Federal Reserve sharpens tools for lift-off
Central bank seeks to ensure short-term market interest rates obediently follow higher target level.
Engineering the great escape from near-zero interest rates will present the Federal Reserve with a universe of challenges. A key one is ensuring short-term market interest rates obediently head where the Fed wants to see them.
Achieving this is going to be a daunting feat for a central bank facing a financial sector that has changed radically following the crisis. Markets specialists at the New York Fed have for two years been extensively road-testing a new toolkit aimed at setting short-term rates in this new world, but success will only be judged when lift-off actually occurs.
Some analysts argue the operation could lead to unexpectedly choppy movements in financial markets.
Zoltan Pozsar, a former adviser at the US Treasury and now director at Credit Suisse, warns: “This could be a turbulent process.”
The Fed needs new levers because of the creation of trillions of dollars of extra bank reserves through its quantitative easing programme. The Fed cannot use its traditional tool of varying the supply of reserves to banks to steer rates: there is simply too much money sloshing around the system.
The central bank’s solution will involve varying the interest rate it pays on those excess reserves parked at the central bank, which total $2.5tn, supplemented by an overnight reverse repurchase, or repo, facility (RRP) to manage the Fed funds rate.
Under the RRP, the Fed will sell Treasuries from its huge balance sheet to a wide array of players, including money market funds, and buy them back the following day. The difference between the selling and buying prices implies an interest rate paid on the cash invested, effectively extending the central bank’s rate-setting reach beyond the realm of ordinary banks.
Brian Jacobsen, chief portfolio strategist at Wells Fargo Fund Management, said: “I’m pretty confident they will be able to hit the target they want. The [RRP] is the really potent tool. They can use that to enlist the money market industry.”
The RRP may be potent, but it is also controversial, and Fed officials have disagreed over how large it should become — as well as how quickly the central bank should attempt to phase it out.
This is in part because some policymakers worry this Fed facility could distort the financial system, for example by becoming a haven for panicking financial institutions in a crisis, affecting the funding for banks.
Fed chair Janet Yellen has said the size of the RRP programme will be “elevated” when rates are first lifted, but that it will be quickly reduced in size thereafter. Ben Bernanke, the former Fed chairman, has on the other hand suggested the RRP should be a permanent feature of a big central bank balance sheet.
Joseph Gagnon, a former Fed official, now with the Peterson Institute for International Economics and who co-authored a key paper on the topic in 2014, argues this flight risk has been exaggerated and that the RRP will either have to be “very big or unlimited in size” if it is to work well. It is currently capped at $300bn.
He questions how easy the Fed would find it to shrink the facility over time. “If depositors move from banks to money market murtual funds, then many of those deposits will stay with the MMFs and the RRP will need to be permanent.’’
Mr Pozsar says tougher regulations under Basel III will encourage many banks to shed institutional deposits that are costly to maintain, and billions could flow out of non-interest bearing deposits and into MMFs when interest rates rise.
He and his colleague James Sweeney have argued the RRP will have to become very big — north of $1tn — as rates rise. “Once you let the cat out of the bag with a large RRP you can’t put it back inside. If you have a large RRP and then try to reduce it, it would be like the Treasury saying it will cut the supply of bills it issues. Rates would respond.”
On top of this uncertainty lies the question of how the Fed will handle the gradual reduction of its vast balance sheet, which following its purchases of Treasury debt and mortgage-backed securities is worth $4.5tn. This is hugely market-sensitive, and if the central bank mishandles its communications about the process of allowing it to shrink, it could trigger a bond market bloodbath.
The longer-term conundrum is what the Fed’s rate-setting mechanism will ultimately look like. William Dudley, the New York Fed president, told the Financial Times back in July that this is very much an open question.
“We are going to learn a lot about running monetary policy with a large balance sheet, using the overnight RRP and interest on excess reserves as our primary tools to affect the federal funds rate target.’’
In the last meeting of the Federal Open Market Committee, Ms Yellen said staff had been tasked with beginning an “extended effort” to evaluate monetary policy implementation frameworks for the long run. That work is expected to continue until the end of next year, underscoring just how complex the project will be.