MNI INTERVIEW: Repos Could Lower Fed Reserves, Political Heat

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve's plan to conclude asset runoffs

this year would still leave its balance sheet at levels that expose the central

bank to potential political pressure, St. Louis Fed economist David Andolfatto

told MNI, calling for the introduction of a standing repo facility as a way to

reduce banks' demand for reserves.

     Policymakers aim to whittle down the Fed's balance sheet to the minimum

level of bank reserves needed to control interest rates effectively. Market

participants project that level to be in the $1 trillion range, much higher than

their pre-crisis average $20 billion to $30 billion, driven by the demands of

new regulations on bank liquidity and orderly resolution.

     Such high levels of reserves could mean that the Fed might be forced to

make large interest payments to domestic and foreign banks if the central bank

significantly raises the interest rate on excess reserves, a situation

Andolfatto said could be "political dynamite."

     "We're subsidizing these large foreign banks by paying a high interest rate

on large reserves. This interest expense is costing the Treasury money. Why do

we want to do this?" he said. "If we could go back to $20 billion in reserves,

the optics look a lot better for the Fed," he said in an interview Thursday.

     --DEMAND FOR RESERVES

     A standing overnight repurchase facility allowing banks to swap Treasuries

for reserves at any time would give banks more confidence that they could buy

government debt - which offers a higher return than interest on reserves --

without fear of being unable to meet cash requirements in a hurry, Andolfatto

said. Demand for reserves would "decline substantially."

     "It will be a foolproof way of adjudicating the minimum level of reserves

needed," he said. "You wouldn't have to guesstimate like the New York Fed is

doing by surveying banks."

     Commercial banks, the U.S. Treasury and foreign central banks earn interest

on balances kept at the Fed. The IOER, currently set at 2.40%, is a key tool

used by the Fed to steer its benchmark federal funds rate.

     Eight of the largest U.S. banks may want to hold $784 billion in reserves

to cover emergency liquidity needs, according to a recent New York Fed analysis.

If they were to substitute Treasuries for these reserves, then the minimum level

needed for the Fed to implement monetary policy effectively "would be closer to

$200 billion," Andolfatto said.

     "It only makes sense. Why would banks hold low-interest reserves when they

could potentially be holding higher yielding Treasuries that are just as safe

and can be liquidated?" he said.

     The repo facility, whose rate would be set by the Fed, would also act as a

ceiling on short-term interest rates. According to the minutes of the latest

FOMC meeting, policymakers would support the use of such a tool.

     "A couple of participants suggested that a ceiling facility to mitigate

temporary unexpected pressures in reserve markets could play a useful role in

supporting policy implementation at lower levels of reserves," the January

meeting minutes said.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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