Fed Ponders New Surgical Tool

February 1, 2010 at 2:00 am 1 comment

The Fed is closely monitoring the recovering patient (the U.S. economy) after providing a massive dose of monetary stimulus. The patient is feeling numb from the prescription, but if the Fed is not careful in weaning the subject off the medicine (dangerously low Federal Funds rate), dangerous side- effects such as a brand new bubble, rampant inflation, or a collapsing dollar could ensue.

In preparing for the inevitable pain of the Federal Reserve’s “exit strategy,” the institution is contemplating the use of a new tool – interest rates paid to banks on excess reserves held at the Fed. A likely by-product of any deposit-based rate increase will be higher rates charged on consumer loans.

Currently, the Federal Reserve primarily controls the targeted Federal funds rate (the rate at which banks make short-term loans to each other) through open market operations, such as the buying and selling of government securities. Specifically, repurchase agreements made between the Federal Reserve and banks are a common strategy used to control the supply and demand of money, thereby meeting the Fed’s interest rate objective.

Source: Data from Federal Reserve Bank via Wikipedia

Although a relatively new tool created from a 2006 law, paying interest on excess reserves can help in stabilizing the Federal Funds rate when the system is awash in cash – the Fed currently holds over $1 trillion in excess reserves. Failure to meet the inevitably higher Fed Funds target is a major reason policymakers are contemplating the new tool. The Fed started paying interest rates on reserves, presently 0.25%, in the midst of the financial crisis in late 2008. Rate policy implementation based on excess reserves would build a stable floor for Federal Funds rate since banks are unlikely to lend to each other below the set Fed rate. The excess reserve rate-setting tool, although a novel one for the United States, is used by many foreign central banks.

Watching the Fed

While the Fed discusses the potential of new tools, other crisis-originated tools designed to improve liquidity are unwinding.  For example, starting February 1st, emergency programs supporting the commercial paper, money market, and central bank swap markets will come to a close. The closure of such program should have minimal impact, since the usage of these tools has either stopped or fizzled out.

Fed watchers will also be paying attention to comments relating to the $1 trillion+ mortgage security purchase program set to expire in March. A sudden repeal of that plan could lead to higher mortgage rates and hamper the fragile housing recovery.

When the Fed policy makers meet this week, another tool open for discussion is the rate charged on emergency loans to banks – the discount rate (currently at 0.50%). Unlike the interest rate charged on excess reserves, any change to the discount rate will not have an impact charged on consumer loans.

While the Fed’s exit strategy is a top concern, market participants can breathe a sigh of relief now that Federal Reserve Chairman Ben Bernanke has been decisively reappointed – lack of support would have resulted in significant turmoil.

The patient (economy) is coming back to life and now the extraordinary medicines prescribed to the subject need to be responsibly removed. As the Federal Reserve considers its range of options, old instruments are being removed and new ones are being considered. The health of the economy is dependent on these crucial decisions, and as a result all of us will be carefully watching the chosen prescription along with the patient’s vital signs.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds but at the time of publishing had no direct positions in securities mentioned in the article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Banking, Government. Tags: , , , , , , , , .

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1 Comment Add your own

  • 1. Btok  |  February 1, 2010 at 8:47 am

    Attention: American Voters, all who voted to give Ben Bernanke another four year term, should be bounced out of Congress, come the election of 2012!
    Make sure you mark them in your Memo pad so you remember to vote each and every one of them out of office in the election of 2012!

    Reply

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