Fed – Two Collision Courses

I got this report from DBS Bank two weeks ago. It argues that Fed policy is on two collision courses with a likely possible scenario of explosive monetary base, hence it forces the Fed to raise rates faster-than-expected once banks start to withdraw their $800 billion of reserves from the Fed. Essentially, Fed is not in the driver’s seat, banks are.

Below is the flow of its arguments, which I tend to agree.

Fed purchases of US Treasuries, especially mortgage-backed securities (MBS) comprise roughly 90% of the monetary base. But the base is being kept stable because the Fed offsets (sterilized) these purchases with sales of other assets. Now, the issue is that Fed is nearly out of assts it can use for sterilization purposes. Under current plans, Fed purchases of Treasuries and MBS will collide with the monetary base in less than 2 months. Either the Fed is finding a new way to mop up these purchases or the monetary base will expand by another $634 billion (35%) by March 2010.

Related to it, if Fed has to sterilized MBS purchase, one may ask why not just purchase fewer MBS? The answer is simply that the Fed is trying to support the housing market and financial institutions exposed to it. Traditionally, the Fed sets the risk-free rate of interest and allows the market or the Congress to pick the winners and losers via fiscal policy. Now the Fed is encroaching on Congressional territory and Congress is beginning to bite back. Two wrongs don’t make a right.

In short, Fed has already expanded the monetary base by some $800 billion since October 2008. So far, banks and other financial institutions have not lent this money out into the economy. Rather, they have kept it on deposit at the Fed. But financial institutions are taking more risk now and as the economy improves, they will withdraw those deposits from the Fed and lend these deposits where they earn a higher return. The Fed will have to match or otherwise markets will be flooded with liquidity.

Rate policy going forward will be determined more by bank willingness to take risk rather than it will be by the Fed per se. DBS argues that Fed would start to raise interest rates in 2Q10, about two quarters sooner than current market consensus, predicated on the view that this downturn was less a garden-variety recession than it was ‘shell-shock’ arising from the Lehman Brothers collapse.