Federal Reserve Mulls New Bond-Buying Technique

 @MikeObelm.obel@ibtimes.com on March 07 2012 12:07 PM

The U.S. central bank, responding to worries that the dramatic increase in the size of its balance sheet may spark inflation, is considering a new bond-buying technique to use if it decides on more economic stimulation, according to reports.

Since 2008 the Federal Reserve has expanded its balance sheet by $2.3 trillion through purchases of Treasurys. Although the Fed does not print money, the effect is an expansion of the money supply, or money printing.

The Wall Street Journal said Wednesday that the Fed is considering creating new money by purchasing long-term mortgage or Treasury bonds and then keeping that new money out of the economy by borrowing it back from investors for short periods.

Known as reverse-repos, the effect would be the same as the Fed's Operation Twist, an effort to reduce long-term interest rates by purchasing long-term bonds and selling short-term bonds, something that raises short-term interest rates.

But unlike Operation Twist, the size of a reverse-repo is not limited by the amount of the central bank's short-term holdings, the Journal said.

Additionally, a reverse repo could be conducted with non-banks, such as money market funds, something that is seen as giving the Fed more flexibility in managing its reserves.

Fed officials are mulling the costs and benefits of a reverse-repo, the Journal said. One downside could be higher short-term interest rates, which the Fed has pushed down to near zero.

There is another downside to a reverse-repo, said Louis Crandall, a money market analyst with Wrightson ICAP LLC. On the one hand, the central bank has described a reverse-repo as a way to tighten credit; on the other hand, using it in combination with a bond-buying effort designed to ease credit, giving markets contradictory signals.

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