Draining liquidity from the banking system

by Rebecca
(cross posted at Newsneconomics)

Prof. Jim Hamilton at Econbrowser (thanks Mark Thoma for the link) addresses one of the Fed’s standard methods of draining liquidity from the banking system: reverse repurchase agreements. Basically, the Fed will transfer some of its assets to the banking system via short-term loans taken out with its Primary Dealers, presumably offering standard (Treasuries) and less standard (MBS or agency bonds) assets as collateral.

Reverse repurchase agreements simply slosh around the assets (MBS, agencies, and Treasuries) between the Fed and the Primary Dealers, rather than removing the assets from the Fed’s balance sheet permanently. Eventually, though, the Fed must sell the securities outright onto the open market – we are far, far from that!

This is all hot air for now. How can the Fed soak up the expansionary liquidity, let alone unwind $1 trillion in assets, when the banking system is still shedding pounds?

The Fed is considering another route, too: conducting the same repurchase agreements with the money-market mutual fund industry in tandem. An excerpt from the FT:

The Federal Reserve is looking to team up with the money-market mutual fund industry as part of its strategy to ensure that its unconventional policies to stimulate the economy do not produce a bout of post-crisis inflation.

The central bank envisages eventually draining liquidity from the financial system by engaging in trades called “reverse repos” with the deep-pocketed money-market funds. In these, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds.

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets. By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure from regulators and investors to stick to low-risk liquid investments.

The Fed is solely attempting to assuage inflation angst at this time; it’s still very premature to talk about an exit of expansionary policies when credit markets still crimp the stimulus that the Fed so desperately wants to get into the open market (much of the base, roughly $855 billion on September 23, 2009 and up from $2 billion in August 2008, remains on balance with the Fed in the form of “excess reserves). Just look at the crunch in the consumer credit space (chart to left).

As Prof. Hamilton suggests, the mechanisms of the reverse repos should successfully sterilize the base before it starts to become inflationary (with either the Primary Dealers and/or the Mutual Funds industry). However, one of the programs through which the Fed utilized previously to sterilize its liquidity, and to which Prof. Hamilton refers, – the Supplementary Financing Program – is unlikely to be an avenue for removing liquidity.

In fact, it’s quite the opposite. The Treasury already announced its imminent plan to liquidate the bulk of its $200 billion account with the Fed. There’s another $200 billion in excess reserves with which the Fed must contend (see my previous post here).

It’s easy to get the liquidity into the financial system. But getting it out without collapsing the economy or allowing inflation pressures to build? Well, that’s a different story.

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