Mutual funds may be used to drain Fed's liquidity bath

Everyone has been wondering when and how the Fed would start exiting from the stimulus packages it implemented at the start of the financial crisis. We're beginning to get a glimpse of what the Fed may do to start draining funds from the economy.

One major strategy could be to work with money market funds to drain liquidity and hopefully avoid post-crisis inflation. The Fed plans to borrow money from money market mutual funds using reverse repurchase agreements (or repos), according to a report in the Financial Times. Using this strategy, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds. When the timing is right, it could then use these reverse repos to begin raising interest rates.
The way repos work is that one party purchases a security with the agreement to sell it at a higher price at some specific date. For the party selling the security (and agreeing to repurchase it in the future, in this case the Fed), it is a repo. For the party on the other end of the transaction (buying the security and agreeing to sell it in the future -- in this case the mutual funds), it is a reverse repurchase agreement. When the Fed starts to purchase backs these securities it will essentially be taking money out of the economy, which will result in interest rate increases.

The Fed also indicated it was making other moves to start slowing the spigot of stimulus funds:

* It's slowing its purchase of $1.4 trillion in purchases of securities and debt issued by Fannie Mae and Freddie Mac through March 2010.

* It indicated in its statement after the meeting that it is slowly retiring some of the tools used to fight the crisis by saying it would "continue to employ a wide range of tools to promote recovery." In previous statements the Fed has used the term "all available tools." That's a subtle but significant change in Fedspeak.

While the market has been expecting the Fed to announce plans to unwind its stimulus, using money market mutual funds surprised Wall Street. The Fed does not think that Wall Street investment banks have strong enough balance sheets to do the job, while money market mutual funds have $2.5 trillion under management. The Fed thinks Wall Street investment banks could provide only about $100 billion while money market mutual funds could provide between $400 and $500 billion.

Reports indicate that the Fed likely will not drain liquidity back to the levels prior to the crisis because it believes it can raise interest rates even if there is a larger amount of reserves in the system. For those of you watching rates, the good news is the Fed does not anticipate raising interest rates before the second half of 2010.

Lita Epstein has written more than 25 books, including The Complete Idiot's Guide to the Federal Reserve.

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