Fed Said to Start Talks With Dealers on Using Reverse Repos

By Liz Capo McCormick

Sept. 22 (Bloomberg) -- The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.

Central bank officials are discussing plans to use so- called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That’s where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system.

There’s no sense that policy makers intend to withdraw funds anytime soon, said the people. The central bank’s challenge is to decrease the cash without stunting the economy’s recovery and before it sparks inflation. Fed Chairman Ben S. Bernanke said in a July Wall Street Journal opinion article that reverse repos are one tool to accomplish that goal without raising interest rates.

“One thing the Fed has to figure out is if they can launch pilot programs without spooking the market and creating the perception that they are about to tighten,” said Louis Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that specializes in government finance. “They are discussing things like accounting issues, and updating the governing documents to the volume of reverse repos the dealer community could absorb.”

Fed Balance Sheet

Deborah Kilroe, a spokeswoman for the Federal Reserve Bank of New York, declined to comment about meetings with dealers. Total assets on the Fed’s balance sheet stand at $2.14 trillion, up more than a $1 trillion since the collapse of the subprime mortgage market in August 2007 triggered the worst global financial crisis since the Great Depression.

The Federal Open Market Committee, at the conclusion tomorrow of a two-day policy meeting, will probably maintain its assessment that “tight” bank credit is impeding growth, said economists including former Fed Governor Lyle Gramley.

The Fed will keep its target rate for overnight loans at a range of zero to 0.25 percent at the conclusion of the FOMC meeting, all 91 economists surveyed by Bloomberg News said.

Minutes from FOMC’s Aug. 11-12 meeting showed that among the exit strategy options discussed were reverse repurchase agreements as well as setting up a term deposit facility to reduce the supply of banks’ excess reserves.

Repo Sizes

At maturity of a reverse repo, the securities the Fed sold to the dealers are returned to the central bank, and the cash goes back to the companies. The reverse repurchase agreements contemplated by the Fed would need to be for a longer period and larger size than has been typical in previous open market operations, according to strategists.

“To be effective, the Fed would have to drain several hundred billion dollars worth of funds through these reverse repos, between about $400 and $600 billion,” said Joseph Abate, a money market strategist in New York at Barclays Plc, a primary dealer. “You may have a dislocation in the repo markets due to the supply effect of the Fed injecting such a large amount of extra collateral into the marketplace.”

Steps taken by the Fed since March 2008 to combat the seizure in credit markets included expanding emergency lending to banks, supporting the commercial-paper market and bailing out New York-based insurer American International Group Inc.

“The timing is not now for the exit strategies to begin,” said Tony Crescenzi, a market strategist and portfolio manager at Newport Beach, California-based Pacific Investment Management Co., manager of the world’s biggest bond fund. Talk of exit strategies “will all seem very preliminary and conditional upon evidence that the economy is moving toward a self-sustaining and self-reinforcing condition. The proof of that will be some improvement in the labor market picture,” he said.

More Participants

The jobless rate reached 9.7 percent in August, the highest in a quarter-century. Employers have eliminated almost 7 million jobs since the recession started, the biggest drop in any post- World War II economic decline.

Bernanke said in the opinion piece that reverse repos could be done with counterparties beyond the Fed’s primary dealers, which serve as counterparties in open market operations and are required to bid on Treasury auctions.

More trading partners may be needed since primary dealers have been shrinking their balance sheets the past two years, and likely can’t absorb an additional $500 billion of securities, according to Abate at Barclays.

Banks worldwide have recorded more than $1.6 trillion of losses and writedowns since the start of 2007, according to data compiled by Bloomberg.

General Collateral Rate

Securities dealers use repos to finance holdings and increase leverage. Bonds that can be borrowed at interest rates close to the Fed’s target rate for overnight loans between banks are called general collateral. Those in highest demand have lower rates and are called “special.”

As the supply of Treasuries increases, which occurs when reverse repos take place, repurchase agreement rates are typically pushed higher. The rate on collateralized loans in the more than $5-trillion-a-day repurchase agreement market, where Treasuries are borrowed and lent, is already higher than the amount changed for unsecured borrowing of federal funds.

The overnight general collateral repurchase rate, which is typically a few basis points below the fed funds rate, opened at 0.20 percent today, compared with fed funds at 0.17 percent, according to GovPX Inc., a unit of ICAP Plc. A basis point is 0.01 percentage point. Wrightson is also part of ICAP.

When the Fed does begin, “it will use reverse repos in tandem with other draining operations,” said George Goncalves, chief fixed-income rates strategist in New York at Cantor Fitzgerald LP, a primary dealer. “The Fed won’t want to totally disrupt the repo markets and the short-term financing of Treasuries given how much debt is coming to market.”

3rd-Quarter Trading off to Strong Start

Day Ahead: Flat Start After Monday's Surge

The United States and Latin America

A new start in the Americas

From The Economist

Barack Obama has dangled a carrot for Cuba and Venezuela. Time for Brazil and others to show a bit of stick

ANTI-AMERICANISM was invented in Latin America as the expanding United States first swallowed a chunk of Mexico and then turned the Caribbean into an American lake, arousing nationalist resentment along the way. There have since been other, more co-operative strands in inter-American relations. But George Bush reminded many Latin Americans that what they like least about their northern neighbours is an attitude of overbearing arrogance. He thus offered an easy target for those, such as Venezuela’s Hugo Chávez, who like to blame their countries’ problems on a foreign scapegoat.

Barack Obama seems determined to disarm such critics. On his first visit to the region, which included a 34-country Summit of the Americas in Trinidad from April 17th to 19th, he charmed his fellow leaders by talking of equal partnership. But will Mr Obama be more successful with the neighbours than Mr Bush, who was accused of allowing his country’s influence in Latin America to decay?

Mr Obama wants to change some of Mr Bush’s policies towards the region while keeping others. He has offered Mexico’s president, Felipe Calderón, support in his fight against drug gangs. Bravely, he wants to resurrect immigration reform, which matters to Mexico and Central America; less bravely, he has little appetite for battling to reinstate a lapsed ban on semi-automatic “assault weapons” in the United States, many of which find their way to drug gangs south of the border. Like his predecessor, Mr Obama has sensibly recognised Brazil’s new stature as South America’s leading power.

Engaging Cuba

The most obvious change has come on Cuba. Shortly before the summit, the administration said it would scrap Mr Bush’s curbs on visits and remittances to the island by Cuban-Americans, and allow American telecoms companies to do business there. This was welcome. As Mr Obama says, the American economic embargo “hasn’t worked the way we wanted it to: the Cuban people aren’t free”. But that is an argument for scrapping it, rather than merely tinkering. The Economist has long believed that the embargo is unfair (it hurts Cubans rather than their government), illogical (America has normal relations with other communist countries such as China and Vietnam) and counterproductive (it gives the Castro brothers a pretext for tyranny). Many Americans have come round to that view. Congress may now start to dismantle the embargo. It is odd indeed that one group of Americans can now travel freely to Cuba while the majority cannot.

Before doing more Mr Obama wants Cuba to reciprocate by, for example, freeing political prisoners. But a more rational American policy should not be held hostage to an immediate response. It is by changing Cuban society, and by offering an alternative to dependence on Mr Chávez’s free oil, that American economic engagement might nudge Cuba to reform.

Mr Obama was polite to Mr Chávez in Trinidad. He is right when he says that Venezuela poses no security threat to the United States. But as Venezuela’s economy weakens, its president is cracking down on his opponents. This month Mr Chávez crudely disempowered the newly elected opposition mayor of Caracas, the capital. Mr Obama seems to agree with Mr Bush that public criticism of Mr Chávez is counterproductive. But it is in the interest of all the people of the Americas that the region’s relatively recent embrace of democracy and human rights be sustained. Mr Obama has made a promising start in his quest to persuade Latin Americans that the United States is “a force for good” in the region. Vain though the hope may be, it would be nice if Brazil and others responded by denouncing those in Havana and Caracas who hide behind anti-Americanism as a pretext for their own authoritarianism.

Crisis Didn't Start in the U.S.

Crisis Didn't Start in the U.S.

By Alan Reynolds

At the recent meeting of G-20 nations in London, officials from many nations agreed on one thing -- that the United States is to blame for the world recession. President Obama agreed, speaking in Strasbourg of "the reckless speculation of bankers that has now fueled a global economic downturn."

One problem with this blame-game is that last year's recession was much deeper in many European and Asian countries than it was in the United States.

By the fourth quarter of 2008, as the nearby table shows, real US gross domestic product was just 0.8 percent smaller than it had been a year earlier. The contraction was twice as deep in Germany and Britain and much worse in Japan and Sweden.

In February, US industrial production was 11.8 percent lower than a year before -- while Singapore was down by 22.4 percent, Sweden by 22.9 percent and Japan by 38.4 percent.

What was the mechanism by which US problems were supposedly spread to other countries? It wasn't international trade. The dollar value of US imports didn't start to fall until August 2008, and imports of consumer goods didn't fall until September -- many months after Japan and Europe fell into recession.

Indeed, most of the economies that fell first and fastest were not heavily dependent on exports to the United States. Even Japan accounted for just 6.6 percent of US merchandise imports last year, compared with 15.9 percent for both Canada and China -- whose economies fared relatively well.

Even if all of the weakest European and Asian economies could plausibly blame all their troubles on the relatively stronger US economy, how could anyone possibly blame banks? There were no bank failures last year in Japan, Sweden, Canada or any other country on this list except Britain. And US and British banks didn't fail until September-October -- at least nine months after the Japanese and European recessions began.

Yet it's clearly US/UK banks being fingered as the villains. German Finance Minister Peer Steinbrueck, for example, criticized an "Anglo-Saxon" attitude in America and Britain that encouraged risky lending and investment practices because of "an exaggerated fixation on returns."

But Germany's GDP and industrial production was down 19.2 percent for the year ending in January -- versus an 11.4 percent decline in Britain and a similar US drop. Are we supposed to believe that German (and Japanese) firms are more dependent on US and UK banks than American and British firms?

Another problem with blaming the United States is that the timing is all wrong. If the US recession had simply spread to other countries like a mysterious infection, shouldn't the US economy have been the first to start contracting?

Yet US industrial production only started to decline from its peak after January 2008 -- long after production began to slow in Canada (July 2007), Italy (August 2007), France (October 2007) and the Euro area as a whole (November 2007). Aside from a one-month uptick in February 2008, Japan's industrial production peaked in October 2007.

By January 2008, when both the US and European recessions are said to have begun, the OECD leading indicators were lower by nearly 0.8 points from a year before in the US -- but down 2.3 points in Sweden, 2.8 points in Japan, 2.6 points in Korea and 4.1 points in Ireland.

Those leading indicators correctly anticipated much deeper recessions in the latter four countries. And the most famous leading indicator -- monthly stock prices -- peaked in October 2007 in the US and UK, four months after stocks had peaked in Japan and the Euro area.

What did all the contracting economies have in common? Not all had housing booms -- certainly not Canada, Japan, Sweden or the other countries at the bottom of the economic-growth list.

What really triggered this recession should be obvious, since the same thing happened before every other postwar US recession save one (1960).

In 1983, economist James Hamilton of the University of California at San Diego showed that "all but one of the US recessions since World War Two have been preceded, typically with a lag of around three-fourths of a year, by a dramatic increase in the price of crude petroleum." The years 1946 to 2007 saw 10 dramatic spikes in the price of oil -- each of which was soon followed by recession.

In The Financial Times on Jan. 3, 2008, I therefore suggested, "The US economy is likely to slip into recession because of higher energy costs alone, regardless of what the Fed does."

In a new paper at cato.org, "Financial Crisis and Public Policy," Jagadeesh Gokhale notes that the prolonged decline in exurban housing construction that began in early 2006 was a logical response to rising prices of oil and gasoline at that time. So was the equally prolonged decline in sales of gas-guzzling vehicles. And the US/UK financial crises in the fall of 2008 were likewise as much a consequence of recession as the cause: Recessions turn good loans into bad.

The recession began in late 2007 or early 2008 in many countries, with the United States one of the least affected. Countries with the deepest recessions have no believable connection to US housing or banking problems.

The truth is much simpler: There is no way the oil-importing economies could have kept humming along with oil prices of $100 a barrel, much less $145. Like nearly every other recession of the postwar period, this one was triggered by a literally unbearable increase in the price of oil.