Thursday, December 11, 2008

For sale: $1.5 trillion in Fed bonds

From the FT Alphaville blog:

Some interesting numbers out of Bank of America today regarding the prospect of the Fed issuing its own bonds.

As noted previously, Fed bonds could help the Fed continue to grow its balance sheet while offsetting the increase in its liabilities through debt rather than excess bank reserves. Kind of like the now-dead Supplementary Financing Programme (where the Treasury issued bills in order to drain the massive amounts of excess reserves from the system). Anyway, the prospect of the Fed doing something similar is rather more challenging. From BoA’s Michael Cloherty:

Normally bank reserves at the Fed are somewhere between $5bn and $10bn. Now they are $650bn, and the MBS/Agency/TALF purchases will add an extra $800bn of excess reserves. In order to start tightening, the Fed would need to get bank reserves back down to the $10bn level, a process that likely would take quarters.

Being able to issue debt that drains reserves would shorten that lag to weeks. Accordingly, the risks of a spike in inflation caused by rates that were too low for too long would be greatly reduced if the Fed could issue its own debt when it shifts back to the tightening side of monetary policy (yes, that will happen some day).

In otherwords, Fed debt could help the US tighten their way out of quantitative easing before causing a mass of inflation.

BUT — there’s a major caveat here (emphasis ours).

The downside of fully draining excess reserves is that it would require a massive amount of issuance - as we said, excess reserves are likely to get close to $1.5T as the MBS/TALF purchases progress. At a time when the Tsy is already facing a financing need that is a multiple of the old record, an extra $1.5T of issuance would be a problem. This is why the Tsy cancelled the SFP program-the burden was too large.

A $1.5tn increase in Treasury-type issuance? Bring on the Treasuries bubble indeed.

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