Mad Scientist Bernanke Plays with a New Tool from His Toolbox

We are in the middle of a crisis and Bernanke continues to play with new tools. I suspect he is really nervous that his plan to control money supply by controlling interest rates on excess reserves may not work the way he would like, and now he has backed himself into a corner because of the huge amount of excess reserves he has created by paying interest on the excess reserves.

The tri-party reverse-repos discussed in the NYT story below appears to be about the Fed's previous announcement that they may trade with money market funds when attempting to drain funds from the system. The advance announcement of the test appears to be so that it does not spook the market into thinking that the Fed is conducting a real drain:

The Federal Reserve Bank of New York said on Monday it had been working on a market tool it can use to withdraw cash from the banking system but stressed that it was not about to use it.

The New York Fed, which is the operational arm of the nation’s central bank, said it has been working over the past year to ensure that “this tool will be ready when and if” the policy-setting Federal Open Market Committee decides to use it.

Monetary policymakers have said that the tool, reverse repurchase agreements, also known as reverse repos, could be one way to drain excess reserves when the time comes to reduce the amount of credit that the central bank has provided to the banking system to avert the risk of inflation.

“This work is a matter of prudent advance planning by the Federal Reserve, and no inference should be drawn about the timing of monetary policy tightening,” the New York Fed said.

In a reverse repurchase agreement, the Fed sells assets such as Treasuries for cash with an agreement to buy them back later at a higher price, thus removing cash from the system.

The focus of the Fed’s recent discussions and tests was to get the documentation and systems in place to be able to conduct tri-party reverse repos, the New York Fed said. The Fed has been conducting tri-party repos with primary dealers since 1999.

In the tri-party repo market, the clearing banks JPMorgan Chase & Company and Bank of New York act as intermediaries, which allows for a wider range of instruments to be used in a transaction.

The New York Fed said “it is likely that the Federal Reserve will engage in additional tests in the future,” and that no actual operations have been conducted as part of these tests.

Playing with new tools in the middle of a crisis does not appear to be a sound move, in my view. The three basics by which to control money supply, the discount rate, the reserve requirement and basic open market operations have always worked just fine.

But, Bernanke's paying of interest on excess reserves (another of his new "tools") has created an unprecedented amount of excess reserves. That's why he is testing this new tri-party reverse repo, since he realizes if his interest rate policy doesn't work, he has created such a monster (excess reserves) that now it can't be put back into the box easily with the traditional three tools.

It remains to be seen what monsters tri-party reverse repos create. He's really winging it, now.

In Bernanke, we are truly watching a mad scientist at work, and the global economy is his laboratory.