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Winehole23
10-20-2009, 09:02 AM
Federal Reserve reverse repurchases (http://www.econbrowser.com/archives/2009/09/federal_reserve_2.html)

Here I offer some thoughts on Bloomberg's account (http://www.bloomberg.com/apps/news?pid=20601087&sid=ax.FBWNLB5_o) that the Fed has made inquiries with its dealers about the feasibility of a significant increase in the Fed's reverse repo operations.


First, a little background. The traditional tool of monetary policy is an open market purchase, in which the Fed purchased U.S. Treasury securities that had previously been held by someone in the private sector. The Fed would pay for those securities by crediting deposits in an account that the selling bank had with the Federal Reserve. These reserve deposits of banks represent claims that the bank could use, if it wished, to withdraw green currency from the Federal Reserve. The volume of reserve deposits historically was extremely important in determining the interest rate at which banks would lend the deposits to one another overnight. The traditional understanding of monetary policy was that the Fed would use open market purchases to achieve its desired objectives for the overnight interest rate and the money supply.


If the Fed wished to implement a purely temporary increase in the volume of reserve deposits, historically the tool of choice was a repurchase agreement, in which the Fed would buy a particular security with a promise to return it at a specified future date. The purchase was again implemented by creation of reserve deposits, and when the security was returned, those deposits came back into the Fed.


The Fed began to see a new potential use for these repos after the initial banking difficulties in August 2007 (http://www.econbrowser.com/archives/2007/08/what_is_a_liqui.html). Although repos were traditionally used as a device for temporarily injecting reserves, their structure amounts to a collateralized loan from the Fed to the counterparty. The Fed's objective subsequent to August 2007 was to increase the volume of its lending and support the market for certain securities that it could accept as collateral for repos. Thus the Fed utilized an expansion of repurchase agreements as one of the initial tools for responding to the crisis, simply rolling them over to create a de facto expanded lending facility.


The graph below tracks the various assets held by the Federal Reserve since the beginning of 2007. The height of the graph represents the total asset holdings at the end of each week, with the colors indicating the contribution of each category. Repos are represented by the turquoise band. This traditionally had been small and highly variable, but grew significantly in the early phases of the financial crisis. Later the Fed came to use direct loans through its Term Auction Facility in preference to repos. Since January, the Fed has been directly buying up mortgage backed securities and agency debt in the way it used to purchase Treasury securities.

Figure 1. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 2009. Wednesday values, from Federal Reserve H41 release (http://www.federalreserve.gov/releases/h41/). Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

http://www.econbrowser.com/archives/2009/09/fed_asset_sep_09.gif
A separate question is what happens to all the reserve deposits created through this process. The Fed has never wanted to see the huge volume of reserves it created end up as currency held by the public, for fear this would be inflationary. It has relied on several devices to keep that from happening. One was use of the Treasury's account with the Fed, another traditional feature of Fed operations that ballooned as it became adapted to new purposes. The Fed asked the Treasury (http://www.ustreas.gov/press/releases/hp1144.htm) to borrow funds that it simply left in deposit in its account with the Fed. These idle reserves held by the Treasury absorbed some of the vast increase in new reserves created by the Fed.


A more important tool was that the Fed started paying interest on reserves in October 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081006a.htm), and by November had increased that rate to the target fed funds rate itself (http://www.federalreserve.gov/newsevents/press/monetary/20081105a.htm). This created a very strong incentive for banks to simply hold reserves idle at the end of each day rather than lend them out on the overnight fed funds market. In effect, by paying interest on reserves, the Fed is borrowing directly from banks and using the proceeds for the various asset expansions detailed above.


The graph below shows the Fed's liabilities at the end of each week. The height of the graph is, by definition, exactly equal to the height of the previous graph at every date. The first graph tracks what assets the Fed acquired with its operations, while the second graph shows where the funds it created ended up. The surge in the Treasury account (in yellow) and excess reserves of member banks (green) explain why the huge expansion in the Fed's balance sheet has not translated so far into a massive increase in the quantity of currency held by the public (blue).

Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 2009. Wednesday values, from Federal Reserve H41 release (http://www.federalreserve.gov/releases/h41/). Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

http://www.econbrowser.com/archives/2009/09/fed_liab_sep_09.gif
The question under discussion at the moment is the extent to which the Fed could continue to rely on these two devices-- Treasury borrowing on its behalf and banks' willingness to simply hold the ballooning reserves-- to contain the monetary consequences of its expansion. The traditional political gamesmanship over the debt ceiling (http://thehill.com/homenews/senate/57493-senate-must-raise-debt-ceiling-above-12t?page=26) could well induce the Treasury to want to discontinue its facilitation of the expansion of the Fed's balance sheet, in which case the Fed must either reduce some of its lending or count on banks to hold even more excess reserves. Some in the Fed are assuming that they could always ensure the latter outcome, if needed, by raising the interest rate the Fed pays on reserves. But clearly the Fed has no desire at the moment to raise interest rates, so it's difficult for me to imagine them taking that step any time soon.


Where else could the Fed get the funds? Fed Chairman Ben Bernanke described his contingency thinking last July (http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html):

the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.
Just as the Fed converted the use of repos, which had historically been used on a small scale to temporarily add reserves, into a much larger operation with which it could lend broadly on a long-term basis, it is now contemplating using the reverse repo, which had historically been used on a small scale to temporarily drain reserves, into a much larger operation with which it could borrow broadly on a long-term basis. Thus we saw the following report from Bloomberg last week (http://www.bloomberg.com/apps/news?pid=20601087&sid=ax.FBWNLB5_o):

The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.



Central bank officials are discussing plans to use so-called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That's where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system.



There's no sense that policy makers intend to withdraw funds anytime soon, said the people. The central bank's challenge is to decrease the cash without stunting the economy's recovery and before it sparks inflation. Fed Chairman Ben S. Bernanke said in a July Wall Street Journal opinion article that reverse repos are one tool to accomplish that goal without raising interest rates.



"One thing the Fed has to figure out is if they can launch pilot programs without spooking the market and creating the perception that they are about to tighten," said Louis Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that specializes in government finance. "They are discussing things like accounting issues, and updating the governing documents to the volume of reverse repos the dealer community could absorb."
Is this a feasible interim plan for handling the liability side without increasing either the money supply or interest rates? In a mechanical sense I believe the answer is yes. But the nature of inflationary pressures that we should be watching at the moment would arise from a depreciation of the dollar relative to other currencies and increase in the dollar price of internationally traded commodities. A modest move toward a weaker dollar and slightly higher inflation would be welcome. But the concern in my mind is whether a flight from the dollar could become more precipitous and destabilizing. It may not be the most likely scenario, but it is one for which I hope there has been some contingency planning.


And if the Treasury and the Fed think they could prevent that simply by borrowing even more without raising interest rates, they are mistaken.

Winehole23
10-20-2009, 09:03 AM
From the comments:


So the Fed has swapped liquid reserve deposits to banks in exchange for illiquid MBS and other risky assets. But now that credit markets have stabilized they are worried that the banks will use those reserves to buy even more risky assets so the banks can make even bigger profits. Too bad, the only reason credit markets have stabilized is that everyone believes that if the banks get into more trouble, the Fed will take even more bad assets off their hands and trade them for even more liquid reserves.

Winehole23
10-20-2009, 09:07 AM
More comments:


One potential problem that I can see with this method of withdrawing reserves is that the primary dealers will presumably have to, in turn, borrow from the market, in which case even if the primary dealers pass on the treasuries that the Fed lends to them, because the market will demand better collateralisation from the primary dealers than they can demand of the Fed, the primary dealers may have insufficient collateral to participate.

Winehole23
10-20-2009, 09:07 AM
There was some talk that the Fed would reverse-repo with money market funds to avoid impacting primary dealer profits -- er, I mean, liquidity.



In the bigger picture, the reverse repo talk is but a symptom of the Fed's lack of clarity in communicating policy. So they are supposed to buy an additional $500-odd billion in MBS/Agencies, but at the same time reverse-repo $185b? Why not just buy $185b less MBS? The impact on the monetary base would be the same. This signals that the primary object of policy is mortgage spreads. Of course, we knew that, but the Fed has never come out and told us. Why not? Ostensibly, its because this admission would take Fed policy dangerously close to fiscal policy (targeting specific sectors of the economy). The Fed doesn't want to be seen usurping the role of Congress, even though the $185b reverse repo talk proves that it is. But wait, there's a price to be paid: Congress is not that stupid. They see the Fed taking on a fiscal role, and they want to re-take some degree of control over their traditional "power of the purse". Hence the drive in Congress to audit the Fed.

Winehole23
10-20-2009, 09:09 AM
So now they are worried about how to withdraw liquidity, without making interest rates go up. I guess that's where this would be all headed. Maybe Marx has some ideas?


One thing that I remember from my econ 101 book is the Fed could raise reserve requirements and make the excess money stay put. Is there some reason they don't ever consider that one? The only thing I can think of wrong with it is weak banks could have a problem complying.

Winehole23
10-20-2009, 09:16 AM
The Fed has many tools at its disposal to control the money supply. The risk is that the markets will misunderstand what they are doing. Take the explosion in the monetary base. Since the Fed started paying interest on excess reserves, the monetary base has ceased to have any economic significance. As the author points out, the Fed is short federal funds and long on commercial paper, mortgage backed securities and long-term treasury debt. This is a massive repeat of Operation Twist designed to keep mortgage rates low to prop up the housing market and to ensure that markets exist for certain kinds of debt given the collapse of the shadow banking system.

Winehole23
10-20-2009, 09:16 AM
The fiscal response to the crisis was to increase government spending, lower taxes, and accept much larger fiscal deficits. Given the collapse of private demand, and the inability to reduce interest rates below zero, governments clearly chose the right response. But large deficits lead to rapid increases in debt, and, because debt levels were already high in many countries, such increases cannot go on for long. As large deficits continue debt sustainability comes increasingly into question. And with this comes the risk of higher long-term interest rates, both because of anticipated crowding out of private borrowers by government borrowers and because of a higher risk of default.



How much longer can the fiscal stimulus continue? On its own, in most advanced countries, probably not very long. The average ratio of debt to gross domestic product (GDP) for the G-20 advanced economies was high before the crisis, and is forecast to exceed 100 percent in the next few years. (The situation is substantially different in a number of emerging market countries, where debt was much lower to start, and where there is more room for deficit spending.)

Winehole23
10-20-2009, 09:17 AM
So Bankers sold assets at non-market valuations to the Fed in exchange for cash, which became bank reserves....and now the Banks are going to use those same reserves to buy the Fed's assets (really, the assets the Banks sold to the Fed above market price), but with a promise that the Fed will buy them back at an increased price on a future date. This isn't far from the communist joke that "they pretend to pay us, and we pretend to work". If the goal is to crash the purchasing power of the dollar, I would bet it will work.


Looks like some parachutes are actually knapsacks.

Winehole23
10-20-2009, 09:19 AM
Bill asks:
"If Fed borrows from money markets using MBS (I fear it will be exclusively) as collateral, and the MBS are proved worthless or nearly so, would not this cause a considerable mark below par $1?"


Bill is correct. Sometimes the Fed talks about this publicly. Watch for articles in which Big Ben Bernanke talks about "capital losses" on his balance sheet. Every dollar of capital losses is a dollar of base money injected into the economy that, in the long run, he can't pull back out of the economy except to the extent that (a) the Fed makes a profit* or (b) the federal taxpayer gives the Fed a bail-out. If he can't pull that dollar back out, it eventually causes inflation. The timing depends on a huge number of variables. And (I think) he could keep putting off the day of reckoning, though there is an implicit cost to doing so. For example, he could raise reserve ratios or raise the interest he pays banks so that they keep the new base money in reserve. But the reserve requirement is essentially a forced loan that damages the banks that have to make it. And paying interest on reserved increases those reserves. So, it is a two-edged sword at best.

clambake
10-20-2009, 09:47 AM
buying more risky risks.....people would have to die, in public.

RandomGuy
10-20-2009, 12:07 PM
They are going to have to tighten the money supply at some point.

It is obvious, based on this article, that they are trying to find alternative levers other than raising the much watched Fed rate.

My concern is the distortion being caused by such large movements of cash into and out of the system, and the fact that the Fed has so deeply leveraged itself to do this.

RandomGuy
10-20-2009, 12:25 PM
One other observation:

This stuff is waaay complex, obviously. It is very hard to fully get all the possibilities down, and the law of unintended consequences is something that keeps me up at night.

My gut says that what the Fed is doing is simply taking what would have been a rather nasty, energetic collapse and spreading out the energy from that collapse over a longer period of time.

I do not see the US economy really doing much other than being very flat for years to come due to the fact that all of this happy shit the Fed has done will have to be wound down over time, and the fact that oil energy is about to get more expensive.

The ability of the Fed to curb the dollar's slide will be overwhelmed if enough global investors start moving away from the dollar, and dollar based investments.

One good thing to remember is that the US economy as a percentage of the global economy is shrinking yearly. We will have the ability to do something useful with the sliding dollar in terms of providing manufacturing jobs.

My concern when a lot of the discussion turns to the velocity of money as it did in that running blog post in the OP is that eventually one MUST run up to sheer physical constraints. You can borrow a billion dollars to run a farm, but at some point, you will run up against simple physical constraints as to how much food you can produce to pay that money back.

I think we have gotten a bit ahead of ourselves and are due for a cutting back of that.

Interesting times indeed. Wish I really knew where all this was headed.

Darts anyone?

EVAY
10-20-2009, 12:41 PM
Isn't the policy problem here that if more reserves are required (and I think they should be), said requirement runs counter to the gov't desire that the banks led money more freely to small businesses and individuals? We want solvency, but we want credit too, to keep the economy rolling.(see discussion in the other thread).

Winehole23
10-20-2009, 02:10 PM
One thing that I remember from my econ 101 book is the Fed could raise reserve requirements and make the excess money stay put. Is there some reason they don't ever consider that one? The only thing I can think of wrong with it is weak banks could have a problem complying.They also don't like the risk profiles anymore. A headline I saw this morning said US housing prices may go down as much as another 11%.

There is a coming wave of commercial, alt-A and jumbo defaults, and we already know the banks are even weaker than advertised.

Winehole23
10-20-2009, 02:11 PM
Hold on tight, SpursTalk posters. We could be in for another rough patch.

Winehole23
10-20-2009, 02:12 PM
Darts anyone?

http://www.thedartsshop.co.uk/blog/wp-content/themes/Ayumi/images/you.jpg

SnakeBoy
10-20-2009, 02:45 PM
My gut says that what the Fed is doing is simply taking what would have been a rather nasty, energetic collapse and spreading out the energy from that collapse over a longer period of time.


Your gut should be telling you that that is what they hope to accomplish. Whether or not they can succeed is still is still yet to be known. A nasty, energetic collapse is not off the table yet. We could just be in the eye of the storm.

SnakeBoy
10-20-2009, 03:08 PM
A headline I saw this morning said US housing prices may go down as much as another 11%.


The median home price is just under 180k so I don't see how housing prices could not fall even further when you look at historical prices. Even with all the huffing and puffing to keep the bubble inflated I think it is just a matter of time.

http://re-calculator.com/united_states.png

LnGrrrR
10-20-2009, 03:27 PM
The median home price is just under 180k so I don't see how housing prices could not fall even further when you look at historical prices. Even with all the huffing and puffing to keep the bubble inflated I think it is just a matter of time.

http://re-calculator.com/united_states.png

I know that this is anti-patriotic and all that, but I sincerely hope that home prices keep falling. Maybe then I'll actually consider buying one.

SnakeBoy
10-20-2009, 04:38 PM
I know that this is anti-patriotic and all that, but I sincerely hope that home prices keep falling. Maybe then I'll actually consider buying one.

It's not anti patriotic, just the opposite IMO.

Winehole23
10-20-2009, 04:56 PM
Price discovery isn't un-American.

http://stats.oecd.org/glossary/detail.asp?ID=6218


Price Discovery - I LOVE this one. I heard this term on Bloomberg Radio recently when talking about the real estate market in the US in September. They said that in many communities ‘price discovery’ was taking place as buyers realized that house or condominium prices were finally at a low enough level to be attractive once again!http://blogtorontorealestate.ca/2008/10/31/toronto-real-estate-terms-youll-need-to-know-to-follow-the-news/

Wild Cobra
10-21-2009, 04:20 AM
I know that this is anti-patriotic and all that, but I sincerely hope that home prices keep falling. Maybe then I'll actually consider buying one.
I disagree about your patriotism. I agree housing prices are still too high. If you consider the constant dollar value around $150,000, then prices are still about 20% too high.