Fed Update: "Low Funds Rate For Extended Period"

Posted by urbandigs

Wed Dec 16th, 2009 02:59 PM

A: Quick check into the fed meeting and statement today.

As expected the Fed left rates unchanged and continues a zero interest rate policy. Actually rates are not zero, but rather hovering between 0.11% - 0.13% or so. Close enough right.

Here is the full Fed Statement.

In my opinion there are a few main things going on here that people should be aware of - Ill point out in bold and then include the fed wording in quotes:

A) Gradual Wind-down of Emergency Liquidity Programs - My thoughts on exit strategy were discussed here back in August. "First they will slowly remove emergency credit facilities", was my starting point.

In the fed's words:

"In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral."

The liquidity spigots that have been wide open and caused a huge carry trade in search for yield, will slowly be turned off.

B) Engineered Bank Recapitalization Environment Will Continue - Make no mistake about it, the fed has successfully engineered an environment suitable for the banks to recapitalize themselves. We can debate the merits of their policy choices in another discussion. The point was to recapitalize the banks, period - and we are in the process of doing this.

Yes unemployment is high and rising, yes we faced a severe recession, but the real damage was done to the banking system and that is where the fed is trying to target their fixes. Without healthy banks even when the economy and unemployment start to recover, lending will be subdued at best. Many think lending will be subdued anyway as accounting rule changes and off balance sheet rule changes will drag the writedown process out for years; i.e. zombie banks. I probably put myself in that camp. We still do not know how far off the marks are for CMBS, Whole Loans, P/E lbo's, etc.., or where these mis-marked assets may be hiding off balance sheet.

Everything and anything was done to help the banks. Now the street is riding the dollar carry gravy train looking for yield!

C) Lending Rates Are Super Low Because The Fed Wants Them That Way - Duh, right? Lending rates are likely 50-75bps lower than they probably would be due to a massive debt monetization experiment in which the fed is buying agency debt and agency mortgage backed securities. The total purchases are set to reach around $1.425 trillion! Umm, I don't even know what that is anymore. Given that close to $2 trillion in losses in the shadow banking system and who knows how many future anticipated losses are sitting on the books of the financials now that every rule was changed to benefit banks, the number is not as inflationary as some may think. In short, the money printing is not entering the economy!

Rather, the banks continue to hoard just under $1.1 Trillion in Excess Reserves as seen in the chart below (via the St. Louis fed).

bank-hoarding-excess-reserves.jpg

Why would they do this? Two main reasons that I see:

1) Banks should not and are not lending to consumers and businesses that are experiencing declining credit quality in a rising unemployment environment where everyone seems to be spending less, and...

2) Money is being hoarded to help absorb future loan losses that were not taken and rebuild capital ratios

If you see other reasons why the banks are hoarding, please speak up! These are the main reasons I think banks are not increasing lending, and rightfully so. Its the one thing banks got right in this whole mess.

So, rates are low because the fed wants them that way. In the fed's own words:
"To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt."
Which leaves us at what moves the fed may have next as they formulate an exit strategy. In my opinion, its the same as I thought back in August:

1. First they will slowly remove emergency credit facilities - that is clear
2. Second, they will be forced to raise rates - timing is iffy, and markets may force their hand
3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves - likely way out there, maybe 2011-2012.
4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. - at some point, yes.

These are my thoughts on the fed, what the fed is doing, the environment they are engineering, and what likely steps they have ahead of them over the next 2-4 years. Since they don't want to rattle markets or do anything counterproductive to their bank recap goals, these steps will likely be implemented slowly and in stages.

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