March 7 (Bloomberg) -- A plan reported to be under discussion by the Federal Reserve to spur the economy while keeping a lid on inflation would drive up short-term interest rates, according to Royal Bank of Canada’s Michael Cloherty.
Fed officials are considering a program in which the central bank would buy long-term mortgage or Treasury bonds and effectively tie up the money by borrowing it back for short periods at low rates, the Wall Street Journal reported without citing sources. The approach would keep excess money out of the system and head off inflation, damping criticism by opponents of earlier Fed efforts to support the economy, the newspaper said.
Such a plan would be “one of the more perplexing policy steps in this crisis” because it would encourage banks to invest their reserve balances in the Treasury repurchase-agreement market, said Cloherty, head of U.S. interest rate strategist at RBC Capital Markets in New York, one of 21 firms that trade with the Fed. This would offset much of the benefit of the low interest rates the Fed has maintained.
“Executing this policy would have a sizable distortions and open a number of questions that the Fed doesn’t want opened,” Cloherty said in an interview. The plan “would do dramatically more harm than good.”
A move to sterilize future asset purchases by tying them up in reverse-repurchase agreements, or repos, would drive up rates in the repo market to as much as 27 basis points, or 0.27 percentage point, Cloherty said in a client note today. That would exceed the Fed’s benchmark interest rate, which it’s held at zero to 0.25 percent since December 2008 to bolster growth.
Repos are transactions used for short-term funding, typically involving the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. In a reverse repo, the Fed lends securities for a set period, temporarily draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to its counterparties.
Rates in the $2-trillion-a-day repo market have already risen amid an influx of collateral as the central bank has replaced shorter-term Treasuries in its holdings with longer-term debt to cap borrowing costs without increasing its balance sheet. The $400 billion program, known as Operation Twist, is due to end in June.
The sterilized-purchase proposal outlined in the newspaper report echoes an earlier policy debate over cutting interest on excess reserves, an idea that was eventually scrapped amid concern it would cause disruptions to the repo market and create other problems, Cloherty said.
Prices of federal-funds futures contracts traded at the CME Group in Chicago fell following the report. The June 2012 contract price was 99.875, for an implied rate of 0.125 percent, compared with 0.120 percent yesterday.
The idea of the Fed sterilizing future debt purchases “certainly put some pressure on the federal-fund futures contracts,” said Kenneth Silliman, head of U.S. short-term rates trading at Toronto Dominion Bank’s TD Securities unit in New York.
Forward repo rates also rose, “which reinforces the perception that repo rates will continue to move higher,” Silliman said. “After Operation Twist, the Fed has very little securities in the front end, so sterilizing with reverse repos or term deposits would be a very logical option.”
The forward rate for borrowing or lending government debt for one day in the June 30 through December 30 period in the repurchases agreement market rose by about two basis points to about 19 basis points, according to TD.
The central bank bought $2.3 billion of securities in two rounds of quantitative easing since 2008 to keep borrowing costs low, as well as conducting Operation Twist.
While policy makers won’t announce any new easing measures at their March 13 meeting, “we still feel that the odds slightly favor more easing,” Cloherty said.
In January, the Fed extended its pledge to keep its benchmark rate for overnight loan between banks at almost zero until at least through late 2014.
The decision bolstered speculation that Fed Chairman Ben S. Bernanke will tolerate faster gains in consumer prices. The Fed set an annual inflation target of 2 percent and policy makers suggested they may conduct a third round of quantitative easing.
The Fed won’t adopt the sterilization program, Cloherty predicted.
“The stated benefit would be to control inflation expectations, but much of the Fed’s policies have been to increase inflation expectations,” Cloherty said. “If inflation expectations have you worried, then why would they do any more easing?”
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