Thursday, February 11, 2010

Re-writing the Playbook on Monetary Policy

Mr. Bernnake's Congressional testimony on the specifics of the Fed's planned "exit strategy" yesterday was quite thorough but held no surprises, as nearly all of the measures he outlined had already been mentioned, in a somewhat piecemeal fashion, as being under consideration in the last few months.

Those measures include, raising the interest rate that the Fed currently pays banks on both their required and excess reserves, offering banks term deposits, and conducting Reverse Repurchase Agreements to drain liquidity directly.

This last point included actually a twist, as the Fed Chairman confirmed that the Fed will be looking to conduct "triparty" Reverse RPs, meaning that, for the first time, the Fed will use counterparties in such open-market operations other than primary dealers. Traditionally, the argument has been that the Fed conducts such sensitive operations only with especially vetted securities firms that have received its "seal of approval". However, this rule will need to be broken now, as this "innovation" is mandated by the staggering amount of reserves -in the vicinity of $1 trillion- that the Fed will need to absorb in due course, while the primary dealer community is thought to be able to handle transactions totaling only $100 billion or so. As such additional counterparties, the Fed is considering the money market mutual fund industry, which has a much greater ability to handle transactions of the required magnitude (link below).

Mr. Bernanke reiterated the obvious- that is, that the federal funds rate is likely to remain at "exceptionally low" levels for an "extended period" and it is indeed unrealistic to expect the Fed to move into a tightening mode over the next six to eight months. However, no one can accuse the Fed of not making meticulous preparations to return the financial system to more normal liquidity conditions when the appropriate time comes. And, just as injecting that massive liquidity at the start required an extraordinary amount of creativity and history-making measures, draining all of that liquidity on the back end will require a comparable degree of innovative tools and tactics, as the Fed continues to re-write the monetary policy-making playbook in this country.

Anthony Karydakis

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