make them worth something one day.

If you bought garbage assets for more than they are worth would *you* sell?

carbonmutant's picture

If diamonds were as common as sand, that's what they'd be worth.

Treasuries are getting pretty common...

merehuman's picture

So the fed holds all the paper on properties, doesnt that make them the largest land holder in the country? Doesnt that mean they own us? And in return we are given green papers.  Is this the gist of it? If so we are the dumbest natives ever conquered.   Where are my beads?

submitted by the man on the street.

Anonymous's picture

No, that's the funny part. The fed owns the paperwork that says they own the rights to the future stream of income on those mortgages that people will surely keep paying on. I hear the Indians actually still own the land. Or the Queen. At any rate it might as well be you as them. Possession and all. Pshaw the Fed doesn't own the land. Heck that's why the banks offloaded the paper onto the Fed in the first place. If the paper represented a claim on real estate well then that would really BE something. If you don't understand this, you must be a regular person.

waterdog's picture

This CD thing is just smoke. The boys know that saying anything, regardless of how stupid, will distract our minds from the real problems.

How does the CRE problem fit in here? Did it solve itself and go away? Last I read, that is a 700 billion dollar bank problem waiting on Bernanke bucks.

 

deadhead's picture

the Fed has answered that one.

the Fed has indicated to banks that they can roll over CRE loans irrespective of collateral values.  nice way to utilize FDIC insured funds.

Cognitive Dissonance's picture

deadhead,

Sadly it's as simple as that. What bad loans? I (the Fed) don't see any bad loans. And you banks don't see any bad loans either. Those old "bad" (not bad, just misunderstood) CRE loans can be easily rolled over to remove the non-performing label. And we (the Fed) and other regulatory agencies will look the other way.

Hell, even an old fart like myself can get laid if every woman I meet has no standards what-so-ever. Of course, that would mean I've died and gone to hell.

deadhead's picture

yep, it is that simple, which is the amazing thing.

along with the pronouncement the Fed did comment some mumbo jumbo that related to underwriting standards, but it was so vague you could drive a truck through it.

it's part of the "all in" bet as they are hoping those malls go to 100% occupancy, rents increase, and debt service becomes a piece of cake.  same with office bldgs, i.e. unemployment goes to 5%, new companies are just clamoring for A space, etc.  the interesting part will be if and when debt service becomes a problem.  i simply don't believe CRE (and the banks, regionals in particular) can pull it off, with some exceptions, naturally.

talk about an abuse of FDIC insured funds.  I still remember the days underwriting loans (for a large regional, one of the sacred 19) and even though the mantra was one of pushing very hard to make loans, it was still a conservative business and there were lots of declines.  my how it has changed.  one of the things I do agree with buffett about is the importance of "old fashioned" underwriting standards: skin in the game by the borrower, reasonable LTV values, reasonable D/I levels, and on commercial non real estate deals, a solid b'ness plan and loan officers that know the customer(s), the market, the product/service, etc.

 

 

trav777's picture

why in the hell would they WANT to drain the liquidity?

Do they honestly have advisors so full of shit that they believe that lending is actually reviving?

The interbank market is still dead, the Fed IS the credit market and the USG IS the borrower of last, first, and only resort!

They have no choice but to ADMIT to permanent liquidity, aka printing.  Unless they want that deflation thing to come back which will destroy the USG's sheet so quickly that the Fed's lifespan as an "independent" organization will be measured in NY seconds.

Lending WILL NOT REVIVE into a contractionary future!  There is no growth to pay the coupon!  The only inflationary tool they have is devaluation.

There is no demand for credit and nobody willing to supply because there are simply so few economically viable activities out there in this astoundingly overcapacitied world.

Anonymous's picture

Lending WILL NOT REVIVE into a contractionary future! There is no growth to pay the coupon! The only inflationary tool they have is devaluation.

There is no demand for credit and nobody willing to supply because there are simply so few economically viable activities out there in this astoundingly overcapacitied world.

This is the best statement I've read and i agree wholeheartedly. The economy has been overbuilt and therefore, there is not enough growth potential to provide a way out of this. The only way out is devaluation in my opinion and this is why I own gold. This is what I refer to a great deal over at 20smoney.com.

Anonymous's picture

The Fed doesn't own AIG - Treasury does.

deadhead's picture

Correct.

And, the Fed owns the US Treasury. 

Just.could.not.resist!

Anonymous's picture

Are Banks Scamming Fannie?

You remember the announcement that Fannie and Freddie would have an "unlimited" credit line from Treasury to cover shortfalls and buy-outs of defaulted loans from MBS, right?

Well then, read this from the forum:

After the Fannie news came out this weekend, a friend called me and his brother works for Chase Mortgage. He told me that Chase is redoing stated income loans and instead of actually appraising the home, they are going back 3 years on the homes valuation in order to get the loan processed. Then they are selling these mortgages to Fannie Mae.

Yes, that's an anecdotal claim, but if true can someone explain to me how this isn't out-and-out fraud?

Is Fannie requiring the actual appraisal with the loan package information they buy, or is the entire "verification" nothing more or less than a checkbox that says "yes, we have an appraisal"?

Toxic waste dumping ground? Maybe.

But one thing is certain - I've not heard of Fannie and Freddie forcing putbacks of loans they purchased from various brokers and originators where there was fraud in the original loan.

Why not?

Why should Fannie and Freddie eat this if in fact the banks breached their reps and warranties in the original tender of the paper?

And since it appears that banks have been tremendously successful in shoveling off garbage paper to Freddie and Fannie while not being held to account for their activity, one has to wonder if this anecdotal report is accurate!

--Denninger

trav777's picture

KD ought to know by now that Fraudie and Phony's mandate is to reinflate the housing market and get loans happening by any means necessary.

Scamming?  LOL...only like you would "rape" a prostitute you already paid for

dnarby's picture

I have wondered if FanFreddie were going to become the defacto "bad bank" for that possible solution (but by buying the assets at inflated prices, e.g. http://online.wsj.com/article/SB123258594265704581.html )

mtguy's picture

Even if there was a demand for credit, why would the banks take the risk? I mean it sounds as if a bank could take some of their reserves and by one of Benny's CD's and earn a spread that way -no risk, no fuss. In fact, once purchased, the banks can plead their case for not lending as they can't lend out the money they put into Benny's CD's. How convenient.

Anonymous's picture

Dont you worry. Ben willfigure it out. After all he went to amerikas bestest schoolin' at ol' harvard collegium of stupidity. Keyenes, keynes marx, and more keynes...

Handle with care's picture

Am I misunderstanding something?  Because it seems to me that the Fed allows banks to borrow at around zero percent and now they want to allow the banks to deposit this money at the Fed for a higher interest rate.

 

Is that really what's happening?

Crime of the Century's picture

They are already doing that. The deposits are liquid however, and so have inflationary potential. What the Fed seeks to do is lock it up. Which goes against the complaints that the banks are already locking it up (having seen their own balance sheets). Doublethink - it's what's for dinner...

Rusty_Shackleford's picture

Yeah.  I get a kick out of that too. 

 

We're going to "drain" liquidity by paying interest on the bank's money

So,......OK, it's 6 months for now and the $1.2 Trillion the Fed is "holding" for the banks is now $1.3 Trillion.  Now what?  Are they going to keep paying interest until the principal is infinity?

seventree's picture

Wow that's scary. Good thing the economy is going to start recovering next week. I heard that on TV.

 

Ripped Chunk's picture

Momentum building. 2010 looks like shit.

Meanwhile the media folks slapping each other on the back and celebrating "mission accomplished" as their relentless PR blast apparently lifted holiday sales to "better than last year" levels.  Or not.

Anonymous's picture

We shit the bed but the media is telling us that it's just a chocolate on the pillow.

Anonymous's picture

From the November 4 FOMC passage above ....

Other participants had reservations about asset sales–especially in advance of a decision to raise policy interest rates–and noted that such sales might elicit sharp increases in longer-term interest rates that could undermine attainment of the Committee’s goals.

Translation - If the Fed sells MBS, they would drive rates higher and Bernanke would need to be placed in a witness protection program. So this is not going to happen.

dead hobo's picture

Every dollar of drained liquidity is a dollar that can't be used to feed the beast when it needs to sell new debt. If they drain, rates rise and the economy folds. I'm still betting they figure out some new way to scare the markets without folding credit too much. The alternative is a textbook economy, with high rates and the corresponding downturn that accompanies high rates.

This is a hell of a puzzlement. Agreed it's probably a smokescreen.

trav777's picture

A rise in rates would precipitate a full-on monetary collapse, as in severe deflation.

The reason EM rates are higher is because they can be...activity there is more profitable than in more mature economies.

There is not enough to do here with rates high; things just aren't that profitable anymore.  All the good oil wells have been drilled and drained, the land cultivated...they suburbanized everything.

Profit margins in mature economies decline over time, which is why the capitalist system moves on to unexploited pastures.

If rates rise sharply, that will revert shit quickly back to feudal rent-seeking behavior.  If economic activity is less profitable than the prevailing coupon, the activity won't happen via lending.  Without lending, we don't have money.  Put simply, a rise in rates leads back to rentierdom and a gold standard.

Crime of the Century's picture

The market will be punk'd in '10 (Round 2), in order to finance some debt. The Gov 401(k) ("Thrift Savings Plan") will be moved into bonds. Private pension plans should be beyond wary at that point...

seventree's picture

Hey it worked in Argentina. By which I mean, their government was able to sieze private savings, replacing them with default-prone bonds, and keep the official machinery going a little while longer.

I would be most concerned about cash IRA's. The IRS can change tax liability rules on these at any time, including a penalty (or mandatory distribution) for account holders that don't elect to move into bonds. Some kind of national emergency would divert public attention.

 

Guy Fawkes's picture

or sold as a way to "protect" everyones retirement 401K accounts. Afterall if it hasn't been taxed yet ... who's money is it really?

Anonymous's picture

Every Ivy League MBA I talk says the same thing: "We didnt go to Harvard,etc to learn anything about business (!!!!!), we went to Harvard,etc to make contacts and networking." This is de facto evidence of the inanity in Amerikan B schoolin' education. It is prima facie evidence of racketeering and consipracy to defraud. RICO anyone? Close down the schools.

SteveNYC's picture

You are right, I've heard the same thing. Having worked in finance for some time, in America and abroad, I can honestly say that a B-school education in the USA is a complete and utter waste of money unless you come out with "the contacts".

The typical MBA from a US college could be completed by a person with severe mental retardation (no offense).

Rainman's picture

Skull and Bones, baby.

Even a dumbshit like W got to be Prez with the proper creds of connection, silence and conspiracy.

No free thinkers or moralists allowed.

phaesed's picture

Actually Fisher was a skull and bone

 

Even more interesting is that he was a moralist until he lost his money in the market, funny how a rich man will do anything to get his money back if he never had to live in it's absence and how a poor man turned rich will just go back to work.