Tuesday, February 26, 2013

Draining excess reserves and the exit strategy

Questions continue to surround the Fed’s eventual exit from years of quantitative easing. The ultimate fate of what is to become of the 3.5 - 4 trillion dollar portfolio of securities (the expected peak holdings of Fed’s balance sheet) will determine, among other things, long-term interest rates, mortgage rates, corporate and US government borrowing costs, profitability of the banking system, returns on pension and insurance portfolios, and even the value of the dollar. In short, the exit strategy will drive the fixed income markets for years to come.

Some argue that the Fed has no need to sell securities and can simply sit on the portfolio as it winds down naturally through maturities and prepayments. The Fed can keep the economy from overheating by simply raising rates on excess reserves. And the fact that bank reserves (deposits at the Fed) will be in the trillions for years to come shouldn't matter they argue. That's because these reserves do not result in excessive lending and therefore are not inflationary. The lack of transmission from excess reserves to lending is visible in the so-called money multiplier (discussed here), which is at historical lows.

In normal times this argument may hold, but these are by no means normal times. By purchasing unprecedented amounts of securities, the Fed “created” trillions of excess reserves. And the central bank may not want to wait until 2020 (see post) for the reserves to decline to more normal levels on their own. Here are some reasons:

1. Some economists feel that even though reserves do not immediately transmit into lending, bank loans and leases have been rising steadily since early 2011 (QE2), and over the years could, if left unchecked, raise the money supply to inflationary levels.

Loans and leases on US banks' balance sheets (source: NY Fed)

2. Bloated excess reserves may ultimately impact the value of the dollar.

3. There are concerns that over a longer period, excess reserves could distort certain markets, creating financial bubbles - as banks seek to deploy cheap capital (in real estate for example).

4. With the reserves at their expected peak the Fed would be paying out about $6bn per year in interest to banks on riskless deposits. And those of us who have checking and savings accounts know that the rate we get on deposits is close to zero. Corporate accounts are not much better. That means that the banking system will get to keep most of that money. Now if the Fed raises the rate it pays on reserves (as suggested above), the banks will generate multiples of that amount in riskless profits. Once again, in a normal environment that would not be a big deal, but these days the Fed doling out free money to banks is not going to be very popular with the public.

These are some of the reasons the Fed may choose to drain at least some of the reserves. Selling assets may be one way to do it, but that may shake up the markets and significantly raise long-term interest rates. It will also generate realized losses for the Fed – another potentially unpopular outcome. But there is another solution. Back in 2009 the Fed set up tri-party repo arrangements with a number of dealers (see 2009 post). Eventually that will allow the central bank to lend out the securities instead of selling them. As dealers borrow the securities over a period of a week for example, they post cash as collateral to the Fed (dealers pay the coupon on the securities they borrow and receive the market repo rate on their cash “collateral”). That cash going into the repo account is taken out of “circulation”, thus draining the reserves.

If the Fed rolls these repo positions over time, the reserves will stay “drained” but the securities will still be owned by the Fed - until they pay down or mature. In effect the Fed would sterilize some or all of its securities purchases. Which means that draining the reserves does not have to entail the painful process of active portfolio unwind. And draining excess reserves is in fact a more likely exit strategy than some economists have been expecting.

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