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Money News

FACTBOX - Potential Fed exit strategy tools

NEW YORK (Reuters) - At a U.S. central bank conference on Thursday, Federal Reserve Chairman Ben Bernanke said the Fed needs to continue to prop up the economy for a while, but it can’t do so indefinitely for fear of triggering inflation.

Chairman of the Federal Reserve Ben Bernanke speaks at the Federal Reserve Conference on Key Developments in Monetary Policy in Washington October 8, 2009. REUTERS/Kevin Lamarque

“Accommodative policies will likely be warranted for an extended period,” Bernanke told participants at the conference held at the Fed’s headquarters.

“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.”

Below are some of the Fed’s exit strategy options from its extraordinarily accommodative policies along with some drawbacks discussed by analysts.

PAYING INTEREST ON EXCESS RESERVES:

By setting the interest rate on reserves the Fed essentially creates a magnet for banks to place those reserves with the Fed rather than lend them out into the financial system -- creating a floor under short-term market rates.

This is because banks generally will not lend funds in the money market at a rate lower than they can earn risk-free at the Fed.

“Raising the interest rate paid on balances that banks hold at the Federal Reserve should provide a powerful upward influence on short-term market interest rates, including the federal funds rate, without the need to drain reserve balances,” Bernanke wrote in his monetary policy report to Congress in July.

A number of central banks around the world have effectively used this tool.

Cons: There could be a political backlash if the Fed was paying banks a significant amount of taxpayer money to push up interest rates. “That payment is perfectly logical from a monetary policy perspective, but it is a disaster from a public relations perspective,” according to BofA Merrill Lynch Global Research.

LARGE-SCALE REVERSE REPURCHASE AGREEMENTS:

The Fed could arrange large-scale reverse repurchase agreements, or repos, with financial market participants, which would drain reserves from the banking system and reduce excess liquidity at other institutions.

Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Con: Large-scale repos could inflate dealer balance sheets as dealers relend the collateral from the Fed to money market funds, wrote BofA Merrill Lynch Global Research analysts, though this could be mitigated by conducting them with other institutions.

TREASURY SUPPLEMENTARY FINANCING PROGRAM:

The Fed could ask the Treasury to ramp up its Supplementary Financing Program again. Last fall, the Treasury raised almost $560 billion by issuing SPF bills and held the funds on deposit at the New York Fed to offset part of the ramp-up in the Fed’s balance sheet at the time. The Treasury is scaling back the program to $15 billion by the end of October as bills mature. The Treasury cited the

debt ceiling as a concern.

TERM DEPOSIT FACILITY:

The Fed could create a new “term deposit facility” for banks, similar to certificates of deposits (CDS) that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the fed funds market.

“Such deposits would pay interest but would not have the liquidity and transactions features of reserve balances. Term deposits could not be counted toward reserve requirements, nor could they be used to avoid overnight overdraft penalties in reserve accounts,” Bernanke wrote in his monetary policy report to Congress in July.

ASSET SALES:

The Fed could sell a portion of its holdings of longer-term securities into the open market.

Cons:

Large-scale selling of Treasury securities could disrupt markets and potentially hamper the Treasury’s ability to issue new debt, analysts said.

The Fed is likely to be very cautious about selling its agency mortgage-related assets for fear of distorting those less-liquid markets.

SOME OTHER POTENTIAL TOOLS DISCUSSED BY ANALYSTS:

FED BILLS:

Other central banks such as the European Central Bank have the authority to issue their own debt as a way to drain reserves.

Cons: The Fed would need congressional authorization and lawmakers, already uneasy about huge bank bailouts, are unlikely to be keen on granting the Fed more powers. Fed borrowing would also compete with Treasury borrowing during a wave of government debt issuance.

RAISE RESERVE REQUIREMENTS:

The Fed cut reserve requirements in the early 1990s to make banks more competitive with the shadow banking system and could raise them. Higher reserve requirements would curtail bank lending.

Cons: It would be an effective tax on the banking system and could make banks less competitive versus non-banks.

“This would be a last-ditch option, as reserve requirements have long been viewed as too blunt a policy tool,” said Ed McKelvey, an economist at Goldman Sachs.

(Sources: Research by Goldman Sachs, JPMorgan, Wrightson ICAP, Bank of America-Merrill Lynch, Ben Bernanke’s Monetary Policy Report to Congress and speeches)

Fed reporting team; New York and Washington

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