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