Wednesday, February 10, 2010

Bernanke: We Are About to Ditch the Fed Funds Rate as Target

In fascinating prepared testimony written for delivery before the Committee on Financial Services of the U.S. House of Representatives, Federal Reserve Chairman Ben Bernanke has outlined the current Federal Reserve's plan for a continued winding down of its various emergency programs instituted beginning in September, 2008. The actual appearance by Bernanke before the committee was postponed was postponed because of the heavy snow conditions.

Of note:

1. Bernanke is signalling that the Fed may ditch the Fed Funds rate as a target

2. The Fed appears ready to raise the discount rate as a symbolic measure.

3. The Fed is going to wind down its purchases of mortgage backed facilities (Watch those excess reserves shrink!)

4. The Fed since the start of the year has closed out most of its other special credit facilities.

Specifically, Bernanke says with regard to the abandonment of the Fed Funds rate as a target (temporarily, he says)
As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn.
I am not sure when Bernanke figured out the Fed Funds rate has become irrelevant, and I am still not sure if he gets exactly why it is irrelevant, but if you are a long time EPJ reader, you knew the Fed Funds were irrelevant in say, October 2008, one month after the Fed started monkeying with interest payments on excess reserves. See my story written on October 7, 2000: Fed Funds Rate Cuts Have Become Irrelevant

That Bernanke is only pointing to the irrelevancy of the Fed Funds rate now brings into focus my continued warning that by Bernanke introducing all these new Fed tools, the danger exists that one of them creates some type of unexpected byproduct that creates major havoc with the monetary system. (File this paragraph under: Bernanke as Mad Scientist)

Bernanke also appears ready to raise the discount rate:
In addition, the Federal Reserve is in the process of normalizing the terms of regular discount window loans. We have reduced the maximum maturity of discount window loans to 28 days, from 90 days, and we will consider whether further reductions in the maximum loan maturity are warranted. Also, before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate. These changes, like the closure of a number of lending facilities earlier this month, should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets; they are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC.
Translation: The discount rate hike will be largely cosmetic in nature.

If the market drops on news of the discount rate hike, it's a signal that there are a lot of clueless traders out there.

Those who have been concerned about the huge excess reserves, are going to be in for the biggest surprise. The climb on the monetary base is about to stop and the drain is about to begin. Heree's Bernanke telling us the climb in the monetary base is about to end (My emphasis):
With its conventional policy arsenal exhausted and the economy remaining under severe stress, the Federal Reserve decided to provide additional stimulus through large-scale purchases of federal agency debt and mortgage-backed securities (MBS) that are fully guaranteed by federal agencies. In March 2009, the Federal Reserve expanded its purchases of agency securities and began to purchase longer-term Treasury securities as well. All told, the Federal Reserve purchased $300 billion of Treasury securities and currently anticipates concluding purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt securities at the end of March. The Federal Reserve's purchases have had the effect of leaving the banking system in a highly liquid condition, with U.S. banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks...
Here's how Bernanke plans to drain the funds (my emphasis):

The Federal Reserve has also been developing a number of additional tools it will be able to use to reduce the large quantity of reserves held by the banking system. Reducing the quantity of reserves will lower the net supply of funds to the money markets, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate on reserves and other short-term interest rates.
One such tool is reverse repurchase agreements (reverse repos), a method that the Federal Reserve has used historically as a means of absorbing reserves from the banking system. In a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future. The counterparty's payment to the Federal Reserve has the effect of draining an equal quantity of reserves from the banking system. Recently, by developing the capacity to conduct such transactions in the triparty repo market, the Federal Reserve has enhanced its ability to use reverse repos to absorb very large quantities of reserves. The capability to carry out these transactions with primary dealers, using our holdings of Treasury and agency debt securities, has already been tested and is currently available. To further increase its capacity to drain reserves through reverse repos, the Federal Reserve is also in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as collateral in these transactions.

As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions' reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves. A proposal describing a term deposit facility was recently published in the Federal Register, and we are currently analyzing the public comments that have been received. After a revised proposal is reviewed by the Board, we expect to be able to conduct test transactions this spring and to have the facility available if necessary shortly thereafter. Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so.

The Federal Reserve also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve's balance sheet.

The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments.... help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid. The Federal Reserve is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities. Although passively redeeming agency debt and MBS as they mature or are prepaid will move us in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted.
So there you have, Bernanke's mad tools to drain the system of excess reserves. On the surface, it should work, but the devil is in the details. What kind of surprise kinks will Bernanke's new tools cause? We know of two kinks that have occurred already. When correspondent banks were at first not allowed to earn interest on deposits with banks that were members of the Fed system, they started pulling their funds. The Fed quickly patched this up by allowing the pass through of the interest. Secondly, the new irrelevance of the Fed Funds rate has to be classified as a kink. Bernanke is only discussing now after it was a clear abnormal change to the system in 2008.

Both these kinks, and that's what they were, did not crash the system, but as the mad scientist Bernanke uses even more tools to drain the system, who really knows if there are other more serious kinks out there.

If things go smoothly with the drain, and they very well could, those who have been screaming about the exploding monetary base are going to have egg all over their face. If there is some unknown kink, Bernanke could blow all are bank accounts up.

To date, Bernanke has been able to wind down the credit facilities fairly smoothly: help stabilize financial markets and to mitigate the effects of the crisis on the economy, the Federal Reserve established a number of temporary lending programs. Under nearly all of the programs, only short-term credit, with maturities of 90 days or less, was extended, and under all of the programs credit was overcollateralized or otherwise secured as required by law. The Federal Reserve believes that these programs were effective in supporting the functioning of financial markets and in helping to promote a resumption of economic growth. The Federal Reserve has borne no loss on these operations thus far and anticipates no loss in the future. The exit from these programs is substantially complete: Total credit outstanding under all programs, including the regular discount window, has fallen sharply from a peak of $1-1/2 trillion around year-end 2008 to about $110 billion last week.
This drain, however, was pretty much in line with an expansion of the MBS purchase program. Now the absolute drain begins.

I'd tell you to buy popcorn, but generally the popcorn eating is for when you are watching an out of control car chase on the big screen from a comfortable seat in a movie theatre, not when you are a backseat passenger in the car that is being chased, and backseat passenger in Bernanke's mad money ride is exactly where you are.

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