WASHINGTON | Fri May 13, 2011 2:02pm EDT
WASHINGTON (Reuters) - If the U.S. Treasury wins a big enough increase in the $14.3 trillion limit on the nation's debt, it will likely use some of its new-found resources to help the Federal Reserve when the central bank finally decides to tighten monetary policy.
Fed watchers say there is logic in replenishing the Supplementary Financing Program, which the Treasury set up to help the Fed manage its fast-growing balance sheet during the financial crisis.
The Treasury has shrunk the program to just $5 billion in its quest to stay under the borrowing cap. The SFP would come in handy when the Fed starts to drain money from the economy and could help ease an acute shortage of Treasury bills in money markets.
"If it weren't for the debt ceiling, the SFP would still be there," said Dana Saporta, an economist at Credit Suisse in New York. "There are benefits to ramping it back up."
It would take a debt limit increase of $2 trillion or more to give the Treasury enough borrowing headroom to restore the Fed account back to its previous $200 billion level and finance the federal government through late 2012.
Many Republican lawmakers want a smaller, short-term debt ceiling increase to keep pressure on the Obama administration for deeper spending cuts. This would make funding the SFP more problematic, as it would need to be quickly drawn back down.
The Treasury launched the program in 2008 when emergency Fed lending to banks exploded as financial markets froze.
The SFP gave the Fed a method to offset some of that lending to prevent an unintended easing of monetary policy by selling Treasury bills and then locking up the cash proceeds in the Fed account. Future bill sales from the SFP would play the same role by drawing money out of the banking system.
At its peak in November 2008, the SFP reached $559 billion, or about half of the Fed's $1 trillion expansion in bank reserves during the crisis.
NEW FED TOOLS
Since then, however, the Fed has developed new tools to help it eventually withdraw billions of dollars from the economy to control inflation as the recovery gains steam.
These include a term deposit facility that allows it to pay interest on excess reserves to banks. Once the Fed starts to increase the interest rate on those reserves, this will act as a giant magnet, sucking money back into the Fed from banks that would otherwise make loans or supply funds to money markets.
The Fed also can engage in large-scale reverse repurchase agreements with financial market participants. These so-called reverse repos temporarily reduce excess liquidity through the sale of securities from the Fed's portfolio with an a agreement to buy them back later at a slightly higher price.
While some analysts say these tools may eliminate the need for the SFP, others say the Fed's job in withdrawing monetary support will be so huge that keeping the account active would be valuable.
"When the Fed starts to drain reserves, it's an awfully big number, and the Fed's own tools may have limited capacity," said Louis Crandall, chief economist at Wrightson-ICAP in Jersey City, New Jersey.
Crandall said some of the securities sold by the Fed in reverse repos may have limited appeal for banks, while the Treasury bills sold for the SFP are a universal currency for money markets.
The Fed contends it could get along without the program if it has to. "The Supplementary Financing Program is a useful addition to our toolkit for managing bank reserves, but it is by no means necessary for the effective conduct of monetary policy," said James Clouse, deputy director of the Fed's Division of Monetary Affairs.
Short-dated Treasury bills used as collateral in interbank markets have been in short supply since the Treasury has shifted toward longer maturities and is no longer selling paper to support the SFP.
This crunch, which has flattened bill yields to near zero, also reflects a change by the Federal Deposit Insurance Corp to assess fees based on banks' total asset sizes -- including excess reserves parked at the Fed, where they have not been earning enough to pay the fee. Thus, a flood of cash has been unleashed in search of short-term securities, and a fresh supply of bills would help money markets function more smoothly.
Treasury officials say they would like to ease these pressures, but are constrained by the debt limit. They have also signaled they are open to replenishing the Fed account.
"I think there's an understanding that we simply don't have the headroom right now to fund that fully at $200 billion, but we have the ability to raise it in the future once the debt ceiling gets raised and if the Fed basically asks us to do so," said Matthew Rutherford, the Treasury's deputy assistant secretary for federal finance.
(Reporting by David Lawder; Editing by Dan Grebler)
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