Thursday, December 17, 2009

McKenzie: Fed's first step in exit strategy

The Fed's support of the financial system since the end of 2007 has resulted in the creation of excess reserves in the banking system of more than $1,000bn. Economists and investors fear that, should banks start lending these reserves into the broad economy, inflation will surge.

Reverse repurchase agreements can be used to fend off such inflationary pressures. In a reverse repo, the Fed sells assets, such as Treasury securities, to dealers for cash, with an agreement to buy them back later at a slightly higher price. In the process, bank reserves are drained from the financial system.

In the coming weeks, the Fed will move from simulated tests of its reverse repo system with primary dealers to tests involving actual dollar amounts. The likely size of such transactions will remain small and the live tests are designed to not influence market interest rates or indicate any near-term change in monetary policy.,,,

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