How Money Market Funds Could Help Drain The Punch Bowl

Punch Bowl

Money market funds could be called on to help the Federal Reserve slowly drain liquidity from the system.

Via reverse repurchase agreements, the Fed could sell treasury and mortgage-backed securities to these funds, with an obligation to buy them back after a fixed period.

These transactions should pull money out of the system temporarily, until the securities are then bought back by the Fed.

Any such action will be tricky. Should the punch bowl drain too quickly, deflation could crash the party.

Reuters: The idea of the Fed using reverse repos to help unwind policy is not new; Fed chairman Ben Bernanke identified them as a potential means of soaking up liquidity in July. But the market had previously expected the repos to be done with primary dealers, including former Wall Street investment banks.

The central bank is now considering dealing with money market funds because it does not think the primary dealers have the balance sheet capacity to provide more than about $100 billion, the Financial Times said.

Money market mutual funds have about $2.5 trillion under management so they could plausibly provide between $400 billion and $500 billion, it said.

The newspaper added that the Fed did not think it would need to drain liquidity all the way to where it was before the crisis, because it was confident it could raise interest rates even with a much larger amount of reserves in the system than existed before the crisis.

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