Will the Fed's Reverse Repos Reverse Anything?

To settle the tummies of inflation hawks, the Federal Reserve Board has announced that it will use reverse repurchases to withdraw some of the oceans of dollars it has pumped into the financial system in the last year or so. If one sniffs this proposal carefully, one might detect an odd odor. We won't go so far as to suggest that it might be a rat, or fishy. Nor will we make commentaries about the state of Denmark. But a brief pause to think might be in order.

As part of its actions earlier this year to stimulate the economy, the Fed purchased vast quantities of U.S. Treasury securities and mortgage-backed securities. In so doing, it shoved enormous amounts of cash out its loading dock. That cash could be an inflationary time bomb if left long enough in the financial system. Now the Fed has been testing the reverse repo as a means of draining away some of the oceans of cash. The question is how well this would work.

A reverse repo consists of the Fed selling some of its Treasury or mortgage backed securities temporarily, with an agreement that it will buy the securities back on a predetermined date. The price it will pay when the securities return is fixed at the time the transaction is initiated, and includes an interest factor that in effect makes the transaction a loan of cash to the Fed by the temporary buyer of the securities. Lending cash to the Fed takes money out of the financial system. But the return trip of the securities back to the Fed releases the cash back into the financial system along with interest. Thus, the cash is withdrawn, but only temporarily.

Reverse repos are short term transactions, lasting a day, two days, a week or perhaps a month. But they do not permanently remove funds from the financial system, nor do they permanently reduce the Fed's balance sheet. At the end of the transaction, the cash goes back out into the financial system and the securities return to the Fed's $2 trillion balance sheet. The Fed could reduce its stimulus over a longer term by doing a continuing sequence of reverse repos, rolling over each transaction as it comes due with a replacement reverse repo. But there are limits to the reverse repo market, as there are to any market. Moving hundreds of billions of dollars of stimulus out of the financial system via reverse repo would surely require raising interest rates and perhaps sharply. That doesn't seem to be in the Fed's game plan, given its stated intention to keep short term rates at zero for an extended period of time.

A reverse repo is a very tentative and temporary way of withdrawing liquidity, and gives the Fed great flexibility to stop withdrawing liquidity on a moment's notice (especially if it uses reverse repos having maturities of not more than a few days). It's not a way to withdraw stimulus on a large-scale permanent basis. One begins to suspect that the Fed doesn't really want to withdraw much liquidity, and is using the reverse repo as a way of doing something to appease inflation hawks without committing to do much. In short, if you're worried about inflation, keep worrying.

The Fed's reverse repo plan also signals more storm clouds for the economy. There is hardly a crowd of "natural buyers" clamoring to buy the hundreds of billions of dollars of mortgage backed securities held by the Fed. "Natural buyers" is a Wall Street term referring to persons who buy for the purposes of investing. Five years ago, mutual funds, pension funds, money managers, municipalities and all variety of investors were natural buyers of mortgage backed securities. We know what happened next. Now, with the real estate market way down and still shaky, borrowers are defaulting and walking away as their homes go underwater. Mortgage backed securities tend to be dodgy investments because it's difficult, at best, to predict default rates (except that we know they can be ugly). In other words, the Fed can't sell its mortgage backed securities, not without driving long term interest rates way, way up (which is something it won't do). And if it tried, it would drain away whatever limited investor money exists for mortgage financing for current and future home purchases. That would only further batter the real estate market. So the Fed's balance sheet is likely to remain very large for quite a while.

The Fed, in truth, is no longer just a bank regulator but has become one of the largest banks in America. It's bought up a large part of the mortgage backed securities market, and funded a lot of sales of Treasury securities (which is really weird because it means, in reality, that the Fed is printing money and handing it over to the Treasury Dept.). The Fed has also provided significant funding for other asset backed securities and assisted money market funds and the commercial paper market. All the while, it's served as the banker of last (and now first) resort of its member banks. The Fed has intervened in a major way with market forces that ordinarily determine who is creditworthy and who is not, and its intervention doesn't appear likely to recede any time soon. Long term suspension of market forces will have deleterious effects. The only question is which deleterious effects will emerge to erode our prosperity. Inflation? Asset bubbles and busts? Inefficient allocation of society's resources in politically favored asset classes? Growth of irrational and irascible populism that will trigger capital flight? More than any other branch or agency, the Fed is substituting governmental judgment for the market's judgment, and for an increasingly extended period of time. Many nations on the Eurasian continent and elsewhere tried this, and it didn't end well. There's no reason to think that things will be different here.

As Congress considers what to do about financial regulatory reform, it is appropriately scrutinizing the growing power of the Fed. We don't think the Fed is acting in bad faith or in collusion with gnomes in Zurich. The gold standard, rifle-cleaning, nonperishables-stocking crowd needs professional treatment for paranoia. But recent history amply demonstrates that the Fed doesn't have all the answers. It reasonably argues it needs independence from political pressure in the formulation of monetary policy. But it doesn't need the authority to be the largest bank and most powerful financial regulator at the same time. There's too much potential for conflict between the roles of central bank, bank regulator, systemic risk regulator and large scale extender of credit to borrowers high and low. The Fed's overall authority should be limited, just as its independence in formulating monetary policy should be safeguarded.