The Fed's Introduction of Innovation

11/22/2013 11:00 am EST

Focus: STRATEGIES

Jim Jubak

Founder and Editor, JubakPicks.com

In order to try to avoid a liquidity crunch in the money market sector, and to offset the negative effects of tapering, the Fed might introduce an alternative to cutting interest rates, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

It's “when” and not “if” on a tapering off of the Federal Reserve's $85 billion a month in purchases of Treasuries and mortgage-backed assets.

The minutes released Wednesday from the October meeting of the Federal Open Market Committee argue that the Fed wants to move to reduce those purchases.

Speeches by Fed governors and by Fed chairman Ben Bernanke point in the same direction.

But for me, the most compelling argument is that posed by the Fed's invention of something called a fixed-rate, full-allotment overnight reverse-repurchase facility (or RRP). This new tool would let the Fed shield money market funds from the worst effects of some of the tools that the Fed might employ to minimize the negative impact of a taper.

Here's why RRPs are significant. (And, of course, it's the consensus belief that the Fed won't taper before March that is letting stocks move upwards now.)

In the minutes from the October meeting of the Open Market Committee, most officials, according to the minutes, said the idea of cutting the interest that the Fed pays to banks—on the reserves that they keep at the Fed—was worth considering. Banks have taken some of the money, created by the Fed in its various programs of quantitative easing, and put it into their reserve accounts at the Fed rather than lending it out. The total is now about $2.5 trillion. The Fed pays 0.25% interest to the banks on this money. In theory, if the Fed cut the rate it pays, banks would put some of that money to use in the economy. The Fed has been considering the possibility of lowering the interest rate it pays to 0.15% or even to 0%. Both times the possibility came up earlier—in 2011 and 2012—the Fed rejected the idea.

No longer.

The problem—cited in those earlier rejections—was what reducing this rate to 0% or near 0% would do to money market interest rates. The rate that the Fed pays banks on their deposits acts as a kind of floor for other short-term rates. Cutting this interest rate to 0% could mean that other overnight rates could fall into negative territory.

The fear then, was that interest rates at that level would be so low that they might throw money markets into something like a liquidity freeze (of the sort that this part of the financial market experienced after the Lehman bankruptcy). Since banks and other financial institutions—as well as corporate treasuries—rely on money markets to buy their short-term paper, a liquidity crunch in the money market sector could have far-reaching effects on the economy as a whole.

Which is where RRPs come in. This Fed innovation basically creates a deposit account for money markets. Money markets could deposit as much money into RRPs as they want, and the Fed could set an interest rate on the RRPs—and this is what's important—that is independent from the interest rate the Fed pays on bank deposits at the Fed.

The Fed could, using RRPs, lower the rate that it pays banks on their reserves to 0%, but still pay money markets enough interest to put a floor under rates in that sector that would be high enough to prevent a liquidity crunch.

No one knows if the Fed will cut deposit rates for banks to 0%, or if the Fed will actually put RRPs to work.

But it is a good bet that the Fed wouldn't have spent time creating this instrument, and wouldn't be spending so much time discussing ways to offset the negative effects of a taper, if it wasn't serious about beginning to end its purchase program.

Not “if” but “when.”

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund of the end of June see the fund's portfolio here.

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