Fed to Quietly Begin Soaking Up Money Supply

The Federal Reserve Board announced today that it approved a new Term Deposit Facility program, which would allow member banks to receive interest on certain deposits held at the central bank. Think of the program as Certificates of Deposits (CDs) for banks. Term Deposits (TDs) would act as a way for the Fed to begin draining some reserves from the banking system and reining in money supply, without much disruption to the broader economy.

The program will start small, but could ramp up as the Fed tries to slowly remove excess credit from the financial system. This is one of the tools that it will use as a part of its exit strategy. It's a clever program, because it will result in temporary reductions in monetary supply -- so they should provide the Fed with flexibility if the recovery stutters. They would discourage banks from letting another credit bubble form between now and when the economy is healthy enough to begin more permanent monetary tightening.

Funds held as TDs will not be a part of the required reserves that members are already obligated to hold at the Fed. They would act as another way for a bank to invest some of its capital. They would curb credit, because banks would be putting cash into TDs instead of funding more loans. Like CDs, TDs will pay interest for a certain time period while the deposits will remain at the Fed. TD maturities will likely be six months or less.

While the Fed had announced its intention to create these TDs several months ago, it's interesting that the FOMC failed to mention the new program in the statement from its meeting earlier this week. It almost begs the question of whether the Fed avoided saying anything about its exit strategy due to fear of spooking the market. It's pretty hard to believe TDs wouldn't have come up in the committee's discussion, considering their formal approval would be announced later in the week.