Thursday, December 31, 2009

The Fed Wants To Absorb Excess Reserves -- Quick

The Fed proposed today to sell term deposits, a few weeks after setting up three-party reverse repos. Both are meant to absorb the banks' excess reserves after the largest monetary expansion in U.S. history. That expansion could cause high inflation, which the Fed typically fights by increasing interest rates. But would that work this time?...

Banks hold so much cash that they would still be able to lend to each other at very low rates even if the Fed started to increase its discount rate. To pump so much cash out of the banking system, the Fed seems to realize it has few means, so it began experimenting with the tri-partite reverse repos -- in addition to more traditional tools like the sale of Treasuries, MBS, and now, deposits.

In my view, the Fed acts like admitting their main inflation-fighting weapon (rates increase) would be ineffective if it had to be used today, and that they're running out of time and out of tools to fix that weapon (i.e., to absorb excess reserves).

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