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Brian Benton




02/16/10 at 3:39 PM CST



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Fed Exit Strategy? Preparing For Inflation: SPDR Gold Trust et al. Part 2

In late July of last year, I provided an analysis of the tools the Federal Reserve was proposing it might use to facilitate an exit from the substantial amount of bank reserve creation (and resultant balance sheet expansion) since September 2008 (Fed Exit Strategy?). Also discussed were some of the problems I felt the Fed would encounter when attempting to execute a real exit. Months later, despite Bernanke's recent press release concerning the Fed's exit strategy, the Fed has not offered anything substantially new.

I would like to begin by offering that the tools the Fed is considering and the use of these tools does not constitute an exit strategy. These tools, such as the 1) continued paying of interest on bank reserves and potentially raising the interest paid on those reserves, 2) paying interest on term deposits, and 3) executing reverse repurchase agreements, are not exit tools. They are delay tactics. Paying interest on reserves (including term deposits) is simply locking up excess reserves or sterilizing them (reserves are not drained). That is, the Fed is using this as a tool to discourage banks from lending and/or investing these excess reserves into the economy, which would result in increases to the money supply and eventually price inflation (all other things being equal). Reverse repurchase agreements are temporary (short term loans to the Fed that drain reserves) ... once they mature, reserves flow back into the commercial banking system. The Fed will likely use reverse repurchase agreements to test the waters this year. But this is not a permanent solution and it is debatable whether the Fed will obtain the information it seeks over such a short duration (maturities are typically less than one month), even with a comprehensive set of staggered reverse repurchase agreements.

The Fed must commence a hearty program of selling assets (assets it purchased in significant quantities since September '08) to execute a real exit strategy. Anything else is simply stalling and does not reduce the Fed balance sheet in any meaningful way. I outlined the problems the Fed will likely face in selling these assets in the above linked July '09 article. The three principal assets the Fed holds on its balance sheet are agency mortgage-backed-securities (MBSs) ($977 billion), treasuries ($777 billion), and agency debt ($165 billion). Bernanke hints that selling assets is well into the future (I have no doubt this is the case). Meanwhile, the Fed may allow maturing MBSs and select maturing treasuries to expire without rolling them over into new securities (which will drain reserves). But this will be minimally impactful to the present size of the balance sheet.

The financial press has been fixated on interest rates influenced and/or set by the Fed, particularly when the Fed might begin increasing its target rate for federal funds (currently managed between 0% and 0.25%) as well as the discount rate (currently 0.50%). But focusing on these interest rates is not keeping the proverbial eye on the ball. Monetary policy targeting the federal funds rate (and discount rate) is impotent now (as discussed in the July '09 article). Massive bank reserve expansion by the Fed made sure of that. Banks are presently flush with reserves. $1.16 trillion in reserves are held on deposit with the Fed alone, significantly more than the roughly $10 billion held on deposit in early September of 2008. The Fed would need to drain a significant amount of reserves from the banking system simply to get the federal funds rate to drift meaningfully north from where it is today (near zero). Bernanke knows this. This is why he suggests that the interest rate paid on reserves will play an important role in implementing its objectives (an understatement). But simply increasing this rate does nothing to drain reserves and decrease the size of the Fed balance sheet. The discount rate is mostly irrelevant as well. There is little traffic at the discount window now. Primary credit offered by the Fed shows a balance of less than $15 billion.

But by speaking out about how the Fed is going to get tough with interest rates, Bernanke can fool most into thinking that the Fed is really tackling the tough problems and is executing a real exit strategy. But he is not. He is buying time ... allowing the Fed to determine the best option spread out over the longest time period possible. Such Fed actions will, however, have a psychological impact on investors accustomed to monetary policy before September of 2008 and believing that such policy is as impactful now as it was then.

At some point this year, the Fed will likely increase the interest rate it pays on reserves. The Fed may even move to increase the discount rate sooner (pinch me). In conjunction with the rate increase on reserves, the Fed will increase the target rate for federal funds to match. But this move to match will be meaningless for the reasons described above.  The interest rate the Fed pays on reserves obviates the federal funds rate. As far as timing is concerned, there is not a compelling reason for the Fed to move now as it is paying only 0.25% on reserves and the banking system still has over $1 trillion in excess reserves. If the banks are not lending these excess reserves now, why would the Fed pay them even more (increase in interest on reserves) to still not lend these excess reserves ... except maybe to send a little more cash their way? But again, this will not reduce the size of the Fed balance sheet.

The real action is going to be when the Fed decides it is time to seriously trim the size of its balance sheet ... permanently. That will be something worth analyzing. Or are we at (or near) a new normal (as Gary North suggests) with respect to the size of the Fed balance sheet and the permanent payment of interest on reserves as the key tool in implementing monetary policy at the Fed? This will not work either.

Related Trade: SPDR Gold Trust (ETF) (Public, NYSE:GLD)

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