Fed's Last Bullet May Be "Golden"

Now why didn't I think of that...?

Ben Bernanke's last bullet: drive up the price of gold and create an inflation expectation (or perception) so that people are scared into spending fiat money (US dollar) fast.

Here's the "golden bullet" part of the article from Zero Hedge:

Jim Rickards Tells His Clients To Get Out Of Stocks And Discusses The Fed's Final "Golden" Bullet (9/6/2010 Zero Hedge)

[From the interview of Jim Richards, Senior Managing Director for Market Intelligence at Omnis, Inc., with Eric King of King World News. Emphasis is mine.]

If you're worried about deflation and you want to cause inflation and you're printing money as fast as you can and the inflation is not happening, at some point you have to stop and ask yourself well what else can I do? Well the answer is that you can severely devalue the dollar against gold...So the Fed wakes up one day and as fiscal agent for the Treasury, we're a buyer at $1,495 and we are a seller at $1,505, and that represents a 20% depreciation in the value of the dollar.

You have to scare the American people into spending money. Right now the American people are more afraid of not having money, they are not afraid of inflation, but if you make them afraid, they will go out and start spending. So what better way than to devalue the dollar 20% against gold, and the way to do that is through open market operations...Well if that happens to be $2,000 an ounce what have you done? You've depreciated the dollar by not quite 50%. Well that's pretty powerful stuff if you are trying to get people to spend money and dump dollars. So they are not out of bullets, they have what I call the golden bullet...They have that kind of ace in the hole if they really want to trash the dollar.

(The whole interview is here.)

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Federal Reserve to Create CDs for the Banks

so that the banks don't lend to Main Street.

Another of Bernanke's so-called "exit strategy" has been put in place. Just another way to keep as many excess reserves at the central bank so that the Fed can continue to support its junky balance sheet ($1.2 trillion MBS and agency bonds that no one wants), and to further encourage banks NOT to lend to credit-starved consumers and businesses.

For more details of this new instrument at the Fed, see my post from December 2009.

Fed adopts plan to let banks set up CDs (4/30/2010 AP via Yahoo Finance)

"WASHINGTON (AP) -- The Federal Reserve has adopted a plan allowing banks to set up the equivalent of certificates of deposit at the central bank. The move would help the Fed mop up money pumped out during the financial crisis and prevent inflation from taking off later.

"Under the plan, the Fed would offer so-called "term deposits" that would pay interest. Doing so would provide banks with another incentive to park their money at the Fed, rather than having it flow back into the economy.

"Once the economy is on firm footing, this would be one of the tools the Fed could use to tighten credit.

"The Fed says Friday's action has "no implication for the near term conduct of monetary policy.""

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Bernanke's Exit Stragegy: Term Deposits

The Federal Reserve wants to create a term deposit facility as part of so-called "exit strategies" as outlined by the chairman Ben Bernanke.

Fed proposes term deposits to drain excess bank reserves
(12/28/09 AFP via Google)

"WASHINGTON — The US Federal Reserve proposed Monday the creation of a term-deposit facility for banks to drain some of the more than 1.0 trillion dollars in excess reserves from the banking system.

"The Fed said it was seeking public comment on proposed amendments to the reserve requirements for institutions eligible to receive earnings on their accounts at Federal Reserve Banks.

""Under the proposal, the Federal Reserve banks would offer interest-bearing term deposits to eligible institutions through an auction mechanism," the central bank said in a statement.

""Term deposits would be one of several tools that the Federal Reserve could employ to drain reserves to support the effective implementation of monetary policy," it said.

"Institutions holding term deposits would "receive earnings at a rate that would not exceed the general level of short-term interest rates," according to the Fed proposal." [The article continues.]

Offering financial institutions interest-bearing term deposits is one of Ben Bernanke's "exit strategies". (For more, please read my post from July, when Bernanke outlined his thinking in Wall Street Journal.)

The Federal Reserve has been paying interest on the banks' excess reserves since October last year. All this term deposit facility will do is to lock up the excess reserves for a period of time, instead of having them as excess reserves (which is good as cash, a demand deposit).

According to the attachment to the Federal Reserve's press release today,

• Term deposits will be made available by auctions.
• No early withdrawal allowed.
• Term deposits will be open to the branches and agencies of foreign banks.
• Maturities will not exceed 1 year, with majority from 1 month to 6 months.
• Institutions can use term deposits as collateral for the Fed discount window.
• Term deposits would receive a zero risk-weight for risk-based capital purposes.

The facility may temporarily transfer the excess reserves into the term deposits at the Federal Reserve, but that will do nothing to shrink the size of the Fed's balance sheet. The term deposits will sit on the Liabilities side of the balance sheet, the same side as the excess reserves.

I find it ironic that the term deposits would receive a zero risk-weight when the Federal Reserve is loaded with agency bonds and mortgage backed securities. That's one advantage of being a central bank, who can print money and who is effectively backstopped by the government (i.e. taxpayers).

What if the financial institutions decline the offer and would rather take the money out of the excess reserves or keep the money in the excess reserves? I suppose that's why the Federal Reserve is seeking comments from the very institutions whom it wants to use this facility and help manage the excess reserves lest they spill over into the real economy (aka Main Street). It is asking the financial institutions what it will take for them to continue to park their money (excess reserves) with the Fed.

Well I have to say, regardless of whether this can be considered as an "exit strategy" (I personally think this should be called "kicking the can further down the road"), the existence of the excess reserves at the Fed is real, not fictional, and the Fed is scared enough of its inflationary implications.

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Borrowings from Fed Down, Reserves Way Up

...so what gives?

The Federal Reserve chairman Ben Bernanke, when he outlined his so-called "exit strategy" back in July, said that the bank reserves at the Fed would naturally decrease as the various loan programs winded down. (If you want to review his strategy, here's my post from July.)

Well, the Fed's various loan programs have been winding down. At their peak, the total borrowings by depository institutions (=banks) exceeded $400 billion. They have been flat about $100 billion since April this year. Have the bank reserves come down?

Answer: Not at all.

I created the graph using St. Louis Fed's FRED. The red line is the bank reserves. The blue line is the total borrowings by the banks from the Fed. As you can see, the bank reserves recently spiked to a new high to $1 trillion. In the latest Federal Reserve Statistical Release H.4.1 Factors Affecting Reserve Balances (10/22/09), the bank reserves are recorded at: $1,034,078 million, up $52,459 million from last week.

$1 trillion minus $100 billion equals $900 billion. How has this $900 billion in the bank reserves been earned? What securities could the banks have given to the Fed in exchange for the credit to their reserves, outside those lending programs that are winding down?

Scanning the Fed's Statistical Release, my eyes stopped at these line items:

Federal agency debt securities (2) 137,866 + 3,320
Mortgage-backed securities (4) 766,543 + 63,970

The first column is the total, the second column is the change from last week. If you add the two numbers in the first column, you get: $904,409 million. Rounding it up, $904 billion.

Oh what a coincidence.

Is it possible that, as the lending programs wind down and the banks takes the collateral back, the banks are selling them back to the Fed as part of the Fed's permanent open market operations (POMO)? So now it's not a loan any more, the sale has been made. The banks have sold the agency bonds and agency-backed MBS that hardly anyone in the world wants to the Federal Reserve, and in exchange they got their bank reserves credited. Probably at the face value, good as cash.

I may be missing some important things and I could be totally wrong and it is just a coincidence, but if this is what has happened, then all the Fed has done is to shift temporary assets (loan collateral) to permanent assets backed by the government.

At least, we now know that Bernanke's "exit strategy" No.1 didn't work. According to Zero Hedge, the New York Fed experimented on another of his strategy to use reverse repo with the primary dealers and the experiment reportedly ended in disaster.

The only way to effectively shrink the balance sheet would be to sell long-term securities in the open market. Treasuries, agency bonds and MBS, which account for $1.678 trillion of the Fed's $2.230 trillion balance sheet.

Why was Mr. Bernanke so eager to be reappointed to be the Fed chairman, given this practically impossible task?

Unless the Fed's interest is not to save the system or the economy, but save its credibility... (One Fed board member said as much, remember?)

Or, unless someone has decided that the proverbial "bad bank" is to be the Federal Reserve, never to fail...

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...And Fed Is Back to Accommodative Stance

A Fed board member and two presidents of regional Federal Reserve banks have spoken about the need for the Federal Reserve to tighten the monetary policy (i.e. raising the Fed funds rate) aggressively even without the overt sign of inflation (for that matter, without overt sign of recovery).

This morning, the Fed trotted out the Federal Reserve Atlanta's president Dennis Lockhart, who said there is no rush for the Fed to begin to tighten the monetary policy.

No rush to tighten, Atlanta Fed's Lockhart says (9/30/09 MarketWatch)

"WASHINGTON (MarketWatch) -- There is no rush for the Federal Reserve to begin to tighten monetary policy, said Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, on Wednesday.

""I think it may well be some time before a comprehensive exit need be under way," Lockhart said in a speech in Mobile, Ala.

"There has been much speculation in financial markets and economic circles about the U.S. central bank's so-called "exit strategy" -- when and how it will start winding down the stimulus and liquidity measures implemented to battle the financial crisis that took hold a year ago."

Well, that speculation has been fueled by none other than the Fed officials. First, it was last week's FOMC meeting (September 22/23): the Fed said it would continue to keep the rate low for a long time to assist the recovery. Then on Friday last week, Kevin Warsh, a Fed board member and former Morgan Stanley banker who worked in the President's Working Group on Financial Markets (aka Plunge Protection Team), wrote an Op-Ed piece on Wall Street Journal strongly indicating that the Fed would move aggressively even if the signs of inflation were not evident. Then came Richard Fisher, president of the Dallas Fed yesterday, basically saying the same thing as Warsh in a plainer English. He was joined by the Philadelphia Fed president Charles Plosser, who delivered the speech in Pennsylvania saying "The Fed will need courage. I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels."

Then today the Atlanta Fed president is sounding like a voice of reason by saying "Assuming stable inflation, I would like to see more evidence of private activity in the economy before advocating change in the Fed's overall monetary-policy stance."

Is the Federal Reserve playing "bad cop, good cop" routine?

The stock market doesn't seem to know what to think of these utterances by the Federal Reserve officials. Chicago PMI number registered a fall instead of expected increase, and that overwhelmed the good news of 2nd quarter GDP (final reading) revised to decreasing only by 0.7% (annualized) instead of -1.1% consensus.

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Fed Is Back to Threatening with Rate Hike

On Friday last week, a Fed Board member Kevin Warsh wrote a please-read-carefully-between-the-lines-and-between-the-words Op-Ed piece on Wall Street Journal.

Today, Federal Reserve Dallas president Richard Fisher spoke in a plainer English.

Official: Fed will need to boost rates quickly
(9/29/09, AP via Yahoo Finance)

"WASHINGTON (AP) -- To prevent inflation from taking off, the Federal Reserve will need to start boosting interest rates quickly and aggressively once the U.S. economy is back on firmer footing, a Fed official warned Tuesday.

""I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity" to when the Fed was slashing rates to battle the recession and the financial crisis, said Richard Fisher, president of the Federal Reserve Bank of Dallas.

"Although Fisher has a reputation for being one of the Fed's toughest inflation fighters, it marked the second such warning by a central bank official in recent days. Fed member Kevin Warsh on Friday said the central bank will need to move swiftly when the time comes to raise rates.

"It's all part of a high-wire act that the Fed has to perform as the economy transitions from recession to recovery."

I guess you could say that. You could also say that the Fed is empowered to make or break the economy. As you see in this comment in the article from a monetary policy expert at University of California Santa Cruz (I didn't even know they have the economics department):

"When the decision is made to boost rates, they will need to be "increased aggressively," argued Carl Walsh, a professor of economics at the University of California, Santa Cruz, and an expert on monetary policy. "Committing to a gradual increase in the policy rate is not justified."" [emphasis is mine]

Not justified?? And "aggressive increase" is justified, then? Why? By who (or what)? The expert continues:

"Consumers, businesses and investors must feel more confident that prices won't spiral higher in the future, so their inflation expectations don't become "unanchored," Walsh said last month."

Is this based on any kind of historical observations, or is it solely his conviction of how consumers, businesses and investor should feel when they see the interest rate being jacked up suddenly and aggressively?

I have this nagging feeling that it's the latter, because it is consistent with other policies having been floated, particularly since the current administration took over. Key word is "should". Policy decisions are to be made on how things "should be", as perceived and determined by the policy makers, whether they are legislators or industry lobbyists or administration officials or the Fed officials. It is normative, as opposed to positive.

It is not new; an unnamed aide to the previous administration said they were not working in the reality-based community. It's just that the current government has turned up the heat on the proverbial pot very aggressively and rapidly. They are not slow-boiling the proverbial frog anymore, and the frog now knows something bad is up and getting rapidly uncomfortable.

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Fed Considers Reverse Repo with Money Market Funds

Your 401K and IRA may get stuffed with bonds no one wants.

Last week the Financial Times reported that the Federal Reserve was considering the use of reverse repurchase agreements (aka 'repos') as a way to reduce its balance sheet ("Fed turns to mutual funds to stave off inflation", 9/24/09 Financial Times). The twist is two-fold: that the Fed wants to do it with large money market funds and not with Primary Dealers, and that the Fed wants to do it with agency bonds and agency-backed MBS, and not Treasuries as they normally do.

The Federal Reserve has used 'repos' with Primary Dealers, and never with any other financial entity. I simply do not know if their charter allows them to deal with money market funds. The reason for the Fed's wanting to deal with money market funds is their sheer size: $2.5 trillion. According to the FT article, the Fed thinks Primary Dealers do not have big enough balance sheets to absorb the Fed's collateral (agency, MBS). By the Fed's estimate, Primary Dealers would have $100 billion that they can spare to accommodate the Fed.

Thus the Fed targets the $2.5 trillion money market funds, where the investors very large and miniscule alike park their unused funds, in 401K, in IRA. And the Federal Reserve wants to stuff them with securities that hardly anyone in the world wants to hold at this point.

Repos and reverse repos are used by the Federal Reserve to temporarily increase (repo) or decrease (reverse repo) the bank reserves. In repos, the Fed temporarily buys Treasury securities from Primary Dealers, thus adding to the bank reserves. In reverse repos, the Fed temporarily sells Treasury securities to Primary Dealers, draining the bank reserves. Repo and reverse repo agreements are usually overnight; though it can be as long as 65 business days it is rarely longer than 14 days (in other words, not very long). [information from Federal Reserve Bank of New York]

Now, if the Fed wants to do reverse repos with money market funds by selling them agency bonds and agency-backed MBS, my questions are:

At what price?
Currently the Fed carries these bonds at FACE VALUE on their balance sheet. Many believe agency bonds and agency-backed MBS trades well below their face values. I don't see why the Fed, in reverse repo, would mark them to market. So the Fed would sell these bonds that hardly anyone in the world wants at this point to money market funds at face value. A dollar for a dollar.

How to account?
Since money market funds are not Primary Dealers, they are not banks and they are not even the Federal Reserve members, where would the reverse repos be accounted for on the Fed's balance sheet?

The Fed sells agency bonds/MBS, which decreases their asset balance temporarily. It receives money for the sale, which then increases the asset balance. So on the asset side of the balance sheet it is basically a wash.

On the liability side, the Fed records 'reverse repo', thus increasing the liability. Since the asset side is a wash, the liability side has to be a wash, too. But since the money market funds are not Primary Dealers and not even the Fed member banks, the Fed cannot reduce the bank reserves as they normally do with regular 'reverse repos' using Treasury securities. So they will have to create a new line item on the liability side of the balance sheet that would offset the 'reverse repo' amount, or create a new line item on the asset side that would somehow account for the reverse repo not being offset on the liability side. How they do it I haven't a clue. But the book has to balance somehow.

Is the Fed allowed to do this?
Money market funds are not Primary Dealers, they are not banks, and not the Federal Reserve member banks. Unless the monstrocity which is the financial system overhaul as envisioned by the administration passes and gives the Fed power to do just about anything (it already does just about anything, with its charter gets amended constantly) on any industry that it declares is related to "finance" (thus any on-going business entity would be the fair target), the Fed has no authority over them.

Financial Times notes,

"Fed officials believe that there may be appetite among money funds to lend the money, since these funds are under pressure from investors and regulators to stick to risk-free and highly liquid business."

Risk-free? Agency bonds and MBS risk-free? Now who is going to be the bag holder?

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Curious Op-Ed Piece by a Board Member of Federal Reserve

Why now? Inquiring mind wants to know.

Kevin M. Warsh is a 39-year-old former VP of Morgan Stanley and a current member of the Board of Governors of the Federal Reserve. He wrote an op-ed piece for Wall Street Journal, which was posted on September 24 for September 25 publication.

It is hard to believe he is 39 years old, for he writes as enigmatically as 83-year-old Alan Greenspan speaks (or used to speak).

The Fed's Job Is Only Half Over
(Kevin M. Warsh, 9/25/09 Wall Street Journal)

"Recent media stories have chronicled in great detail the events of the last couple of years. A pair of conclusions might be fairly drawn from these early drafts of history. One is that the financial-market turmoil of the last year proved to be of significant consequence to the economy. The second is that the Federal Reserve distinguished itself from historical analogues by taking extraordinary actions to address risks to the economy. Commentators, however, tend to disagree as to whether the extraordinary actions undertaken were to the good or the detriment of the U.S. economy in the long-run."

With this not so attention-grabbing opening, he drools on about how the Federal Reserve has done a good job but that this is no time to "declare victory". And I'm thinking "OK, what is your point?"

Then, he delivers, sort of, one of the points [emphasis is mine]:

"It is unwise to prejudge the Federal Reserve's policy strategy—or to declare the victor or the vanquished—by the split time, however notable it might be. We are at a critical transition period, of still unknown duration, and we must prepare diligently for an uneven road race ahead. If policy is not implemented with skill and force and some sense of proportionality, the success of the overall endeavor could suffer."

He seems to me to be saying, in crude language, "Don't ask questions. Leave it us, or you will suffer a consequence of your meddling."

Then he mentions "policy makers". At first, I thought he means legislators. But as I read the article, I now think he means "policy makers" at the Federal Reserve, because he starts to talk in first person.

"It also means that policy makers should acknowledge the heightened costs of policy error. The stakes are high, in part, because the policy accommodation that requires timely removal as the economy rebounds is substantial. And our policy judgments will ultimately prove worthy of the accolades, and tender the ultimate rejoinder to our critics, if we rise to meet this heightened responsibility. I am confident we will."

Tender the ultimate rejoinder to our critics? (He talks like Edward IV or his brother Richard III, last king of the House of York.) Is he challenging the supporters of H.R. 1207 (audit the Fed), which is slated to be introduced in the House Financial Services Committee on September 25?

A curious part comes in the last three paragraphs:

"In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities."

Is he saying that the Fed will drain the liquidity sooner and faster than it becomes necessary? Even if that could threaten the market crash and economic crash? (Maybe that's why he, in the preceding paragraphs, cites history full of unintended and unfortunate policy errors?)

""Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers."

This to me is the most curious remark. The Fed would do "whatever it takes" at a recovery stage "to ensure the Federal Reserve's institutional credibility". The Fed would do it, not that it is necessary or it would help the recovery, but to ensure its credibility. Also the next sentence is interesting. He seems to be saying that if the Fed doesn't do "whatever it takes" in the recovery stage, it would lose those valuable weapons - various lending programs, buying securities that are not allowed by the Fed's charter (i.e. agency bonds and MBS), owning stakes in a private business (AIG), creating SIVs (Maiden Lane LLCs), "whatever it took".

"For those of us at the Federal Reserve, the task ahead involves longer days, but, in all likelihood, fewer weekends. While the undertaking is as challenging as any we faced in the preceding period, it is exceptionally well suited to the Federal Reserve's comparative advantages of deliberation, dispassion, and a determination to make judgments based on the long-term interests of the U.S. economy."

In 1913 when the Federal Reserve System was born, one ounce of gold was US$18.92. Today, one ounce of gold is $996. US dollar's purchasing power as measured by gold has dropped 95% since the Fed came into being. And that is the long-term interest of the U.S. economy?

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Bernanke's Exit Strategy May Be No Strategy

The Federal Reserve Chairman Ben Bernanke testified before the House today, the first day of the semi-annual ritual before Congress on the subject of the Federal Reserve's monetary policy. (This semi-annual testimony, by the way, is about the only Congressional oversight on the Federal Reserve.)

What set today's testimony apart was in the prepared statement and his op-ed piece on Wall Street Journal: the Fed's "exit strategy" - how to shrink the Fed balance sheet once the economy gets going on its own.

I ran into two articles that say "When" is more important than "How": Here's one, by Catherine Rampell of New York Times; the other is here, by Jill Schlesinger of CBS. They both gloss over the "how", treating them as standard, run-of-the-mill tools.

Are they?

The Federal Reserve's balance sheet exploded from $900 billion in September 2008 to over $2 trillion two months later in November 2008. This is simply historically unprecedented. Don't we need to examine the tools that purportedly shrink this balance sheet, or whether it would be ever possible to do so at all? Could "standard" tools do? If not, what would happen?

I am more interested in knowing the "how"; from the recent past, I'm resigned to the probability that the Fed will get the "when" very, very wrong, unless by chance. So, let's take a look at the op-ed piece in Wall Street Journal, in his own words.

The Fed’s Exit Strategy (Ben Bernanke, 7/21/09 Wall Street Journal)

"The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

"These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages."

Many people (including myself) would question the validity of the second paragraph, but the first paragraph describes what the Fed has done. I accept that.

"My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road....

"The exit strategy is closely tied to the management of the Federal Reserve balance sheet... as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy." [emphasis is mine]

And exactly how is he going to do that?

First, it will happen automatically anyway: "To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities."

Second, he can raise the interest rate on the reserves so that the banks will keep their money at the Fed and not lend out: "we can raise the rate paid on reserve balances as we increase our target for the federal funds rate."

The first one is not a policy choice, so basically the first and foremost attack on bulging reserve is to raise interest rate on the reserve so that it will not leave the Fed and flood the Main Street and cause inflation.

Ummmm, hasn't the government been complaining that banks are hoarding the money at the Fed and not lending to Main Street?

Bernanke then cites European, Canadian, and Japanese experience where the interest rate on reserve acted as floor support for their short-term funds rates. However, despite "this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed" and the Chairman partly blames it on banks' inexperience with the new system. (Yes, it's irrational, isn't it Mr. Spock?)

If this gap between the Fed funds rate and the reserve interest rate persists, Bernanke says there are four ways to tighten the monetary policy:

1. Large-scale reverse repurchase agreements with financial market participants;
2. The Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline;
3. Offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers; and
4. Reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Now, let's examine these four choices against the Federal Reserve's latest balance sheet.

1. Reverse repo agreements:

Repo agreements inject short-term credit, reverse repo agreements drain short-term credit. Currently the Fed has $66 billion reverse repo agreements on the balance sheet (liabilities), entirely with foreign and international account dealers. The Fed wants to greatly expand reverse repo agreements with a lot more institutions to drain liquidity. It is short-term and temporary.

2. Treasury sells bills and deposits the proceeds at the Fed:

That's a longer-term than reverse repo agreement, but still temporary.

3. Offer term deposit to the banks:

The Fed already pays interest on the reserves. All term deposit offers is that the Fed will be able to lock up the reserve for a specified amount of time.

4. Sell portion of long-term securities in open market:

Which long-term securities? As of Wednesday July 15, The Fed has

• $659 billion Treasury notes and bonds and TIPS held at face value;
• $102 billion Federal agency debt securities held at face value;
• $526 billion Mortgage Backed Securities guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae held at current face value (=remaining principal balance of the underlying mortgages)

It seems to me that there are so many Catch-22 here.

First, Treasury notes and bonds. They are part of the collateral held against Federal Reserve notes (U.S. dollar bills, $1,054 billion outstanding). Also, if the Fed wants to vastly expand reverse repo agreements to drain liquidity, it has to post collateral, and the collateral for that operation is Treasury notes and bonds. That would mean the U.S. dollar's value would drop, as the dollar is backed less by Treasuries and more by securities of dubious quality (agency bonds and MBS).

Second, the federal government will have to issue more Treasury debt as far as eyes can see on their ambitious programs. Adding to the supply would lower the price, raising the yield and raising the cost of the debt.

Third, who in the world (literally) wants agency bonds, and who wants them at face value? No one. Ditto for MBS guaranteed by the likes of Fannie and Freddie. I don't know how much the Fed can get in the open market for these securities, but definitely NOT AT FACE VALUE.

The only method that would actually reduce liquidity seems to be the No.4, but then the house of cards would come tumbling down when the open market price discovery happens.

Luckily for Ben Bernanke, banks have very little interest in lending for now, as the economic "recovery" is seen tepid and slow. Unless they are forced to lend, like the Chinese central bank forced its banks by lowering the reserve interest, we don't need to worry about how the Fed is going to absorb excess liquidity.

I would like to know what exit strategy the Chinese central bank has, if any...

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