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Monday, September 29, 2008


fed to pay interest on reserve deposits

across the curve cites the jpmorgan chase outlook.

This change would greatly increase the ability of the Fed to expand the size of its existing liquidity facilities. Under current procedures, any time the Fed has provided market liquidity by injecting reserves into the banking system — be it through the TAF, PDCF, discount window lending, lending to AIG, or other forms of Fed lending — the increase in reserves has had to be ’sterilized’ by selling Treasuries, conducting reverse repos, or, more recently, through the novel route of having the Treasury overfund itself to increase its account at the Fed. Those means of sterilization threatened to run up against certain balance sheet constraints: the Fed now has less than $250 billion of Treasuries that it hasn’t lent out through the TSLF and TOP, and the Treasury’s overfunding could eventually bump up against the debt ceiling.

With interest on reserves, the Fed would not have to sterilize injections of reserves into the banking system. Normally, reserve injections need to be sterilized to prevent the fed funds rate from undershooting the FOMC’s funds rate target. With interest on reserves, wherever the Fed sets the rate on its deposit facility would effectively set a floor under the funds rate: anytime the effective funds rate would be below the deposit rate, banks would have an incentive to deposit excess reserves with the Fed. Excess reserves would be ’sterilized’ by banks depositing them with the Fed.

One proposed operating procedure using interest on reserves, called the floor system or the Goodfriend system, would have the Fed set the deposit rate at the FOMC funds target rate and then inject massive amounts of reserves into the banking system — possibly by increasing TAF or similar facilities — and allowing the excess reserves to be deposited with the Fed at the target rate. Following such an operation, the Fed’s balance sheet would contain more risky assets and — on the liability side — more deposits (the monetary base would be roughly unchanged); the private sector’s balance sheet would contain less risky assets and more safe assets in the form of deposits with the Fed. The effect on the private sector balance sheet from the TARP is similar, though in that plan Treasury debt takes the place of Fed deposits.

expect then to see significant expansion of the fed's balance sheet.

in conjunction with the expansion of the last two weeks, this becomes a major turning point in the history of american monetary policy. in reaction to a precipitate debt-deflationary unwind, the united states government is regretfully -- in what is to my mind and that of minyanville's mr. practical misguided defense of asset prices -- embarking on an inflationary path that may well lead to significant destruction of the purchasing power of the dollar. to be sure, these first halting steps are not tantamount to a hyperinflation; but they may be taken as a compass upon which to infer the government's future direction. the adjustment in our wealth and standard of living will, if government succeeds, be transmitted to us not in lost savings and income but in the diminishment of the real value of those savings and income streams.

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