The Fed’s stealth monetary ease

December 7, 2011

Banks took more than $50 billion from the European Central Bank on Wednesday in the first offering since it, the Federal Reserve and other major central banks slashed the cost of borrowing dollars in response to a worsening euro zone crisis. The high volume of emergency borrowing was seen as a sign that some of the region’s banks are having  problems obtaining dollar funding.

This means that, as our friend Mike Derby aptly predicted, the Fed’s balance sheet, currently around $2.8 trillion, will show a big increase when its weekly custody holdings figures are released on Thursday.

If one believes, as the Fed does, that the extent of unconventional monetary stimulus depends on the stock of assets the central bank holds rather than the “flow” of its interventions in Treasury and mortgage bond markets, then this amounts to a defacto monetary easing – about 1/12 of the Fed’s $600 billion QE2 bond-buying program.

Still, given that the move is a reaction to market tighteness, the overall economic impact will likely be more subdued, argues Alan Levenson at T. Rowe Price:

We do not expect the Fed to sterilize this operation, so that the expansion on the asset side of the Fed’s balance sheet (central bank liquidity swaps) will be offset by an increase in reserve liabilities. Technically, the increase in bank reserves represents an increment of “credit easing.” We view it as less potent than outright asset purchases, however, as it is a response to financial market dislocation (market-based tightening of monetary policy) and will dissipate as Europe’s interbank funding markets re-normalize.

George Goncalves at Nomura, for his part, was relieved that at least the stigma of such borrowing appeared to have been removed.

We view this as a positive first step. It leads a string of potential policy actions as authorities attempt to break the negative feedback loop from the eurozone and limit contagion back to the US. It will be a bumpy ride but this is encouraging news.

Still, he did not see such emergency liquidity measures as a sustainable solution to the underlying crisis.

Today’s action certainly changes the direction of funding stress, but it is not a game changer as it was in 2008-09. The problems facing USD funding markets are centered on counterparty risks because of lack of confidence about the EU situation and EU banks. Although this event should eventually motivate speculators to close their short positions in LIBOR/FX basis market, which should normalize these markets, it’s an EU story with concerns about sovereign and bank solvency in that region still unresolved.

One comment

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Hi Pedro-

Your conclusions, and Mike’s, I think are unwarranted, or at least premature, until we see the H41 for this week or next, depending on when the funding settles. If not same day, the effect would not show up until next week’s H41.

First, even assuming all of the $50 billion came via swaps with the Fed, custody holdings are custody holdings. They are assets of foreign central banks. They are not part of the Fed’s asset base. There is no direct connection between the swaps and the custody holdings.

In fact, sale of those holdings would one means by which the ECB could have raised the $50 billion in USD to fund these loans which would have NO IMPACT on the Fed’s balance sheet.

Even if we assume that the Fed funds the swaps, there are a number of ways that can be done and simultaneously sterilized. And there are ways it may be accomplished which would actually shrink the balance sheet.

In fact, the Fed’s balance sheet has been shrinking since June as MBS holdings have been paid down, and the replacement MBS purchases have apparently all been 60 day forwards. As a result, the Fed’s assets have shrunk by about $50 billion since July, and, all other things being equal, would not begin to rebuild to the $2.654 trillion SOMA target until the purchase program is complete this coming June, and the settlements continue through August. The point here is that the Fed has shown no inclination to grow its balance sheet. There’s been a lot of hot air about it, but they haven’t pulled the trigger.

I reported last month the big withdrawal from the bank reserves deposits at the Fed that went into Other Deposits. I tried, but failed, to interest any mainstream reporters, including your friend and mine Mike Derby in this massive transfer. There have now been several massive deposits and withdrawals between bank reserves and Other deposits on the Fed’s balance sheet in the past several months. The net amount remaining in Other was $52.8 billion last Wednesday. That’s a sea change from the nominal amounts typically held in Other deposits.

“Other,” as defined by the Fed, includes “foreign official organizations,” along with GSE direct deposit accounts at the Fed, and the account of the US ESF, aka the Plunge Protection Team.

Since we are making assumptions, let’s assume that the $52 billion are mostly funds of “foreign official organizations.” If these are ECB funds and the ECB withdraws them to fund these dollar loans, this would force the Fed to either borrow the dollars itself, which would seem to be a non starter under current market circumstances, or sell SOMA Treasury holdings outright, thereby SHRINKING rather than expanding the Fed’s balance sheet. The Fed could not on the one hand see its liabilities reduced and its assets increased. It would have to sell assets to fund the closing of the liability under this scenario.

Now I have no clue what WILL happen, but neither does Mike Derby, unless he just got off the phone with Ben. Maybe he’s right, maybe not. Let’s wait until the data is in before we jump to conclusions and maybe end up with contusions.

Lee Adler- The Wall Street Examiner

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