In addition, when SOMA holdings of a specific issue exceed 30 percent of outstanding securities, the Desk limits the rate at which it acquires new holdings of that issue based on a predetermined, graduated schedule. The Desk also refrains from purchasing certain Treasury securities in its operations if investors’ demand for those specific securities as collateral in the repurchase market or as deliverables into Treasury futures contracts is relatively high. In the event of significant market demand for specific Treasury collateral held by the SOMA, investors can borrow these holdings through competitive securities lending operations. In the MBS market, the Desk is supportive of market functioning in two main ways. First, as I mentioned earlier, we adjust our purchase allocation as necessary to respond to concerns about relative scarcity in particular contracts. Second, we use dollar roll transactions to facilitate the orderly settlement of our unsettled purchases. Selling dollar roll contracts essentially postpones the settlement of an outstanding purchase, while buying dollar roll contracts brings it forward. The Desk actively monitors implied financing rates on dollar roll  10  Since TBA transactions settle on a forward basis, the Desk is exposed to the risk that a primary dealer is unable or unwilling to meet its contractual obligations. If a counterparty does not deliver on its obligation, the Desk could be forced to replace the transaction at a higher prices.

These costs emanate from a variety of sources, including: increased uncertainty about the outcome of business decisions and profitability; adverse effects on the cost of capital resulting from the interaction of inflation with the tax system; reduced effectiveness of the price and market systems; and distortions that create perverse incentives to engage in nonproductive activities. BIS Review 17/1997  -2-  As a former commercial banker, I am especially aware of the negative effects of one particular type of nonproductive activity induced by inflation’s distortion of incentives -- the overinvestment of resources in the financial sector. It is well known that, in high-inflation economies, the resources diverted from productive activities to nonproductive financial transactions are enormous. But even moderate inflation rates can cause substantial diversion to nonproductive financial activities, and this diversion deserves greater attention than it often receives in economists’ list of the costs of inflation. As I look back over the last ten years or so, I am pleased that the Federal Reserve and many other central banks have been successful in controlling price pressures and putting inflation on a long-run downward track. Success in dealing with inflation clearly enhances the credibility of monetary policy and policy makers. From my perspective, the continuing challenge for central banks is to ensure long-term credibility for monetary policy by sustaining low inflation environments. Central banks are generally better able to meet this challenge if they are substantially immunized from short-term political pressures, and are firmly committed to price stability as the overriding goal of monetary policy.