The Fed: Making New Year's More Liquid Than Ever
With Y2K looming, one would expect that the Federal Reserve, guardian of the money supply, might be feeling a bit nervous these days. In fact, U.S. financial markets show no signs of concern about a liquidity crunch. The reason: unprecedented steps to make plenty of extra money available--from printing a mountain of new banknotes to giving banks and dealers access to more borrowing. Most major central banks elsewhere are taking similar steps. The Fed, however, has come up with an arcane new ripple: selling so-called liquidity options to market makers, who could get financing if interest rates went sky-high.
According to sources at the Fed, the central bank is less worried about computer glitches than the fear of computer glitches. It's easy to conjure up horror scenarios: markets seizing up as investors dump stocks and bonds before yearend and dealers refuse to make markets, or massive runs on banks as depositors withdraw cash. In the worst case, a drying up of short-term credit could bring the whole U.S. financial system to its knees.
FOREIGN DEMAND. To head off such disasters, the Fed has moved on three fronts. For people who want to hold cash over the yearend, the Fed is ready with $200 billion in newly printed banknotes, a 40% increase in currency in circulation. Since about two-thirds of U.S. currency is held outside the country, the Fed has to anticipate a lot of demand from abroad.
For banks, the Fed has opened a special Y2K credit window to supply extra reserves, albeit at a high price. The banks are unlikely to tap it in a major way unless the cost of borrowing in the Fed funds market, where banks lend to each other overnight, rises above 7%.
The most novel moves involve the Fed's financing of securities dealers. The Fed routinely uses repurchase agreements, or repos, to finance dealers, which include brokerage firms and banks. Dealers sell U.S. Treasury or agency securities to the Fed and agree to buy them back at a specified date, ranging from one to 60 days later. Although repos are sale-buyback transactions, they work like loans, and the securities are considered collateral.
In October, the Fed changed the game in several ways. It created longer-term repos that mature in 90 days, thus giving dealers a way to fund their yearend operations a month earlier. According to Peter R. Fisher, who runs the New York Fed's open market desk, these extended repos have helped dealers to the tune of $37 billion.
The Fed has also expanded the acceptable collateral to include mortgage-backed securities such as Ginnie Maes and Freddie Macs. Dealers, fearing that Y2K anxieties would make Treasuries scarce, greeted this expansion with a huge sigh of relief. "Expanding the range of collateral really changed the psychology," says James E. Glassman, senior U.S. economist at Chase Securities Inc.
Most intriguing are special call options--rights to buy an asset for a set period of time--that the New York Fed sold to 30 primary dealers of Treasury securities. The Fed's options essentially allow dealers to borrow substantial funds from the Fed, via repos, if interest rates rise above 7%. The options cover three weeks, from Dec. 23 through Jan. 12. Bidders have bought options on $223 billion for the key week spanning the yearend, and on $114 billion and $144 billion, respectively, for the preceding and follow-up weeks. Because the repo deals mature the next day, at no time will more than $223 billion be added to the system.
Won't a bulge in liquidity be hugely inflationary? "The options will probably never be exercised," says J.P. Morgan & Co. economist Marc Wanshel. "They're backup, a kind of insurance." Adds Fed watcher Allan H. Meltzer at Carnegie Mellon University in Pittsburgh, "The only serious problem is that the Fed's doing so many things that they'll be busy as beavers unwinding it all in January."