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Comment

We believe the proposal of this new tool signals the Federal Reserve is still flailing around trying to look busy so everyone is assured they have a plan. The fact is they have no plan and are still throwing everything on the wall to see what sticks. From the November 4 FOMC minutes :Participants expressed a range of views about how the Committee might use its various tools in combination to foster most effectively its dual objectives of maximum employment and price stability. As part of the Committee’s strategy for eventual exit from the period of extraordinary policy accommodation, several participants thought that asset sales could be a useful tool to reduce the size of the Federal Reserve’s balance sheet and lower the level of reserve balances, either prior to or concurrently with increasing the policy rate. In their view, such sales would help reinforce the effectiveness of paying interest on excess reserves as an instrument for firming policy at the appropriate time and would help quicken the restoration of a balance sheet composition in which Treasury securities were the predominant asset.Furthermore, they believed that other reserve management tools such as reverse RPs andwould likely be sufficient to implement an appropriate exit strategy and that assets could be allowed to run off over time, reflecting prepayments and the maturation of issues. Participants agreed to continue to evaluate various potential policy-implementation tools and the possible combinations and sequences in which they might be used. They also agreed that it would be important to develop communication approaches for clearly explaining to the public the use of these tools and the Committee’s exit strategy more broadly.

The Federal Reserve first hinted at term deposits almost two months ago, although exactly what they were talking about was left vague until now.

Remember that the Federal Reserve has to withdraw over a trillion dollars of excess liquidity. The easiest way to do this is to sell hundreds of billions of MBS, Treasuries and agencies. As the bold highlighted passage above implies, they are scared to death of doing this, so they propose complicated schemes to withdraw liquidity like reverse repos and now term deposits.

We have argued that these schemes will not work. They cannot be done in the sizes necessary or enough to even matter. The Federal Reserve could possibly drain tens of billions of dollars via these schemes, but collectively that will amount to a rounding error when the goal is to withdraw over a trillion in excess reserves.

The Federal Reserve does not want to admit defeat, so they continue pursuing these strategies that will not make a difference. We believe they also do it to “look busy” as they are taking measurements and notes as to how to withdraw all the liquidity they have pumped in. They think this will give the market comfort that someone is on the case and that inflation expectations will not get out of control. As the TIPS breakeven chart in the block above shows, the market is not buying this. Inflation expectations are going vertical.

Reinvestment Risk

As to term deposits, the Federal Reserve is proposing an illiquid short term instrument for banks to invest in. Banks would buy these instruments and “lock up” the excess reserves they now have. This would have the same effect as draining excess reverses. The maturities of these instruments would be as long as one year.

It is unclear if there will be a secondary market for these instruments, and if so, how liquid it will be.

Without a secondary market, buyers of these instruments face huge reinvestment risk. 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? This is especially true given the Federal Reserve’s statement that the “maximum-allowable rate for each auction of term deposits would be no higher than the general level of short- term interest rates.”

The general level of short-term interest rates is set on known instruments that have generations of history and active secondary markets. If the Federal Reserve wants to introduce a new, and wholly unknown instrument with an uncertain secondary market and offer no interest rate premium, then we cannot see how this will work beyond a token amount after some arm twisting to get them sold. The Federal Reserve will have to offer a premium for uncertainty and illiquidy to make this fly in any major way, something they said they will not do.

Complicated Is Simple

The Federal Reserve owns 80% of AIG. With each passing day it looks like the Federal Reserve is adopting AIG Financial Product’s business practices. 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. Once the tools are so complicated that no one understands them, you will be hailed as an expert with no peer. You might even be named TIME’s Person of the Year.