FED EYES TIE-UP WITH MUTUAL FUNDS / THE FINANCIAL TIMES

Fed eyes tie-up with mutual funds

By Krishna Guha in Washington and Michael Mackenzie in New York

Published: September 23 2009 23:41

The Federal Reserve is looking to team up with the money-market mutual fund industry as part of its strategy to ensure that its unconventional policies to stimulate the economy do not produce a bout of post-crisis inflation.

The central bank envisages eventually draining liquidity from the financial system by engaging in trades called “reverse repos” with the deep-pocketed money-market funds. In these, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds.

The discussions about the strategy form part of a Fed effort to ensure it will be in a position to raise interest rates when it decides the moment is right – even though most officials believe it is still many months away from having to do so. In its policy statement, issued after a two-day meeting, the Federal Open Market Committee on Wednesday signalled a slightly brighter outlook for the economy. Indicating that it does not expect a double-dip recession, the Fed said it expected a “strengthening of economic growth”.

The US central bank said it would complete its planned $1,450bn purchases of securities and debt issued by Fannie Mae and Freddie Mac at a reduced pace, allowing it to stretch out the buying to March 2010.

However, it indicated it is slowly retiring some of the tools used to fight the crisis, saying it would “continue to employ a wide range of tools to promote recovery” rather than “all available tools” as in past months.

The central bank reiterated that it expects to keep interest rates near zero for an “extended period”. The Fed said activity has “picked up” and noted signs of a rebound in activity in the housing market. But policymakers still appeared very unsure about the prospects for household spending – which they said “seems to be stabilising, but remains constrained”.

Most policymakers presently ancitipate that the first rate hike will not come before the second half of 2010. However, the Fed wants to establish the mechanisms for doing this well in advance, which is why it is exploring the idea of transactions with money funds.

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets. By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure from regulators and investors to stick to low-risk liquid investments.

During the crisis, the Fed created roughly $800bn of additional bank reserves to finance asset purchases and loans. This total is likely to rise in the coming months as the central bank completes its asset purchases and the Treasury unwinds financing it provided to the Fed. Fed officials think they could raise interest rates even with this excess supply of reserves by offering to pay banks to deposit their surplus funds with it rather than lend them out. However, they also want to use reverse repos in tandem to soak up some of the excess reserves. Policymakers call this a “belt and braces approach”.

Copyright The Financial Times Limited 2009.