You’ve always had the power to go back to Kansas.
–the Good Witch of the East, to Dorothy, in The Wizard of Oz
(This is the conclusion of a two-part essay. For Part 1 click here.)
Equipped with some historical background, we can now consider ways in which the Fed might get the Treasury and Foreign Official Institutions (FOIs) to revive their pre-crisis practice of parking surplus dollars somewhere other than at the Fed. In fact, most of the necessary means are already at hand. Fed officials only need to recognize and take advantage of them. They need, as it were, to click the heels of their ruby slippers together, and repeat three times that, so far as foreign dollar pools and big Treasury balances are concerned, “There’s no place like somewhere else.”
Just how can the Fed get the Treasury and FOIs to take their business elsewhere? Broadly speaking, their options are: capping their Fed deposits, or making those deposits less remunerative, or taking steps to restore the attractiveness of alternative investments that don’t gobble-up bank reserves.
Draining the Foreign Repo Pool
In principle, limiting FOIs’ use of the Foreign Repo Pool (FRP) is very easy, because the Fed is free to set any rules it likes for that facility. Specifically, as Matthew Klein observes in his Barron’s piece, “The New York Fed has the right to ‘manage the overall size of the foreign repo pool’ to ‘maintain orderly market or reserve management conditions’.” The Fed could, therefore, restore the limits it once placed on the pool. It could even scrap the facility altogether, since it operates the FRP as a courtesy to FOIs, and not because the Federal Reserve Act obliges it to do so.
Why shouldn’t the Fed take one of these steps? According to Zoltan Pozsar, it may be reluctant to cap the FRP because other central banks offer similar facilities without capping them. Consequently, he says, the “optics” of the Fed either limiting or discouraging the use of the FRP would be bad. Caps would deprive FOIs of an unlimited and relatively remunerative safe haven for their dollars when private banks come under stress.
These arguments aren’t all that convincing. Optics? Those of the Fed’s recent repo-market tribulations, of its deciding to renew its asset purchases, and of the huge balance sheet it must possess by continuing along its present course, are themselves far from appealing. A “safe haven” for FOI dollars? Should the Fed make it easy, during times of financial stress, for FOIs to yank their money, not just from particular U.S. banks, but from the U.S. banking system as a whole? Isn’t it supposed to protect U.S. commercial banks, not Foreign Official Entities?
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