The Fed's New Operating Tool - The TAF

by: John M. Mason

My February 12 post reviewed the operations of the Federal Reserve in 2007. The analysis stopped short of the full year because of the innovations that the Fed introduced in December. This post picks up the story. On December 12, 2007, the Federal Reserve announced, along with the Bank of Canada, the Bank of England, the European Central Bank [ECB], and the Swiss National Bank [SNB] “measures designed to address elevated pressures in short-term funding markets.” The actions taken by the Federal Reserve included the establishment of a temporary Term Auction Facility (TAF) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank. Under the TAF program, the Federal Reserve auctions term funds to depository institutions against a broader range of collateral than under normal open market operations. The effort is to “help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.” In effect, the Federal Reserve used the TAF to supply reserves to the banking system for terms of roughly one month while reserving the use of its standard tools— repurchase agreements and reverse repurchase agreements—for shorter term reserve adjustments. The temporary reciprocal currency arrangements with the ECB and the SNB will provide dollars for these organizations to use for supplying liquidity within their jurisdictions. The swap lines were approved by the Federal Open Market Committee of the Federal Reserve System for up to six months.

One can observe the use of these facilities on the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions. The Federal Reserve release can be obtained from the website of the Federal Reserve under “Economic Research and Data” and then “Statistical Releases and Historical Data.” There is a new line item on this release called TERM AUCTION CREDIT: an increase in Term Auction Credit supplies reserves to the banking system. The information on the swap lines is a little more difficult to come by…it is aggregated in the line item labeled OTHER FEDERAL RESERVE ASSETS. The only thing one can say about this line item is that it usually does not change very much. The swap transactions with the ECB and the SNB are usually relatively large and hence can be estimated by the magnitude of the changes in Other Federal Reserve Assets. An increase in Other Federal Reserve Assets supplies reserves to the banking system.

Now, let’s review Federal Reserve actions for the period that includes December 2007 through the most recent statistical releases. I will divide this period up into the time before the banking week ending January 23, 2008, the banking week ending January 23, and the time period after this. The crucial date in all of this is January 21, 2008 which is the day that information became available about the $7.2 billion write-off to be taken by a French bank due to the actions of one of its traders. This knowledge and the fact that the bank was trying to sell off the positions established by this trader led to a ‘liquidity crises’ in world security markets. The next morning the Federal Reserve announced that it was lowering its target Federal Funds rate by 75 basis points, an extraordinary amount. But, let’s go back to early December.

Up through the banking week ending January 16, 2008, two factors dominate the statistics. First, there is the normal Christmas season/end-of-year swing in various items that are a part of the Fed’s basic operations. Currency in circulation always increases in the holiday season and then declines right after the first of the year. This season was no exception and was handled in the usual way. Second, however, there was the introduction of the TAF. The first auction settled on December 20 and was for $20.0 billion; the second auction settled on December 27 and it, also, was for $20.0 billion. These can be seen clearly on the H.4.1 for the banking weeks ending December 26 and January 2. One can also notice from these releases that OTHER FEDERAL RESERVE ASSETS increase by $14.3 billion and $11.2 billion, respectively. We assume that these increases reflect the use of the swap lines set up with the ECB and the SNB. The Federal Reserve offset these increases by allowing parts of its Treasury bill portfolio to mature without being replaced ($29.0 billion) along with a decline in repurchase agreements ($16.0 billion). Roughly, the Federal Reserve added $65.5 billion in reserves to the banking system through the new measures announced on December 12, 2007, and allowed $45.0 billion in securities to run off which reduce reserves in the banking system. The difference between the two offset other factors influencing bank reserves with nothing else out-of-the-ordinary occurring. Thus, the initial implementation of the new facilities seemed to go ahead without any disruption to the financial markets.

World financial markets dropped precipitously on Monday, January 21, a day which fell into the banking week ending January 23. On that Monday afternoon members of the FOMC got together by phone and voted to reduce the Fed’s target Federal Funds rate by 75 basis points. The Fed had already injected the third round of TAF funds into the banking system on January 17 in the amount of $30.0 billion, $20.0 to replace those funds maturing from the first auction plus an additional $10.0 billion. The financial markets stabilized: the only market comment being on the size of the reduction of the target rate. In terms of the statistical data, even with all the turmoil in the world markets, there was very little movement in the Fed’s major operating areas.

Three important things events took place in the next three banking weeks. First, at the January 29 meeting of the FOMC, the committee lowered the target Federal Funds rate another 50 basis points, bringing the total reduction to 125 basis points in ten days. This was huge, historically! Second, the Fed held another auction on January 28 for $30.0 billion, $20.0 to replace the funds maturing from the second auction and another $10.0 million in new auction funds. Third, in the banking week ending January 30, the Fed put about $8.0 billion of reserves into the banking system by means of repurchase agreements. These were allowed to expire in the banking week ending February 6 along with another $3.3 billion of repurchase agreements that expired in the banking week ending February 13. One can assume that these repurchase agreements had provided liquidity to help settle the market turmoil mentioned above and as the disruption receded the Fed just allowed these positions to unwind.

The market sell-off on January 21 represented a true liquidity crisis. Here a banking organization HAD to sell securities. The bank was identified and the market realized that A LOT of securities had to be sold. As has been described in earlier posts, this meets the definition of a liquidity crisis where the question becomes, “Where should market prices be?” Until the market is able to answer this question sellers in the market tend to outnumber buyers and prices continue to fall. The classic response of the central bank is to provide liquidity to the marketplace. And that is what the Federal Reserve did.

Operationally, the Federal Reserve seems to have acted quite well during this whole period. It handled the normal seasonal swings without any trouble. It also proceeded with the transition to the TAF and the swap agreement without difficulty. Basically, the Fed put $60.0 billion in Term Auction Funds into the banking system while allowing $65.0 in it holdings of US Treasury securities to mature without replacement. Finally, here we are four weeks after the ‘liquidity scare’ and markets are functioning without problems. Yes, there are still solvency problems that must be resolved, but that is another story, a longer-term story. One can argue that the Fed’s actions in January and beyond helped to short-circuit the liquidity crisis which is exactly what a central bank is supposed to do.

People in the financial markets, as well as analysts, still have some questions about the leadership of the Fed. Many market participants feel that last fall there was a disconnect between what the Fed said and what the Fed eventually did. Also, the substantial drop in the target interest rate raised a flag about the stability of Fed decision making. Concerns like these contribute to a lack of complete confidence in the abilities of those currently guiding the Fed. Public officials, until their credibility is proven, always face confidence issues early on in their tenure.