Another Fed Maneuver to Digest
The Reserves announced this afternoon that it is going to revive a program in which it borrows $200 billion by issuing small-term bills and leaves the cash on deposit with the Federal Reserve. Why? And why now?
The Reserves initiated this program — called the Supplemental Finance Program — at the peak of the financial crisis. It was a way to get the Fed cash it needed to fund a myriad of new programs to get credit into the financial system. The Reserves reduced the program last year as its borrowing authority approached legal limits. But since Congress earlier this month approved an increase in the debt limit, it is able to revive it.
?The intention always was to resume SFP issuance when the debt ceiling was augmented on a permanent basis, which finally happened earlier this month,? said Lou Crandall, a money market analyst at Wrightson ICAP LLC. ?The Reserves kept $5 billion of SFP bills outstanding throughout all the debt limit negotiations as a placeholder to indicate that it wanted to go back to the reputation quo ante.?
The practical effect of this go is that the Fed will be able to end $1.25 trillion of buys of mortgage backed securities by the end of March without printing more money. As a replacement for, it will have the cash on hand from the Reserves deposits to fund the buys. As of February 17, the Fed?s portfolio of mortgage backed securities had reached $1.025 trillion, roughly $200 billion small of the objective.
The supplemental finance program go is part of a complex dance that the Fed has to undertake to manage its large and on the rise balance sheet. Cash deposits from the Reserves were used to fund some of the Fed?s ahead of schedule interventions into the financial system in 2008. But as the interventions grew, and the economic outlook worsened, the Fed took another approach. It started printing the money itself, in effect crediting the accounts of banks with cash when it made loans or bought securities.
Printing money made sense to rescue a wobbling financial system, but it could cause problems down the road. At some point, the Fed will need to drain this money — known in central banking parlance as “excess reserves” — to prevent an onset of inflation. It has been experimenting with and debating uncommon ways of doing that. The Fed could sell some mortgage backed securities, taking cash from the buyers which reduces the give of money in the system. It would soak up money itself by taking longer-term deposits from banks or doing trades with financial institutions that pull money away from them.
Excess reserves were $1.1 trillion on Feb. 10. Having the Reserves renew its supplemental finance program makes it simpler for the Fed to contain the progression of this number and officials see it as a helpful supplement to its tools. But taking Reserves deposits aren?t seen surrounded by the Fed as a step toward tightening credit broadly in the economy.
When that time comes, and it will, the Fed is likely to increase the interest rate it pays banks on these reserves so they place money at the Fed as a replacement for of lending it out. That step is still likely at smallest amount several months away, something Fed Chairman Ben Bernanke is likely to reiterate in testimony to Congress Wednesday on the outlook for the economy and monetary plot.