“Sterilised” | FT Alphaville


Fed transparency anyone?

First, the key bits of what Fedwire reported on Wednesday…

Federal Reserve officials are considering a new type of bond-buying program designed to subdue worries about future inflation if they decide to take new steps to boost the economy in the months ahead…

Many Fed officials believe strongly the bank reserves it has created as part of this money creation isn’t an inflation threat. But they are acutely aware of a popular perception, also held by a few inside the Fed itself, that the money the Fed has created could cause an inflation problem down the road. An approach that limits the amount of new money flowing into the system—through another Operation Twist or a sterilized operation—could help them manage that perception.

Under the third approach, the Fed would create new money as it buys long-term bonds. But then it would effectively lock up the money rather than letting it loose in the broader economy. The Fed would do this by borrowing the money back from investors for short periods—say, 28 days—in exchange for some low interest rate it would pay investors.

Transactions like those under the third scenario are called “reverse repos.” A related program called “term deposits” also ties up short-term money held by banks. The effect of this approach is the same as Operation Twist: The Fed would hold more long-term bonds and investors and banks would get more short-term holdings in exchange.

Officials at the Federal Reserve Bank of New York have designed the reverse-repo program for use when the economy is much stronger and they want to tighten credit. But the same tools could, in theory, be used now to fine-tune a program meant to ease credit conditions.

Moreover, the program could be conducted with financial institutions other than banks, like money-market funds, increasing the Fed’s flexibility in managing reserves. The reverse-repo program was designed to include money-market funds and these institutions don’t participate directly with the Fed in other operations.

OK — we’ve got no fewer than three possible explanations for what’s going on.

They range over the Fed’s reaction to oil prices and the thorny topic of the similarity of the above to Twist or tightening. Then the implications of this sterilisation for possibly relieving repo markets (the main aim?). Finally this whole issue of Fed communications becoming a major part of its policy.

But you’ll have to wait for another post in just a sec!