Has the Federal Reserve Board eased credit and is it allowing interest rates to decline? Last week was dominated by technical considerations that completely clouded the easing issue, which resulted in confusion and volatility in the market. The facts are as follows:
To begin with, the market was facing the $14.25 billion, three-issue Treasury offering. Government dealers do several things in an effort to protect themselves from falling prices during large financings. They will sell, prior to the auctions, issues similar to the ones being offered in the auction. If the market declines, they will purchase the securities they sold at lower prices and make a profit. They hope that this profit offsets any losses sustained from securities acquired in the auctions that may have declined in price.
They can also hedge their positions by selling on the futures market. They may also sell the actual issues that are being offered in the financings, on a "when-issued" basis. These ploys protect the dealers from falling prices. Conversely, should prices rise before they "buy in" their positions, they lose money, since their purchase price is higher than the price at which they sold them.
Currently, the Treasury's cash balances have swelled to an extraordinary size--in excess of $22 billion--due to increased revenues and slower expenditures. As the revenues roll into the coffers they are deposited in commercial banks, and a working balance of up to $3 billion is maintained with the Federal Reserve. The commercial banks must collateralize these Treasury deposits, and when they reach $18-19 billion, the banks become saturated with these deposits and cannot handle more. The excess is then deposited in the Treasury's account at the Fed. When this happens, reserves are drained from the banking system, which the Fed must offset through its open market operations.
Last week, the Treasury and Fed were in a dilemma. If they did not offset the draining of reserves, the federal funds rate would have reflected the tightness in the banking system by rising. This would have forced other rates higher, especially the rates on the three new issues. This forced the Fed to engage in massive open market operations to supply reserves to the banking system and to keep the federal funds rate from rising.
In the confusion, bond prices rose and some felt that the Fed had eased. Dealers were forced to buy in their "short" position, which helped to move prices even higher. In spite of all this, no one could be sure if the activities were technical or if in fact the Fed had used this confusion as a smokescreen to cloak some easing. In any event, the three auctions came at rates lower than had been anticipated.
As to whether or not the Fed has eased, only future Fed data will reveal. However, it seems doubtful that the Fed would ease now while the economy is still so upbeat. Further, the election is still over a year away and the administration certainly would not like the Fed to apply the brakes to the economy prior to the election, resulting from easing carried out now. Of course, this could be a smokescreen for the Fed to hide behind, too.