Fed Not Just Printing Money, UBS Says

(RTTNews) - The new Treasury Supplementary Financing Program announced on Wednesday will help the Fed finance its loan to AIG, note the analysts at UBS. The Fed will allow its balance sheet to expand, but the impact on banking system reserves and the monetary base will be neutralized or sterilized by the Treasury depositing special T-bill auction proceeds in its account at the Fed. In short, the expansion will not be equivalent to printing money.

Until now, the expansion of Fed lending through liquidity programs such as the TAF has been largely offset by a reduction in the Fed's outright holdings of securities. The Fed's overall balance sheet has been expanding at a fairly moderate 3-4 percent y/y pace. The monetary base has been rising at a 2 to 3 percent y/y pace recently. The AIG loan will require more adjustments, however, since the Fed is drawing in a non-depository institution into its balance sheet data. The result will be offsetting boosts to both sides of the Fed's balance sheet, with no significant net impact on the monetary base.

The Treasury's new SPF potentially also could be used to bring additional assets onto the Fed's balance sheet. On Wednesday, Senator Dodd of Connecticut (D | Quote | Chart | News | PowerRating) suggested that the Fed could become an "effective Resolution Trust Corporation," purchasing and ultimately disposing of depreciated assets.

Even without lending to AIG, the weekly balance sheet data from the Fed on Thursday are likely to show more growth than usual, reflecting efforts to offset the severe upward pressure on the effective funds rate this week; injections of liquidity through overnight repos have been unusually large. In addition, the Fed reportedly lent $87 billion to Lehman Brothers this week, fully collateralized, to help the company settle trades — effectively a discount window loan.

Fed still has balance sheet capacity. The use of multiple liquidity measures by the Fed over the past year has transformed the Fed's balance sheet, but there is still ample room for more measures if necessary. As of September 10, the Fed had $362 billion in "unencumbered" securities holdings: $480 billion in outright holdings less $117 billion that had been lent out.

If absolutely necessary, the Fed's balance sheet could be expanded significantly without the neutralizing impact of increased Treasury deposits at the Fed—expanding the monetary base. However, we believe that approach is unlikely until after other measures, including further lowering of the funds rate, are also taken. Also, that approach will likely first require Congressional approval of an existing Fed request to allow the Fed to pay interest on reserves immediately. Under current law, the Fed will be allowed to pay interest on reserves starting on October 1, 2011. That authority would enable the Fed to increase total bank reserves significantly without having to push the funds rate all the way to zero.

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