Fed fears risks posed by exit tools; plan almost done

JACKSON HOLE Wyoming Fri Jul 11, 2014 7:43pm EDT

U.S. Federal Reserve Chair Janet Yellen delivers remarks at the inaugural Michel Camdessus Central Banking Lecture at the International Monetary Fund in Washington July 2, 2014.  REUTERS/Gary Cameron

U.S. Federal Reserve Chair Janet Yellen delivers remarks at the inaugural Michel Camdessus Central Banking Lecture at the International Monetary Fund in Washington July 2, 2014.

Credit: Reuters/Gary Cameron

JACKSON HOLE Wyoming (Reuters) - Federal Reserve officials are cautiously nearing completion of a new plan for managing interest rates, concerned that some of the new tools they are likely to rely on could pose unintended risks in a crisis.

The central bank has devoted extensive debate to the matter over the past two months and officials "have made a lot of progress" on a strategy to return monetary policy to a more normal footing after years of coping with crisis, Chicago Federal Reserve Bank President Charles Evans said on the sidelines of an economic conference here.

However, the sheer magnitude of the amounts of money used to combat the crisis - $2.6 trillion sitting at the Fed as bank reserves and $4.2 trillion held by the Fed in various securities - may complicate the U.S. central bank's ability to control its target interest rate once the decision is made that it should be raised. A decision to begin increasing interest rates is expected in the middle of next year.

In recent weeks, the Fed has neared consensus that its workhorse tool will be the interest it pays banks on excess reserves on deposit at the Fed - giving the central bank a direct way to encourage banks to either take money out of circulation and leave it at the Fed, or lend it elsewhere.

Another tool would have a similar impact but apply more broadly, using overnight repurchase agreements that would let money market funds and other institutions as well as banks essentially make short-term deposits at the Fed.

The worry is that if financial conditions tighten, those large funds of money would flee to the repo facility as a safe haven, depriving the economy of credit and making a potential crisis even worse.

"The broad concern is whether we want to facilitate what could be a period of financial stress by providing in a large or unlimited way that refuge, and whether that would tend to exacerbate a financially stressful situation," said Atlanta Fed President Dennis Lockhart.

The concern is apparently widespread at the central bank. Minutes of the Fed's June policy committee meeting said that "most participants" shared worries about the "unintended consequences" of the repo facility and its potential to be used as a shelter from risk.

Still, the repo tool, which is being tested by the New York Fed, is expected to form part of the new exit strategy, although it is likely to be in what Lockhart described as a "supporting role." The minutes from the Fed's June meeting said that restrictions could be placed on the use of the repo tool to limit the potential risks.

Lockhart said a completed exit policy could be formally announced as early as this fall. The federal funds rate, which is the rate that banks charge each other for overnight loans, will remain part of the central bank's tool kit. But it is not expected to play the main role it has in the past because banks with rich reserves don't rely on that market as much as they used to for overnight funding.

(Reporting by Howard Schneider; Editing by Jan Paschal)

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Comments (9)
nose2066 wrote:
This story: “During a period of quick risk aversion … we would have to understand what movements into this product would be,”

This seems strange. Doesn’t the Federal Reserve decide ahead of time how much money it (the Fed) wants to borrow from the banks each night via this repo system?

Jul 11, 2014 6:36pm EDT  --  Report as abuse
CharlesReed wrote:
So as the Ginnie Mae MBS don’t actually have any underlying collateral at what point does the Fed deal with all those securities it has purchase?

Jul 11, 2014 7:05pm EDT  --  Report as abuse
CharlesReed wrote:
This is all because of the Housing Crisis with the Fed just put out some bogus report about the Independent (wink wink) Foreclosure Review Board that was any thing but independent. The GOA put out a report that with BOA it had something like a 24% error rate that was 20% away from what they Fed was basing it opinion to stop the reviews and re-settle in Jan 2013.

How does the Fed 1 1/2yr after the fact and the Justice Department settling with JPMorgan and Sun Trust Bank for bad securities that had bad underwriting approval, and falsifying documents and not actually processing the loan for modifications. The Justice Dept is is currently in negotiation with BOA, Citicroup and Wells Fargo all for the same thing as the other settlement, but the Fed is putting out that not many were financially harmed?

Who when the FHA took a $70 billion loan losses was on the receiving in of the illegal foreclosures and illegal insurance claims at the end of it all? It was the Fed who received these funds as the investor that purchase the Ginnie Mae Mortgage Backed Securities.

So the question come to mind, how was the Fed negotiating with the bank as to who was harmed when those harmed went to payments to the Fed! RICO come to mind in the behavior of the Fed as they are the investors in the matter of Ginnie Mae MBS!

Jul 11, 2014 8:07pm EDT  --  Report as abuse
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