On Monday December 29 2009, the U.S. Federal Reserve proposed a program to sell interest bearing term deposits to banks, in an attempt to reduce some of the $1 Trillion in excess reserves that was pumped into the banking system earlier. The program would be part of an exit strategy to help reduce the inflationary impact of expanding the Federal Reserve’s balance sheet during the financial crisis, which was the largest monetary expansion in the history of the United States. Its balance sheet grew to $2.2 Trillion via various liquidity “bailout” programs, purchases of asset-backed securities, and other quantitative easing programs.
This proposal comes after recent comments from the Federal Reserve that inflation was not going to be an issue. They mentioned that they “expect that inflation will remain subdued for some time”. In addition, its only been a few weeks since analysts and bank economists had brushed off high inflation as a potential problem. The money supply was grown so rapidly through their debt purchases and was essentially funded by printing money. As mentioned in my earlier articles, because of their rapid printing of money, inflation would be an issue if they cannot reduce the money supply in a quick enough manner to minimize it’s impact. However, it will not be an easy task, as reducing the money supply too quickly would derail the economic recovery.
Furthermore, the central bank has stated that such a move would not have any implications for monetary policy decisions in the near term. However, we need to remember that is only their intent. Implications on monetary policy decisions are yet to be seen, and should not come as a surprise to people if it does have implications on such decisions.
The proposal indicates that term deposits could be sold in an auction or through a formula. The central bank indicated that the maximum rate for each auction of term deposits would be no higher than the general level of short-term interest rates. Basically, banks would be allowed to bid on the deposits and submit the interest rate that they would want on their money (up to the maximum rate). They would also submit the amount they would like to deposit. Likely terms are 14 day, 28 day and 84 day term deposits. Maturities would not exceed one year, and will probably range between 1-6 months. In a reverse repurchase agreement they would lend securities for a set period of time. At maturity the securities are returned to the Federal Reserve, while the money is returned to the primary dealers that act as counterparties to the central bank. Officials have proposed permanently reducing reserves through the sale of Treasuries or mortgage-backed securities.
These actions would reduce the money supply in the banking system, and would also be an attempt to gain more operational control over the federal funds rate. This is because the excess cash now held by banks would be tied up, in turn reducing downward pressure on the federal funds rate. To keep the federal funds rate set at the target determined by the Federal Open Market Committee, the Fed must prevent reserves from flooding the market and lowering the target rate.
The proposed plan is subject to a 30 day comment period. Fed officials are likely to determine maturities on the term deposits after banks have a chance to comment on the proposal.
The United States Federal Reserve:
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