Explainer: Five ways the Fed could calm frazzled markets

Oct 13 (Reuters) – Federal Reserve policymakers have pushed back on the notion that tensions in U.S. financial markets are about to require their intervention, as is the case in Britain, but the central bank has a range of options should domestic market conditions worsen. materially.

Here’s a look at how the Fed could forestall a market malfunction if it threatened to emerge, roughly ranked from most to least likely to unfold.

SPEAKING THE WORD

In recent days, Fed policymakers have acknowledged some liquidity constraints in U.S. financial markets — the Treasury market in particular — and the risk that raising interest rates to fight inflation could exacerbate vulnerabilities. both nationally and abroad. So far, the situation is not one of sellers of Treasuries barely able to find buyers, which was the kind of liquidity crisis that prompted the Fed to intervene in the pandemic and the financial crisis of 2007-2009. Policymakers said they were monitoring the situation.

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A next step may just be sharper talk, says Steven Kelly, senior research associate in Yale’s Financial Stability Program, “going out and telling markets that while markets may sell off as the Fed tightens , the Fed is ready to use all of its tools to enable an orderly tightening.”

Promises of action can, in themselves, calm the markets. Still, Fed policymakers would likely be cautious about raising their jaws one notch for fear of perhaps inducing too much calm and undoing the very tightening they need to get inflation under control.

STAND READY

The Fed has a few operational tools that can provide liquidity at a glance, the very existence of which probably already acts as a “stabilizing force” for otherwise volatile markets, Fed Governor Christopher Waller said last week.

Currency swap lines, established during the financial crisis and made permanent since, allow six major central banks to call on the Fed for dollars when needed. Widely used at the start of the pandemic, they have been little used lately.

For smaller central banks without permanent swap lines, the Fed offers a repurchase agreement or repo facility as an easy way to borrow money against their holdings of Treasuries. It hasn’t been used significantly for a year and a half.

It also has a permanent repo facility, established last year, which acts as a sort of automatic safety valve against upward pressures in money markets for US banks. Like the other two, usage has been minimal.

An increase in the use of any of these facilities would signal an increase in problems and set the stage for more active Fed intervention to come.

INTEREST ON BANK RESERVES, REVERSE REPOS

The Fed has pledged to raise its benchmark policy rate to beat inflation, but may change other rates it controls to inject more liquidity into the financial system. As PSC Macro’s Roberto Perli explains, the Fed could try to replenish bank reserves – an important pool of market liquidity – by raising the rate it pays on those reserves or cutting the rate it offers to funds. money market to park their cash at the Fed. , or both. This could also limit the use of repos by money market funds. “Each of these measures would have downsides, but the Fed may eventually have to use at least some of them,” Perli wrote.

BALANCE SHEET ADJUSTMENTS

As part of its effort to reverse years of stimulus and tighten policy, the Fed is cutting its balance sheet by nearly $9 trillion. This process intentionally drains liquidity from the financial system. Going too far, as happened the last time the Fed pursued so-called quantitative tightening in 2019, can cause market turbulence. Slowing that effort could ease tensions, but it could also send a confusing signal to markets that could conclude the Fed is pulling out of the fight against inflation.

Another option is to engage in targeted and temporary securities purchases, as the Bank of England has done recently.

PULL STOPS

Market speculation on the contrary, slowing or halting interest rate hikes in response to financial stability concerns is not under consideration or likely at all, Waller said last week. The Fed would likely only do so once it had exhausted all of its other tools, Perli wrote; anything else, like reviving the crisis lending facilities created during the pandemic, “seems pretty much out of place.”

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Reporting by Ann Saphir; Editing by Dan Burns and Chizu Nomiyama

Our standards: The Thomson Reuters Trust Principles.

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