No-Exit Strategy May Be Fed Burden in Unwinding StimulusMatthew Boesler and Rich Miller
The Federal Reserve is trying to change as little as possible as it crafts its strategy to exit from record stimulus. The trouble is financial markets have changed so much that the still-developing plan may prove costly and ultimately unworkable.
The approach, sketched out in the minutes of the Fed’s June 17-18 meeting and in officials’ comments since then, retains a focus on the federal funds rate as the central bank’s target. Policy would continue to be conducted mainly through banks rather than via dealings with money-market funds.
“They don’t want to make wholesale changes in the way they interact with markets when they are going to have so many other issues in play” as they raise interest rates, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, who has been watching the Fed for three decades.
The strategy has drawbacks, given the way money markets have evolved since the recession. Banks no longer need to borrow in the once-vibrant fed funds market to meet reserve requirements, as they did before the crisis, because the Fed has pumped so much money into the financial system during the last six years. As a result, trading in that market has dwindled and now mainly comprises U.S. branches of foreign banks acting as arbitragers, according to research by economists at the Federal Reserve Bank of New York.
To help keep that market alive, the Fed will have to pay those banks a premium to continue trading in it, which will eat into the profits the central bank remits to the U.S. government each year. And even then, foreign banks may be unwilling to continue their trades as stricter regulations on leverage take effect.
“I don’t like the political or economic implications” of the plan, Joseph Gagnon, a former Fed and U.S. Treasury official who is now at the Peterson Institute of International Economics in Washington, said in an e-mail.
“It costs the taxpayers money, and it makes for a less efficient financial system,” he added, a view echoed by former Fed Governor Jeremy Stein in an interview.
Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, suggested in a July 11 interview with Bloomberg News that policy makers would reach a final agreement on their exit blueprint at their next meeting in September.
Under the developing plan, the Fed would continue to set a target range for its benchmark federal funds rate, which banks charge each other on overnight loans. The interest rate it pays banks on reserves would be the ceiling, and the rate it pays to borrow cash from money funds and others would be the floor.
The Fed has made “excellent progress” toward deciding on the details of the exit strategy, Federal Reserve Bank of Richmond President Jeffrey Lacker said today in an interview.
“Our announced target range for the fed funds rate is going to be our main communications device,” he said. “The interest rate on excess reserves is going to play a key role in anchoring interest rates, including the fed funds rate,” while the rate available to money funds would be “a kind of insurance policy, but not the main driver of our control of short-term interest rates.”
In the minutes of their June meeting, Fed officials displayed a preference for continuing to conduct policy mainly through the banks, which they regulate, rather than through money funds, which they don’t. Most participants agreed that the rate of interest the Fed pays on bank reserves would be their “central” policy tool when the time comes to increase short-term rates, an event they forecast will occur in 2015.
The overnight reverse repurchase program the Fed has been testing since last year to soak up cash from money funds would be relegated to a “supporting role,” partly because of the Fed’s concern that expanding its footprint in money markets may “reshape the financial industry” in ways that would be “difficult to anticipate.”
In an overnight reverse repo, the central bank borrows cash from money funds and other counterparties using securities as collateral. The next day, the Fed returns the cash plus interest to the lender and gets the securities back.
The Fed currently pays 0.25 percent interest on reserves it holds for banks and 0.05 percent interest on the cash it borrows through the reverse repurchase program.
Many members of the FOMC judged at the June meeting that “a relatively wide spread -- perhaps near or above the current level of 20 basis points -- would support trading in the federal funds market and provide adequate control over interest rates,” according to the minutes.
That desire surprised market participants. Implied yields on all eurodollar futures contracts maturing between June 2016 and June 2017 fell 5 basis points, or 0.05 percentage points, on July 9, the day the minutes were released.
Until then, traders had expected the Fed to move the reverse repo rate closer to the rate on reserves, according to Joseph Abate, a money-market strategist at Barclays Plc in New York. A narrower spread would have given the reverse repo facility a bigger role as the Fed raises its benchmark by encouraging depositors to pull cash out of banks and put it in money funds in search of higher returns.
Economists criticized the Fed’s strategy as inefficient and costly for taxpayers. The higher rate it offers banks to keep liquidity from shifting into money funds eats into the profits from its investment portfolio that it remits to the Treasury. Last year, it gave the Treasury $79.6 billion.
“The Fed is not a profit-maximizing entity, but in this case, I think it’s not at all a dumb question to say, why aren’t you funding as cheaply as possible?” Stein said.
“There is no macroeconomic consequence of doing it the cheaper way,” said Stein, who resigned from the Fed in May to return to teaching at Harvard University and is also a contributor to Bloomberg View. “You can get rates to wherever you want either way; and arguably, as Milton Friedman would have said, you should sell your money to the highest bidder, because then it is being used most efficiently. And that would be the RRP counterparties here, as opposed to the banks.”
The situation is complicated further by the reluctance of domestic banks to engage in arbitrage in the fed funds market, because Federal Deposit Insurance Corporation insurance fees increase proportionally with bank leverage, reducing the profitability of the trades.
“The only people that are really arbitraging at the moment would be the foreign banks without domestic deposits that need to get insured,” said David Keeble, head of fixed income strategy at Credit Agricole in New York. “Ultimately, you’re allowing the arbitrage to continue and giving money” to foreign banks rather than domestic ones, he said.
The foreign banks now are borrowing from U.S. federal home-loan banks, which aren’t eligible to earn interest on reserves held at the Fed and so are willing to lend cash in the fed funds market at a lower rate. That rate has averaged 0.08 percent in the past year. Since foreign banks are eligible to earn interest on reserves, they can place the borrowed cash at the Fed and collect a 0.17 percentage point profit on the overnight transactions.
Their willingness to continue may wane as new leverage requirements and other regulatory changes make these trades less attractive, according to Ted Wieseman, an economist at Morgan Stanley in New York.
In what may be a sign of things to come, they “pulled back en masse” from conducting this kind of arbitrage on June 30 to avoid inflating their balance sheets at the end of the quarter, Crandall said in a July 14 note to clients.
The result: Money funds and others had to park their cash with the Fed because they couldn’t lend it to the foreign banks via time deposits, another instrument the banks use to finance the reserves they hold at the Fed. Instead, the money funds loaned a record $339.5 billion to the central bank through reverse repo agreements, more than three times the average daily amount during the rest of the month.
If foreign banks continue to retreat from overnight arbitrage trading as leverage requirements become increasingly binding, the Fed may be forced to transact more with money funds and abandon the fed funds rate as a policy instrument, Wieseman said.
“They are going to do a lot of reverse repo. I think that’s pretty clear -- it’s inevitable,” Wieseman said. “The idea that the fed funds rate is going to be an active part of the exit strategy just isn’t realistic.”
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