MNI POLICY: Fed Staff Suggest Repo Facility To Cut Reserves

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve could further reduce the size of its

balance sheet by offering a repo facility allowing commercial banks to swap

Treasury bonds for reserves at any time, two Fed staff economists said

Wednesday.

     Market participants estimate that the Fed's plans to consolidates its

long-run monetary policy framework around a floor regime will see it holding

about $1 trillion in commercial bank deposits in excess of regulatory

requirements. But St. Louis Fed economist David Andolfatto and Fed Board

economist Jane Ihrig pointed out on the St. Louis Fed website that this would be

roughly 50 times pre-crisis levels, and noted that banks have been said to feel

under regulatory pressure to maintain high levels of high-quality liquid assets.

     While Treasury bonds are highly liquid and yield more than reserve deposits

at the Fed, banks may fear debt prices could fall at times of stress, leaving

them struggling to raise sufficient cash in an emergency, Andolfatto and Ihrig

wrote.

     A standing overnight repurchase facility allowing banks to swap Treasuries

for reserves at any moment would reassure lenders that they could meet their

requirements, they said. Eight large banks may hold a total $784 billion in

reserves to cover emergency liquidity needs, they said, citing the Federal

Reserve Bank of New York's Liberty Street Economics blog.

     "These banks would presumably not want or need $784 billion in reserves if

higher-yielding Treasuries could be liquidated at a modest discount on a

reliable basis in times of stress," wrote Andolfatto and Ihrig. "The Fed could

easily incentivize banks to reduce their demand for reserves by operating a

standing overnight repurchase (repo) facility that would permit banks to convert

Treasuries to reserves on demand at an administered rate."

     This rate could be set "a bit above market rates -- perhaps several basis

points above the top of the federal funds target range -- so that the facility

is not used every day, but only periodically when a bank needs liquidity or when

market repo rates are elevated."

     Having such a facility in place would make holding Treasuries more

attractive to banks, they said. Demand for reserves would "decline substantially

as a result."

     The FOMC in January committed to using an ample reserves framework for

implementing monetary policy but has set an aim to hold "no more securities than

necessary to implement monetary policy efficiently and effectively."

     "The interest rate ceiling established by the repo facility implies that

the Fed can retain interest rate control independent of any shock to reserve

demand or to the Fed's nonreserve liabilities," Andolfatto and Ihrig said.

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

[TOPICS: MMUFE$,M$U$$$,MT$$$$]