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It is no secret that the Fed’s, or more specifically, the Federal Open Market Committee’s (FOMC), asset purchases have created an enormous amount of money in the financial system. Traditionally, pre-crisis, the Fed would simply execute an overnight reverse repo transaction (ON RRP), sometimes known as matched sales, in order to drain money out of the system. The smaller amount of reserves in the system would cause the banks to bid up overnight rates. This was not overly complicated and had worked for decades.
Normalization Tools in the Fed’s Toolbox
Today that simply isn’t possible. In today’s environment, the Fed will be using the following tools:
- Interest on Excess Reserves or IOER, which is the amount of interest the Fed pays on reserves
- ON RRP, but capped at $300 billion
- Term Deposit Facilities or TDF
- Proper/effective communication
Questions to Consider on the Fed’s Path to Normalization
Although there is more involved than just the above, the Fed’s quest for normalization will be challenging. Some questions where the answers are still to be determined include:
- What is normal in today’s interconnected world and financial systems? Will the Fed have to continue asset purchases after October 2014 if the economy starts to falter?
- How will this impact the value of the dollar?
- How will the enactment of the liquidity coverage ratio, or LCR, impact banks’ decision making process on whether to execute deals with the Fed, leave balances with the Fed or execute transactions away from the Fed?
- What happens at traditional times of the year, such as fiscal year end, when balance sheets get “cleaned up”? Will this cause excessive volatility in the overnight Fed Funds rate?
All makes for some interesting times and will require monitoring by market participants!
