The Fed is mothballing its $559bn supplementary financing program. Or, to put it even more obliquely:
Washington - The balance in the Treasury’s Supplementary Financing Account will decrease in the coming weeks as outstanding supplementary financing program bills mature. This action is being taken to preserve flexibility in the conduct of debt management policy in meeting the government’s financing needs.
The SFP is the principle means by which the Federal Reserve has been offsetting - since September - its massively expanded liquidity operations.
It’s basically a Treasury bill issuance scheme: by issuing new Treasuries, the Fed basically drains capital from the system, offsetting or ’sterilising’, in Fed jargon, the excess liquidity created by its vastly expanded open market ops.
But there is a problem. What with the TARP, as well as a host of other government interventions, there is a huge financing need at the Treasury. One which will need to be funded through issuance of Treasury bonds and bills. There’s consequently then, something of a glut. One which would be - somewhat - alleviated by ending the SFP.
And the SFP can be unwound because the Fed is effectively sterilising its open market ops by another means: encouraging massive excess reserves. Banks have to post reserves at the Fed - normally around $7bn worth. But bank reserves deposited at the Fed are currently pushing $1 trillion. Part of the reason for this is that the Fed has increased the interest rate it pays on reserves (or rather, decreased the penalty to the target rate). Part of this is because banks are looking for somewhere safe to hoard cash. Depositing with the Fed, in the current market, is a competitive store of value.
And in terms of monetary supply, banks increasing their reserves with the Fed acts just like the SFP does, because it is a drain on liquidity in the system.
But as Michael Cloherty at Bank of America observes in a note today…
…there are costs: The Fed funds market will be massively distorted as bank reserves climb well over $1T ($7bn is a normal level), so banks will never get caught short of reserves and need to borrow in the funds market. In addition, excess reserves are likely to climb to roughly 10% of total bank assets. Ratios like net interest margin and return on assets will be weighted down by all of those reserves-look for some crowding out effect on bank balance sheets.
There is another cost too. As interest rates move to zero, the Fed’s becomes less and less effective: low-yielding treasury bills are barely distinguishable from cash.
The answer to this is to expand the balance sheet: the Fed has to grow larger and larger to allow it to continue to affect rates.
This is all remarkably similar to the policy of quantitative easing adopted by the Bank of Japan in the 1990s. It’s odd really that the Fed is not giving much clarity on its actions. Odder yet that people aren’t looking to Ben Bernanke’s numerous papers on fighting deflation to see the germ of current policy.
We reprise the below, from 2002:
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
…
To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.
Bernanke then wonders why - if the policy options for fighting deflation are so varied - did Japan fail, through its quantitative easing programme? Tellingly, he concludes that the problem there was as much political as economic.
The question then, is whether the US quantitative easing program will succeed.
In the event it does not, one final deflation-fighting measure to consider, from Ben:
Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.
Related links:
Fed capitulates: the central bank is broken - FT Alphaville
Dollar *danger* ahead - FT Alphaville
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