GOIH Global Economic Strategy Federal Reserve Open Market Operations: Part 1

Last week the Fed injected liquidity into the banking system via its open market operations increasing the reserves in the system by lowering the Federal Funds Rate below its target rate of 5.25%.
Apparently banks within the Fed system would not loan to other banks that had reserve requirements at the target rate of 5.25% suggesting that the banks that had an excess of reserves did not feel comfortable in loaning these reserves to other banks.
The reluctance to loan reserves suggests that member banks of the Federal Reserve System foresaw losses in their loan portfolio on deposit at the Fed, i.e., AAA rated MBSs, and would need the reserves to meet their own reserve requirements. See WSJ article, http://online.wsj.com/article/SB118666332147492919.html?mod=2_1312.htm_1.
If the financial system reserve aggregate amount was insufficient to meet the system requirements of its member banks, the Fed was obligated to step in and increase aggregate reserve amounts otherwise the financial system would freeze up and fail to clear transactions.

On Friday of last week BNP Paribus---France's largest bank, announced it was ceasing redemptions in several of its hedge funds that held mortgage securities, i.e., AAA rated bonds. Most probably the AAA rated bonds were being used as reserve collateral at its central bank—ECB, the European equivalent of the Fed.

Because the value of these securities could not be “accurately” determined according to the bank, it was ceasing redemptions and in effect marking to market the securities at a steep discount, thereby causing it to be deficient in its reserve requirements at the ECB.
The ECB sensing that if BNP, France’s largest bank was having a problem, its other member banks must be having the same problem and system aggregate reserves would be insufficient to meet the needs of member bank reserve requirements. The ECB injected more than €93 billion in the European banking system to allow its member to maintain reserve requirements demand.
In essence the ECB, and the Fed foresees loses in the value of securities it holds on behalf of member banks necessary to meet their reserve requirements. If the ECB and the Fed had not increased the aggregate system reserves, by the repo transactions conducted last week, the Fed Funds Rate would have skyrocketed due to the increase demand for reserves to offset the losses in the reserve securities being held on deposit at the central banks around the world.

Additionally, the Fed accepted MBSs as collateral for repo transactions from member banks that needed to raise funds to meet their reserve requirements for the first time since 9-11-01.

So what does all this mean?

It means that the residential mortgage market will not improve anytime soon until the Fed Funds Rate decreases below 4.25% which will lower the rate charged on 30 year mortgages, which will again allow a family with the average income to afford a mortgage on the average price home in the market.

The down side to this is that the Fed stated that core inflation remains a problem and a decrease in the Fed Funds Rate will have an inflationary effect as well as a severe decrease in the value of the dollar relative to other currencies, unless there is a coordinated decrease in interest rates by the G-7 countries.

Conclusions:

Our global economic strategist foresees a coordinated move by the G-7 central banks to lower interest rates around the world to ease reserve requirements of the global banking system. We foresee a coordinated move within the next sixty (60) days of 0.25-0.50% decrease in interest rates which will have the effect of increasing the value of fixed income securities, increasing the securities on deposit at central banks allowing banks to continue lending.