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Fed’s Death Star weapon trumps taper concerns

Investors concerned that the Federal Reserve massive balance sheet expansion will cause inflation shouldn't bother – the Fed has also built the Death Star.

Furthermore, the growing influence of this new central bank tool suggests that investor fears of market collapse as the Fed ends its quantitative easing program are misplaced. In fact, the Fed is already using the Death Star to take more money out of financial markets than QE is adding.

The Death Star is the nickname coined by Cronus Futures' Kevin Ferry for the Fed's reverse repurchase agreement (reverse repo) facility officially named "the Fixed Rate Full Allotment Over Night Reverse Repo Facility."

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The ominous tone of the name reflects the potential power of this Fed tool, rather than the potential for mass market destruction. The Death Star provides the central bank with the ability to drain a virtually limitless amount of liquidity from markets if inflation pressures appear.

Central banks using reverse repos is not new, but the scale of the new program is. The process is just an exchange – the Fed sells Treasury bonds along with an agreement to purchase them back, usually the next day, for a specified amount. The purchaser of the bond receives a small profit, recently increased to five basis points per day, when the transaction has been completed.

The novel feature of the Death Star is that reverse repo facility is open to 94 major money market funds, not just the major banks. This gives the Fed access to an ocean of cash that it could, by setting a rate that makes it profitable for money market fund managers to use the Death Star facility, take out of the financial system quickly.

The taper involves a steady reduction in asset purchases from the current $65-billion (U.S.) per month. Meanwhile, reverse repos are removing an average of $74-billion of liquidity. On a net basis, the Fed is already reducing money supply in financial markets by $9-billion per month.

The nature of QE and The Death Star mean they do not act in the same way, so their effects on money supply are not perfectly analogous. QE is active in longer-term bonds with durations of between five and 10 years. The Death Star would affect only securities of short, less than 12-month maturities.

Also, when the Fed buys a mortgage-backed security as part of QE, the money goes into the financial system for good. A reverse repo, on the other hand, is usually only a temporary withdrawal of funds – the money is usually repaid the next day.

Still, the average $74-billion in overnight money taken out of money markets represents funds that can't be used by managers that day. It is a real decline in money supply, if only temporarily.

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The major policy implications of The Death Star are still being studied. A paper by economists Joseph Gagnon and Brian Sack argues that a combination of the reverse repo facility and interest paid on bank deposits at the Federal Reserve will eventually replace the Fed Funds Rate as the primary means of setting interest rates.

One thing that's clear is that the Fed now has an inflation-fighting tool of unparalleled power. Previously, the Fed would raise interest rates and then wait until the growth-slowing effects of higher borrowing rates filtered through the economy.

With the Death Star, the Fed could theoretically remove a trillion dollars from available market funds almost instantaneously through reverse repos.

The existence of The Death Star also suggests that investors are too concerned with the Fed taper – in some ways, monetary stimulus is already over.

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