Brian Sack, Executive Vice President of The Federal Reserve Bank of New York, gave a speech yesterday at the Federal Reserve Bank of Philadelphia entitled, "Implementing the Federal Reserve's Asset Purchase Program", on the "implementation of the recent monetary policy decisions of the Federal Reserve and the associated implications for its balance sheet" and the recent "unconventional policy decisions of the Fed. Sack said, "In the second half of 2010, the FOMC made two important policy decisions about the size and composition of the Federal Reserve's balance sheet."

He explained, "In August, it decided to begin reinvesting the principal payments from its holdings of agency debt and mortgage-backed securities into longer-term Treasury securities, thereby keeping the amount of domestic assets held in the System Open Market Account (SOMA) portfolio unchanged at about $2 trillion. In November, the FOMC announced that it intended to expand the SOMA portfolio by purchasing an additional $600 billion of longer-term Treasury securities through the end of the second quarter of 2011, bringing the intended level of domestic securities holdings to $2.6 trillion. Those decisions were aimed at providing more monetary policy stimulus to the economy. The FOMC saw the additional stimulus as warranted because it viewed the progress toward its mandated objectives of full employment and price stability as disappointingly slow."

Sack continued, "But while the intention of the recent policy decisions may be similar to traditional monetary policy adjustments, the implementation of them is not. These policy decisions involve what are presumably some of the largest and most rapid portfolio adjustments that have ever taken place by any single financial market participant. To put it in perspective, note that these recent policy decisions involve the Federal Reserve purchasing, over an eight-month period, more Treasury securities than the amount currently held by the entire U.S. commercial banking system. It is therefore no small task to determine how to implement these purchases in an effective and responsible manner. That task falls to the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York. Let me describe how the Desk has conducted those purchases and some of the issues that we have taken into consideration during the process."

He commented, "To achieve these objectives, the Desk relies on a system in which it purchases securities through reverse auctions with a set of established counterparties called the primary dealers. The securities that are eligible for each operation and an indication of the total size of the operation are announced in advance. Dealers then submit offers to sell those securities, either for their own accounts or on behalf of their customers, over a 45-minute period on the morning of the operation. Those offers are assessed by the Desk based on two criteria: their proximity to market prices at that time, and an internal methodology for comparing the relative value of the securities at the offered prices. This process occurs over a proprietary trading system called Fedtrade under the oversight of Desk staff, and the results are typically finalized and published within a few minutes of the close of the operation."

Sack also said, "Moreover, our purchases do not appear to be causing significant strains on the liquidity or functioning of the Treasury market. It is unusual for the market to have such a large, persistent, and one-sided participant, and we had to worry about how it would adjust to our presence. However, the available evidence suggests that market liquidity is decent at this time. Measures of liquidity, such as trading volumes, bid-ask spreads, or quote sizes, worsened in December, but that pattern appears to have been driven by year-end effects rather than our presence in the market. These measures have recovered since the year-end, moving back toward the levels observed before the start of the purchases."

Sack commented, "Since early November, one of the notable developments in financial markets has been the sharp increase in longer-term interest rates. At first glance, this change may seem at odds with the portfolio balance channel. However, it is important to understand the factors that led to the increase in interest rates in the current circumstances. The upward movement in longer-term interest rates in large part reflects the greater optimism among investors about the outlook for economic growth. Investors revised up their baseline forecasts for the economy and reduced the perceived downside risks that they see around that outlook. This shift in the outlook led the market to price in the possibility of earlier increases in short-term interest rates and to scale back the size of asset purchases that they expect from the Federal Reserve. Both of those developments contributed to the significant rise in yields."

In a section entitled, "Ensuring our Ability to Remove Policy Accommodation, Sack explains, "While the potential risks around the SOMA portfolio will not hamper the implementation of monetary policy, the size and duration of the portfolio will have to be taken into account when considering the appropriate policy strategy. In that regard, it is worth noting that, even as the Federal Reserve has been expanding its balance sheet, it has not lost any momentum in the preparation of its exit tools. When the FOMC eventually determines that the time to begin reducing policy accommodation has come, the critical tool will be the ability to pay interest on reserves. As has been discussed on many occasions, paying interest on reserves will allow the FOMC to control the cost of short-term credit even with an enlarged Federal Reserve balance sheet."

He added, "In addition, we continue to make considerable progress increasing our capacity to drain reserves if necessary. At this time, more than 500 depository institutions have registered for the term deposit facility. Those firms, in aggregate, hold nearly $600 billion of the reserve balances that are currently in the financial system. We also have added 58 money market funds as counterparties for reverse repurchase agreements, in addition to the 20 primary dealers that are our regular counterparties. Those money funds currently hold more than $1.5 trillion of assets, with a good portion of those assets in the type of short-term repurchase agreements that we would be offering. In short, we have already established considerable capacity to drain reserves with these two tools, and we will continue to advance them in productive directions."

Finally, he said, "My purpose today was to provide information on the manner in which the Desk has conducted the asset purchases that the FOMC has decided to pursue and the associated implications for financial markets and the Federal Reserve's balance sheet. On the whole, I believe that the recent asset purchases by the Federal Reserve have had helpful effects on financial conditions and have been implemented in a manner that has been flexible enough to avoid any significant negative consequences for the functioning of financial markets. Moreover, while the programs have resulted in significant changes to the characteristics of the SOMA portfolio, those changes will not impede the ability of the Federal Reserve to adjust the degree of policy accommodation when judged appropriate by the FOMC."

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