Federal Reserve: Readying a Stealth Tightening of Monetary Policy?

The Federal Reserve impacts the economy by raising and lowering the Federal Funds Rate. With the Fed Funds rate currently at a range of 0-.25%, the Federal Reserve has no more ammunition to positively impact the economy, right? No! Readers of Sense on Cents are fully aware of the other measures the Fed, in conjunction with the Treasury, has utilized to inject money into the economy, including:

1. Quantitative easing in which the Fed has purchased U.S. Treasury and mortgage-backed bonds.
2. Backstopped money market funds (FYI . . this program ended last Friday).
3. Providing federal guarantees for banks to issue debt.
4. Facilities to assist in the issuance of securitized assets (TALF).

Collectively, these programs have achieved an effective negative Fed Funds Rate. This development is not only historic but very daunting for the economy and market. When and how will the Federal Reserve and Treasury begin to exit some of these programs, and take some liquidity out of the system without spooking the markets? In the process, the Federal Reserve will begin a de facto tightening of the monetary policy even if it does not immediately begin to raise the Fed Funds Rate.

This tightening process may be in its formative stages. How do we know? Bloomberg reports, Fed Said to Start Talks With Dealers on Using Reverse Repos:

The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.

Central bank officials are discussing plans to use so- called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That’s where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system.

Given the amount of liquidity the Fed has pumped into the economy over the last year, these reverse repurchase agreements would have to be of huge size and for a longer tenure in order to truly make an impact.

What would be the impact of sizable reverse repurchase agreements? I would make the following assessments based upon my feeling that the market would perceive these agreements as a tightening of Fed policy:

1. The yield curve would flatten, meaning short term rates would raise relative to long term rates (revisit your Algebra II chapter on slope).
2. The U.S. dollar would strengthen as the market perceives this move an indication that the Fed is closer to raising the actual Fed Funds Rate than it was previously.
3. The markets, both equities and bonds, would very likely sell off in a reversal of the price action of the last six months. Both our equity and bond markets have been supported by the cheap funding provided by the Fed. This phenomena led to the dollar carry trade which I highlighted a week ago in writing, “Dollar Carry Trade Drives Global Equity Markets.”

The dollar is getting hammered again today and that fact is supporting our markets, both equity and bonds. Watch the US Dollar Index as it is clearly the best indicator as to the Fed’s intentions and market direction. If and when you see the dollar start to improve (currently quoted at 76.13), then look for stocks and bonds to weaken.

Disclosure: No position in US Dollar

Comments

[Moon Kil Woong:]

Thanks for your perception. Any move at fiscal tightening and a strong dollar move upwards is a death knell for the current market rally. Apparently the Federal Reserve, even under Bernake who is the loosest Fed Chief in history (even more than Greenspan), doesn't like the idea of the dollar dropping more than 5% a year with inflation or no inflation. Certainly, I don't either.

We all seem to be in the market until the government calls an end to the game of musical chairs.

Sep 23 05:55 AM

[Michael Clark:]

I like your disclosure: 'no position in the U.S. Dollar'.

That's funny, because all Americans and many foreigners have a position in the U.S. Dollar even if they don't think they do.

Very interesting article. The only thing that infuriates bankers more than seeing gold rise in price is seeing real assets deflate. They're between a rock and a hard place. They have to keep rates low to protect asset prices (stocks and real estate), but that also puts a floor beneath gold prices.

Sep 23 06:20 AM

[Pauly B:]

Great great insight. Wish you were a FED governor!

My fear is that if the FED doesn't get this exit of stimulus right the consumer is really going to take it on the chin.

I hope the FED does say something about the dollar today. This is getting concerning. If they dont I am going to see it in the grocery isle!

Sep 23 09:44 AM

[Steve B. Wise:]

Very nice piece.

Sep 23 11:37 AM

[JasonC:]

$700 billion in short term credits the Fed supplied as of this April have already been repaid.

Sep 23 12:00 PM

[tunaman4u2:]

The programs are the 1st to go prior to rate cuts... I agree 100%

Sep 23 12:17 PM

[Mad Hedge F...:]

edc ) I spent the evening with David Wessel, the Wall Street Journal economics editor, who has just published In Fed We Trust: Ben Bernanke’s War on the Great Panic. I doubted David could tell me anything more about the former Princeton professor I didn’t already know. I couldn’t have been more wrong. Bernanke was the smartest kid in rural Dillon, South Carolina, who, through a series of improbable accidents, ended up at Harvard. He built his career on studying the Great Depression, then the closest thing to paleontology economics had to offer, a field focused so distantly in the past that it was irrelevant. Bernanke took over the Fed when Greenspan was considered a rock star, inhaling his libertarian, free market, Ayn Rand inspired philosophy. Within a year the landscape was suddenly overrun with T-Rex’s and Brontesauri. He tried to stop the panic 150 different ways, 125 of which were terrible ideas, the remaining 25 saving us from the Great Depression II. This is why unemployment is now only 9.8%, instead of 25%. The Fed governor is naturally a very shy and withdrawing person, and would have been quite happy limiting his political career to the local school board. But to rebuild confidence, he took his campaign to the masses, attending town hall meetings and meeting the public like a campaigning first term congressman. The price of his success has been large, with the Fed balance sheet exploding from $800 million to $2 trillion, solely on his signature. The true cost of the financial crisis won’t be known for a decade. The biggest risk now that having pulled back from the brink, we will grow complacent, and let needed reforms of the system slide. How Bernanke unwinds this bubble will define his legacy. Too soon, and we go back into a depression. Too late, and hyperinflation hits. Let’s see how smart Bernanke really is.

Sep 23 09:45 PM