Fed Exit Strategy: Reverse Repos

How and when the Fed will unwind the massive amounts of liquidity it has provided to shore up the financial system and economy?  Will the Fed be able to manage the unprecedented unwinding skillfully so that they successfully manage to steer a course between overtightening (which could slow growth) and undertightening (which could fuel inflation)?

To answer these questions, the latest term of art to be added to our financial crisis lexicon is: “triparty reverse repo operations”.

A reverse repo - or repurchase operation - is expected to be a key tool in the Fed’s withdrawal of liquidity. It occurs when the Fed sells an asset that had been held on its balance sheet. At the same time, the Fed agrees to buy it back at a later date at a certain price, which will increase Fed balances when the transaction takes place.

The NY Fed recently announced that it would start to test “triparty reverse repo operations” in the real world. A report in today’s press suggests that it is indeed testing these operations on a very small scale: the Fed has drained $180 million from the system through triparty reverse repo arrangements that settle tomorrow.

A recent interesting talk by NY Fed Trading Desk head Brian Sachs on the Fed’s balance sheet provides more insight about the Fed’s exit strategy, including:

• Many of the special facilities created by the Fed to provide liquidity are scheduled to expire February 1.

• Other tools to tighten policy – apart from raising the federal funds target rate and discount rate - are the Fed’s relatively new ability to pay interest on reserves; and its sales of longer-term security holdings (one of the traditional tools for tightening monetary policy).

• The total amount of credit extended has fallen from a peak level of $1.5 trillion late last year to around $160 billion today.

For further reading, see The Fiscal Roadmap Project’s paper, “The Extraordinary Actions Taken by the Federal Reserve”.