Market Mover - BNP PARIBAS - Investment Services India

More clarity was given on the sequencing of
monetary policy tightening
The testimony provided a baseline scenario of the
steps that would be taken to tighten monetary policy.
He described the large-scale purchases on
Treasuries, Agencies and MBS as a component of
monetary policy put in place when the Fed reached
the zero bound on interest rates and the economy
was still under “severe stress”. These purchases
were financed through the creation of a tremendous
amount of excess reserves that led to loss of control
over the effective Fed funds rate (Chart 1) even as
they “helped improve conditions in private credit
markets and put downward pressure on longer-term
private borrowing rates and spreads.” However, the
extreme liquidity in money markets has apparently
led the Fed to decide two things: first, it will need to
mop up some of the excess reserves before actually
raising rates, and second, “during the transition to a
more normal policy configuration”, the Fed is
considering shifting its target policy rate to the rate
paid on reserves rather than a target Fed funds rate.
The reason that the policy to pay interest on bank
reserves did not effectively put a floor under Fed
funds is that the mortgage agencies are suppliers of
funds to the overnight lending market and yet cannot
place deposits at the Fed; therefore, the Fed funds
has traded below the rate paid on reserves since the
policy to pay interest on reserves was implemented
in October 2008. A Congressional act would be
required to allow the mortgage agencies to deposit
money at the Fed, and it is not clear why the Fed
does not pursue this as a way to gain more control
over short-term rates. In any case, the Fed has
concluded that “the Federal funds rate could for a
time become a less reliable indicator than usual of
conditions in short-term money markets” and is
considering shifting to a target rate over which it
would have absolute control. Presumably, this would
come along with an expected range for Fed funds
and Chairman Bernanke also suggested it could
involve targets for reserve quantities.
The tools for draining excess reserves, as previously
announced, include mainly reverse repos and a term
deposit facility at the Fed. He said “The capability to
carry out [reverse repos] with primary dealers, using
our holdings of Treasury and agency debt securities,
has already been tested and is currently available.
To further increase its capacity to drain reserves
through reverse repos, the Federal Reserve is also in
the process of expanding the set of counterparties
with which it can transact and developing the
infrastructure necessary to use its MBS holdings as
collateral in these transactions.” Presumably, the
counterparties beyond primary dealers could include
money markets and possibly even the mortgage
agencies. The Fed has had some concerns about
Chart 3: Consumer Spending Subdued
Reflecting Deleveraging
Source: Reuters EcoWin Pro
Chart 4: Credit Supply and Demand are Weak
Source: Reuters EcoWin Pro
possible market distortions from going outside the
primary dealer community for these transactions,
although it is clear that balance sheet constraints
limit the amount of liquidity that dealers can absorb.
The Fed has apparently decided that capacity is the
bigger concern.
The Fed has already put forward a blueprint for the
term deposit facility and is “currently analyzing public
comments”. It expects to conduct test transactions
this spring and to have the facility available if
necessary “shortly thereafter”. This facility would
involve the auctioning of large blocks of term
deposits to depository institutions that would reduce
overnight cash in the market and tighten liquidity
conditions.
Asset sales are a last choice for policy and an
unlikely outcome
Chairman Bernanke clearly stated that he “currently
[does] not anticipate that the Federal Reserve will
sell any of its security holdings in the near term, at
least until after policy tightening has gotten under
way and the economy is clearly in a sustainable
recovery”. He said the Fed will let MBS holdings run
off over time through prepayments and maturities
Julia Coronado 12 February 2010
Market Mover
5
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