The Tell: The Fed can take these two steps if its balance sheet expansion is making markets too frothy, says key Bofa strategist

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Now that it has calmed the repo market, the Federal Reserve might consider a few regulatory tweaks to tame risk-taking as its balance sheet expands, says Bank of America Global Research’s Mark Cabana, who saw the funding squeeze coming last September.

Whether or not the Fed believes its moves to soothe money markets constitute a form of unintended monetary policy easing, Cabana says the U.S. central bank could tinker with certain regulations to make financial conditions less accommodative without having to terminate its balance-sheet expansion, in a Thursday research note.

After the funding squeeze in short term U.S. money markets in September, the Fed not only conducted billions of dollars worth of repo auctions to provide liquidity via short term loans to cash-starved banks, brokers and hedge funds, but it also bought U.S. Treasury bills.

The Fed’s actions have drawn criticism for pushing up the prices of stocks and other assets despite protests from the U.S. central bank which has said monetary policy has remained on hold since the last of its three interest rate cuts in October.

See: He warned the Fed might lose control over a $2 trillion interest-rate market — Now he says it might happen again

To counter excessive risk-taking resulting from the extra easy money, Cabana offers two solutions.

First, the Fed could take measures to wean banks away from their reliance on reserves held at the central bank as their preferred form of capital used to assess liquidity requirements under regulations introduced after 2008 crisis which demand banks carry enough cash to handle sudden outflows, he said.

For example, the opening of a standing repo facility, where market participants could temporarily exchange their government bonds for cash, could increase the incentives for banks to hold Treasurys instead of cash reserves. This could serve as one solution to worries that banks aren’t lending sufficient funds to money markets.

Secondly, the central bank could increase the counter cyclical capital buffer also introduced after the 2008 crisis. The idea behind this measure is to impose additional capital requirements on banks when the economy and financial markets are doing well so that the financial sector does not get caught out during an economic downturn.

“However, the bar may be high to use this as a signal for overly easy financial conditions given risks of a negative market interpretation,” he said.

Cabana acknowledges the adjustments he proposes are unlikely to take place anytime soon, but he said the central bank may still see regulations as the most convenient way to rein in excesses in financial markets.

Investors have noted stocks and corporate bond prices both notched impressive gains since the Fed’s measures in September and October to increase the size of the balance sheet.

Since late August, the Fed’s portfolio of securities has climbed by around $500 billion to $4.17 trillion as of Jan. 13. Over that same period, the stock-market has also set off on its own record-setting climb, with the S&P 500 SPX, -0.59%   gaining close to 19%, FactSet data show.

To be sure, the fourth-quarter’s impressive run up in risk asset prices coincides with the signing of the phase one trade deal between the U.S and China which helped ease fears that the global economy would succumb to a slump.

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