For the past four years, the Federal Reserve and the market have turned a blind eye to the flaws of the eventual end to their relationship. Just last week Chair Yellen told investors that the zero interest rate regime was ending as the risks are beginning to outweigh the marginal benefit. Policy normalization is coming in 2015 and we thought it appropriate to discuss the implementation mechanisms and challenges the Fed now faces as it begins this process.
Large Scale Asset Purchases, the Fed’s portfolio and monetary reserves
The hurdle rate is high for the Fed to deviate from the reduction of quantitative easing, projecting a completion by October 31. At that point the Fed’s portfolio of securities will exceed $4.25 Tr, mirrored (roughly) on the liability side of their balance sheet by currency in circulation and bank reserves.
We believe the portfolio of securities and reserves in the system will remain elevated for many years. A deeper dive into the portfolio’s holdings reveals that the total Treasuries maturing over the next two years are de minimis (< $5B). Conversely, the Agency MBS portfolio is likely to experience pre-payments of $175B per annum. The Fed’s principal objective has been to support the mortgage market. It would seem counter-intuitive to end this support, particularly since the recovery in housing has been lackluster.
Additionally, allowing the portfolio to mature would drain reserves (cash) from the banking system, sending a contradictory message to these institutions. Reducing cash, while regulators are putting in place liquidity and other capital limitations, runs the risk of a further deleveraging impetus. A recent interview with NY Fed President Dudley** suggests the Fed is adopting a similar view, “I don’t think that there’s any strong imperative for the Fed to have to shrink the balance sheet. I think we can conduct monetary policy with a very large balance sheet indefinitely.” So, how can the Fed influence short rates while keeping the balance sheet elevated?
Raise the Fed Funds Rate
Unfortunately the Fed Funds rate targets the liability side of the banks balance sheet and banks are deposit rich. With all the cash in the system there should be limited (if any) follow-through impact on short-term rates. The monetary base has consistently run between 5-7% of Nominal GDP, but will grow to 23% by October. While the Fed Funds target rate has been between 0 – 0.25%, short term rates have drifted lower (toward the 0 band) with each successive increase in the monetary base.
Raising Interest on Excess Reserves (IOER)
IOER has prevented short rates from turning negative, but has done little to lift short rates toward the 0.25% upper band. Given the regulatory environment, the spread between IOER and deposit rates would need to be significantly greater (a political risk), before competition for deposits ensued. Conversely, should the economy accelerate more quickly, the IOER rate would need to rise considerably before the risk adjusted spread would be a disincentive to lending (politically infeasible). So what’s left?
Reverse Repo Facility (RRF)
The RRF will (hopefully) play an important role in addressing the available reserves and setting the short-term borrowing rate. In order for the RRF to be effective the participation needs to be broad and the size and implementation of the program credible. We expect the GSEs to participate along with the money market community (representing ~$2.7Tr*** in cash). Realistically, given the logistical issues and regulations an amount in excess of $1 Tr would be required. There is some debate as to whether the facility needs to have this much capacity to influence rates. However, given the size of the monetary base, we view capacity as a necessity (at least in its infancy). The Fed’s program would represent more than a doubling of capacity (Tri-party system currently handles ~$1.1Tr in flows****). While the feasibility and logistics are a clear headwind, a heavier reliance on RRF coupled with high IOER balances should allow the FOMC to maintain control over short-rates.
Risks to implementation
If the RRF is not credible, short rates will detach from the Fed’s intended target, damaging their credibility. An inability to influence short rates may encourage investors to releverage and reach for yield. Taking this risk to its farthest conclusion, the Fed would be forced to push even harder on its available tools to achieve its goals, heightening policy error. It still maintains the option of selling its portfolio outright, but this could create the type of instability that undermines their “achievements” over the past few years.
What to look for as policy normalizes
Focus on the RRF, as the program should be expanding toward $750B by the end of the year with a gradual increase in interest paid toward the Fed Funds effective rate. In Q1 of 2015, the program should be approaching $1Tr in assets and an interest rate paid equal to IOER.
What does this mean going forward?
The Fed will continue to reinvest its portfolio of securities. The Fed Funds rate will not set short-term rates; this measure will be a causality of the RRF, IOER and the Fed’s balance sheet. The FOMC will continue to reference the Fed Funds Rate, partly as a signaling tool to influence financial conditions and to maintain continuity with historical measures. However, the success of policy normalization will hinge on the Reverse Repo Facility. If the logistics and capacity is sufficient the FOMC should be able to set a floor on rates and transition toward higher yields with an elevated balance sheet for several years. However, if the RRF is operationally ineffective or the economy accelerates too quickly, it remains to be seen whether the new monetary tools, will suffice or if the Fed will be forced to sell assets. Either way, “Breaking up is hard to do.”
* Neil Sedaka
** William Dudley interview at the Wall Street Journal Breakfast March 6th, 2014
*** Figure calculated using the Federal Reserve, “Money Stock Measure – H.6” Institutional and Retail Money Market estimates as of Dec. 2013 and Dec 2013 financial statements from FHLB, FNMA and FHLMC
**** New York Fed, “Update on Tri-Party Repo Infrastructure Reform” February 2014: Daily flows of Treasury and Agency MBS Tri-Party agreements