The word is out that the Fed will rely on money-market funds to help sop up the “excess” liquidity created by the Fed’s record-shattering explosion of credit.
The Fed has been discussing its “exit strategy” ever since it pumped huge amounts of credit into the markets since mid-2008. The dilemma, in Ben Bernanke’s mind, is that if it tightens credit in an attempt to reduce the volume of “excess” reserves, it may quash the recovery. On the other hand, if it doesn’t reduce the credit created it faces the specter of inflation — perhaps very high inflation.
The plan is that the Fed will allow money-market funds to purchase Treasury debt directly from the Fed, much as do primary dealers.
According to the report:
“The Federal Reserve is in talks with money-market mutual funds on agreements to help drain as much as $1 trillion from the financial system as policymakers prepare for the first interest-rate increase since June 2006, according to a person familiar with the discussions.
“The central bank is looking to the money-market mutual fund industry, which manages $3.2 trillion in assets, because the 18 so-called primary dealers that trade directly with the Fed have a capacity limited to about $100 billion, estimates Joseph Abate, a money-market strategist at Barclays Capital in New York.
“Money-market funds may welcome the opportunity to trade with the Fed after the financial crisis reduced the supply of safe assets in which they can invest.”
This has several ramifications. First, as U.S. savings continue to increase, more money has been flowing into the money market, which has resulted in a jump in the amount of Treasuries bought by the domestic market.
Second, this new policy will further increase domestic purchases of Treasuries because in a competitive market, money-market funds can buy Treasuries cheaper at the Fed window and offer better yields to investors. Domestic buying also will help offset any threat of foreign dumping of Treasuries.
We just saw where China took the opportunity to dump 4.3 percent of its U.S. holdings in December, which put Japan into the No. 1 spot of foreigners holding Treasuries. The strong Treasuries market gave China an opportunity to lighten up. There are rumors floating around that it really isn’t dumping Treasuries, but there is still the danger that as the U.S. deficit grows, foreign buyers will become averse to Treasuries.
With the PIIGS in trouble, money has been flowing into Treasuries and the dollar rallied against the euro. On the other hand, the threat of Fed tightening scares buyers because that would drive down the price of Treasury paper. It’s a complicated game.
What increased domestic demand for Treasuries will do for us is serve as a cushion against well-founded foreign doubts about our fiscal resolve and take pressure off the dollar. For the time being. Thus we can expect relatively low interest rates as demand for Treasuries will stay strong.
When will the Fed tighten? It thinks it will soon, but it won’t. In the latest FOMC report, the Fed raised its estimate of 2010 GDP growth from 3 percent to 3.2 percent. This enabled the inflation hawks (Thomas Hoenig) to muster enough brass to say that the Fed needed to tighten credit sooner rather than later. But what if GDP growth stalls? I am looking for flat real growth this year, which is based on an anticipated decline in economic activity in the second half of 2010.
In such a scenario, the Fed has few alternatives. Additional fiscal stimulus spending is probably infeasible because of political pressure. It wishes to increase the interest rates on reserve accounts at the Fed to entice banks to leave their reserves there, but as I have been pointing out, banks don’t view their reserves as excess as long as they fear the impact of bad CRE debt to their balance sheets and Tier 1 capital ratios.
The Fed is also considering reverse repurchase agreements with mortgage lenders Fannie Mae and Freddie Mac, according to a person familiar with the discussions. Freddie Mac spokeswoman Sharon McHale declined to comment, as did Fannie Mae spokesman Brian Faith.
“To further increase its capacity to drain reserves through reverse repos,” Bernanke said, the Fed is “in the process of expanding the set of counterparties with which it can transact” beyond primary dealers of government securities.
As we all know, the Fed holds about $1.25 trillion in GSE paper. It needs to unwind these holdings in order to drain credit from the pond. But will Fannie and Freddie do that? They are lending like crazy right now and selling paper as fast as they can to follow Congress’ mandate to save the housing market. Reverse repos would thwart this effort and probably cause mortgage rates to rise. If the Fed thinks foreign sovereign wealth funds will step in to take up the Fed’s position, they are mistaken.
Look for a continued strong dollar, increased demand for Treasuries from domestic buyers and continued low interest rates — and wait for the double dip.
What a tangled web the Fed weaves.
— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.