Will the Fed's new toy work?

The Fed's new toy to drain the monetary sandbox has arrived, and though the first trial run will be small ($1 billion), there are some interesting observations to be made that will be relevant as the Fed ramps up down the road. Are the new Fed Bills (as I called them in January) simply the Fed issuing its own debt? Will they be effective at all once short term rates begin to rise?

As it announced it would soon do a few short weeks ago, today the Federal Reserve scheduled the first auction for its Term Deposit Facility. The full release is below:

The Federal Reserve has scheduled three small-value auctions of term deposits through its Term Deposit Facility (TDF) over the next two months. These auctions are a matter of prudent planning and have no implications for the near-term conduct of monetary policy.

All term deposit auctions will use a single-price format in which all winning bids will be awarded at the highest rate accepted at the auction. The first auction will offer $1 billion of 14-day term deposits; the auction will be conducted on June 14 with settlement on June 17, and the deposits offered will mature on July 1. Each participating institution may submit up to three competitive bids; the maximum award to any individual bidder will be set at $250 million and the maximum rate at the auction will be set at the primary credit rate [Bob: 0.75%]. Depository institutions may submit noncompetitive bids; each individual noncompetitive bid will be filled up to a limit of $5 million at the highest rate accepted in the competitive auction. The amounts awarded to noncompetitive bidders will be added on to the $1 billion offered at the competitive auction.¹

The second auction will offer 28-day term deposits; the auction will be conducted on June 28 with settlement on July 1, and the deposits offered will mature on July 29. The third auction will offer 84-day term deposits; the auction will be conducted on July 12 with settlement on July 15, and the deposits offered will mature on October 7. The amount of term deposits offered along with other parameters for the second and third auctions will be announced at a later date.

The Federal Reserve may schedule up to two additional small-value TDF auctions later in the summer.

1. Additional details of the first auction will be made available on June 11 on the TDF Resource Center athttp://www.frbservices.org/centralbank/term_deposit_facility.html.

In the final Rule Amendment to Regulation D, the Fed stated it did "not expect to permit pledges of term deposits to third parties" -- a key distinction from Treasury Bills. However, it stated it did expect purchasing banks to be able to pledge them at the Fed's discount window.

Similar to the new ECB facilities, this means in a pinch, a bank would be able to get cash for the TDF at an effective fee equal to the difference between the primary credit rate (now 0.75%) and the interest the bank receives on the TDF. It seems like it would be a more effective policy tool than simply paying interest on excess reserves (IOER) because there is no lockup in banks' reserve accounts. The risk is that volatile short term interest rates could render the IOER policy method impotent. Brian Sack, manager of the world's largest hedge fund (the Fed's System Open Market Account) was acutely aware of this in his speech on December 2, 2009:

A key part of the framework is the ability to pay interest on excess reserves. This authority alone may allow the FOMC to control short-term interest rates to its satisfaction, even if the banking system is saturated with a large amount of excess reserves. Indeed, the interest rate on excess reserves should act as a magnet for other short-term interest rates, keeping them relatively close together. In the current environment, the federal funds rate has remained modestly below the rate paid on reserves, typically by 10 to 15 basis points. If that spread were to remain steady near those levels even as the interest rate on excess reserves was increased, then policymakers would have sufficient control over short-term interest rates without the use of additional instruments. They could still choose a target level of the federal funds rate and could hit it by adjusting the interest rate on excess reserves.

However, policymakers face some uncertainty about how stable that spread will remain as short-term interest rates increase. The behavior of the spread today might not be that informative in this regard, as the proximity of short-term interest rates to the zero bound prevents the spread from getting much larger. In my view, the most likely outcome is that the spread will not widen substantially as short-term interest rates increase. However, if the spread does become large and variable, then policymakers will need other tools for strengthening their control of short-term interest rates.

With that in mind, monetary policymakers have asked the Federal Reserve staff to develop the ability to offer term deposits to depository institutions and to conduct reverse repos with other firms. These tools are similar in nature, as they both absorb excess reserves by replacing them with a term investment at the Fed. By removing reserves that would have otherwise been available for overnight lending, these tools could pull the federal funds rate and other short-term interest rates up toward the interest rate on excess reserves, providing the Fed with more effective control over the policy rate.

But even the new TDFs do not cure this apparent deficiency in IOERs, should short term interest rates move to quickly. Considering the unprecedented monetary and interest rate intervention and the law of unintended consequences, it is conceivable that short term interest rates could rise to close the effective fee gap between the primary credit rate of 0.75% and the rate paid by the Fed on the TDF. At that point, it would be economical for banks to go to the discount window, get their cash back and reinvest it somewhere else.

It will be interesting to watch the results of these auctions to see how TDFs compete with Treasurys and their relation to the IOER. TDFs should auction at a discount (higher yield) to similar tenors along the Treasury yield curve because they are illiquid. If nothing else, we will have an additional set of spreads to watch.

With all its new facilities--TDF, IOER, tri party repos--the Fed is making sure it has as many tools as possible to keep its trillions in monetization from flooding the general economy down the road. So far so good, but it also makes you wonder if they're planning even more monetization.