You’ve probably heard that the Fed has proposed a new program that will act like CDs for bank reserves.



The plan is to have the Fed issue the term deposits to banks, with maturities up to one year. The hope is that these Fed CDs will encourage banks to park reserves at the Fed rather than lending them out, keeping the huge amounts of money locked up as excess reserves from entering the economy through loans and triggering inflation.



Give them credit for bold action. Nothing like this has ever been tried before. If it worked, it would take the Fed’s control of bank lending to an entirely new level. By raising and lowering the rates on the CDs, the Fed could potentially micro-manage bank lending behavior to an extent unimaginable before our crisis.



It’s far from clear that the plan will work in the way the Fed hopes. In the first place, the CD program is likely to be too small to matter. The Fed is worried about over a trillion in excess reserves that it has built up inside of banks to keep the financial system afloat. It seems likely that the CD program won’t be anywhere near large enough to handle this.



The plan could also run into trouble with politicians. There is still a lot of criticism of the banks for not lending enough. The entire point of this program is to keep money out of the lending stream. As long as unemployment and small business bankruptcies are rising, fighting inflation by intentionally reducing bank lending will be a political lightning rod. Indeed, the direct nature of this program seems likely to make it far more controversial than traditional Fed inflation fighting measures.



The program is also unlikely to be popular with banks. It’s not clear yet whether the CDs will be tradeable and, if they were, whether an effective secondary market would develop.



“Without a secondary market, buyers of these instruments face huge reinvestment risk,” James Bianco explained in a recent note. “The future course of short term interest rates is arguably to the most uncertain it has been in decades. Will the Federal Reserve stay near zero until 2012 or will they be forced to raise rates in the first half of 2010? Given all this uncertainty, who wants to lock up money in something that cannot be sold before maturity?”



It seems likely that the Fed would have to compensate banks heavily for this lock-up, which means it will be very costly for the Fed. Worse, the interest paid on the CDs will actually be adding more money into the system—creating even more built-up inflationary pressure. The plan might kick the inflation can down the road but it will be rattling louder than ever.



But if the CDs aren’t likely to work, what’s really going on with the latest zany Fed scheme?

The key issue is one we discussed on December 21st—the inflation bomb hiding on the Fed’s balance sheet in the form of mortgage backed securities. In 2008, the Fed did something it had never done before—buying mortgage backed securities off the market. It now has over $1 trillion of mortgage securities on its balance sheet. This created a giant policy and financial risk for the Fed.



The Fed’s purchases of mortgage securities increased the monetary base, creating a huge inflationary danger. If the Fed were to the Fed to start sucking back these funds, it will have to sell these into the market. Unlike the repo and lending programs, however, the Fed cannot simply order the banks to repurchase the mortgage backed securities. It has to sell them at market prices.



The market’s knowledge that the Fed has become a seller rather than a buyer for mortgage backed securities will likely result in the pricing of these securities falling. In order to bring the yield of these securities up to a level acceptable to the market, they will have to be sold at a discount. This discounting means that the Fed will not be able to withdraw as much liquidity as it added, leaving some portion of that $1 trillion (plus its multiplier effect) in the economy to create inflation.



Think of it this way. If the Fed bought a mortgage backed security for $100 but can only sell it for $90, there’s a 10% inflationary discount occurring. It’s leaving in the economy a portion of the excess liquidity equal to the discounted price of the mortgage backed security. Which is to say, the Fed’s MBS has inflation built right into it.



The Fed is also concerned about the effects on the housing market and mortgage rates of any attempt to sell its mortgage portfolio. Fear of an additional $1 trillion of mortgage securities coming on to market could easily destroy any appetite for new issues, which would discourage mortgage lending and could snuff out a potential housing recovery.



The Fed also wants to communicate the idea that it is prepared to fight inflation without raising its target rates. The idea is to quell fears of future rate hikes that could spark a premature market pullback and avoid a contractionary rate hike while the economy is still in shambles.



With all the evident defects in the Fed’s plan, however, it’s not clear that it can accomplish any of these goals. It cannot sop up excess reserves because it is too small. It may actually add to the inflation problem, while merely delaying the inevitable. It won’t dampen concern about a Fed-selling induced mortgage backed security glut or coming rate hikes because it lacks credibility as an inflation fighting vehicle. In short, it’s all foam and no beer.



“With each passing day it looks like the Federal Reserve is adopting AIG Financial Product’s business practices,” Bianco wrote in his note. “That is, when faced with a financial problem, they create complicated tools (like CDS). When critics says these new products will not work, tell them they do not know what they are talking about and create even more complicated tools to dazzle everyone.”