Sunday, March 11, 2012

Fed's sterilized purchases will raise short term rates

Much confusion still persists in the media about the Fed's potential "sterilized" securities purchases. The diagram below shows the flows of securities and cash for such a transaction. Note that "Dealer 1" and 2 here may be the same dealer, but most likely multiple dealers involved in multiple transactions - selling securities to the Fed as well as lending cash to the Fed. The custodian bank would typically be State Street, BNY Mellon, or JPMorgan.



These types of transactions are extremely common among financial institutions globally - billions get transacted daily. In Europe this has become the predominant way that banks lend to each other.

This type of program allows the Fed to reduce long term rates (thus lower corporate borrowing costs and mortgage rates) by purchasing longer term securities (as it has been doing with Operation Twist). At the same time the Fed keeps the monetary base constant by sweeping out the cash it has put into the system. But this monetary strategy doesn't come for free. The "Cash borrowed" in the above diagram is typically a very short term loan, often just overnight. With sufficient amount of sterilized purchases, the Fed will increase demand for short-term money as it keeps re-borrowing hundreds of billions each day. And that may raise short-term rates, possibly even the Fed Funds (unsecured) rate. Therefore lowering long-term rates in a sterilized fashion may end up raising short-term rates - there is no "free lunch". It is therefore unlikely the Fed would employ such strategy in the amounts as large as QE2 or run it for a long time.

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