Photo: Jordan Roy-Byrne, CMT
There have been a flurry of rumours recently about the Federal Reserve investigating “sterilized” quantitative easing. Although the financial media has been harping on the concept, it has provided very little explanation of the actual process itself.When the Federal Reserve purchases a bond, mortgage-backed security, or other asset as part of typical quantitative easing, it essentially injects cash into the economy, and theoretically the value of the dollar would decrease because of the greater supply.
“Sterilization” at its essence just means that the Fed is not expanding its balance sheet (or creating money) when it purchases these assets because it’s absorbing money from elsewhere in the system.
But given that the Federal Reserve could potentially “sterilize” asset purchases in a number of different ways with a variety of different limitations, it’s important to understand what’s going on logistically.
First, the term “sterilization” is probably a misnomer for what’s really going on here, Lorcan Roche Kelly, Chief Europe Strategist at Trend Macrolytics, tells us. Ultimately, we should really just call “sterilized” QE a “cash neutral” operation.
So if a central bank were to buy assets and put money into the system, then sterilization is any operation that takes exactly that cash injection out of the system. There are three major ways a bank could do this:
Let’s say the Fed wants to purchase mortgage-backed securities in an attempt to inject money into the housing sector. The first—and most probable—way it would “sterilize” the money it’s putting into the market would be offering commercial banks interest to deposit money at its deposit facilities. This is currently the method the European Central Bank uses to neutralize its sovereign bond purchases through the Securities Markets Programme.
Roche Kelly explains that a central bank pursuing such a policy “is just moving money around in the market from one place to another…It’s saying, we think there’s money out there but we’re not sure where it is.” Commercial banks have money sitting on their books doing nothing and will (in general) gladly put it to use in a safe deposit facility with the central bank.
In order for this to work, the Fed would have to hold these deposits longer than just overnight. Otherwise, the cash wouldn’t come out of the system during business hours. That’s why the ECB auctions off these deposits for week-long intervals in what it calls “Fine Tuning Operations.”
Though unlikely, if a central bank is repeatedly unable to garner sufficient deposits to sterilize its activities, the consequences can be severe.
“What they do doesn’t matter; it’s what they’re perceived as doing that matters,” Kelly points out. If term deposits start missing, then sterilized QE becomes unbridled QE that expands the central bank’s balance sheet. If the central bank has committed to cash-neutral asset purchases but can’t complete them, the this generates “the appearance that the [central bank] can’t control the money supply.”
While a central bank can fail to receive sufficient bids from banks to deposit money, in practice these failures are infrequent and not systemic. “Given the current upper boundary (1%) and the near-zero short term rates, it’s impossible for auctions to fail (in fact they clear at levels quite distant from the maximum rate),” Banca IMI’s Gustavo Baratta told Business Insider about the ECB’s sterilization activities. Conditions are much the same for the U.S. right now.
Photo: Wikimedia Commons
2—Reverse repurchasing agreements (“reverse repos”)Another possible, but less likely, way the Fed could sterilize asset purchases is through reverse repos. Under this plan, dealers would offer to lend money to the Fed at a certain interest rate in return for collateral, generally Treasury bonds.
The New York Fed offers a brief explanation of how this works:
Fed reverse repos are settled DVP [“delivery versus payment”], where securities are moved against simultaneous payment. In this case, the Fed sends collateral to the dealers’ clearing bank, which triggers a simultaneous movement of money against the security. At this point, reserve balances are extinguished. When the deal matures, the dealer sends the collateral back to the Fed DVP, which triggers the simultaneous return of the dealer’s funds. This act re-creates the reserve balances that were extinguished on the front leg of the transaction.
In this case the Fed must go search for banks willing to buy specific securities—Treasury bills—worth a certain value, whereas banks come to the Fed offering funds when it uses term deposits. The T-bills offered by the Fed have maturities between one and 65 days.
Because they provide the Fed with the ability to choose exactly how much money to absorb, Roche Kelly considers term deposits to be a more flexible mechanism for absorbing excess liquidity. However, the frequency with which the Fed normally conducts reverse repos to “[offset] temporary swings in the level of bank reserves caused by such volatile factors as float, currency held by the public and Treasury deposits at Federal Reserve Banks,” indicates that the Fed could pursue such a policy if it were to pursue a policy of sterilized QE.
3—Hiking reserve rates
Last but not least, the Fed could hike reserve rates, forcing banks to hold a higher proportion of their Funds at its deposit facility. That would take money out of the open market and allow the Fed to offset asset purchases, but at a steep cost.
While the Fed would be injecting liquidity into specific parts of the economy, demanding that all banks across the system uniformly devote more of their funds to the central bank would have a harsh effect on the supply of credit available for lending in the system.
And if the asset purchases are being pursued as an economic stimulus anyway, then Kelly explains that this “makes a bad situation much worse.”
Thus, it’s doubtful the Fed will pursue this avenue.
Is this even likely?
Amid reassuring signs of economic growth, investors generally believe that the Fed will be wary of any liquidity measures that could cause inflation, particularly since there is already a lot of pressure on savers to make ends meet.
Sterilized QE, then, is an excellent solution to continued easing without incurring inflation, and a very real possibility that the Fed should consider as it searches for ways to keep the recovery alive. In the same vein, this type of easing also poses similar risks as the inflationary kind—getting banks hooked on capital that will not always be there.
A program involving sterilized asset purchases would actually be quite similar to the Fed’s current “Operation Twist,” a program which has allowed it to purchase long-dated Treasuries funded through sales of short-term Treasuries. Just like these other methods of sterilization, this program has been cash-neutral.
But unlike Twist, sterilizing asset purchases through term deposits (its most likely route) would allow it to more directly target areas of weakness in the economy while pulling cash out of the economy where it’s not needed.
Nonetheless, it would be surprising to hear anything more than vague consideration of such a policy from the Federal Open Market Committee’s meeting today. Investors are convinced that the Fed will continue to sit on its haunches today and analyse more data before pursuing another round of easing.