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The Future of the Federal Reserve's Balance Sheet - Larger.
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2019 Feb 23, 2:25am 908 views 3 comments
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anonymous
2019 Mar 3, 11:07am
The Danger Lurking in the Fed’s Monetary Policy
Last Monday, the Federal Reserve embarked on a yearlong listening tour to discover the concerns of the American people. The whole shebang of modern monetary methods—manipulated interest rates, levitated asset values, the supposed necessity of a 2% inflation rate—is on the table for constructive criticism.
But you know how it is with constructive criticism. The friend who asks to hear it really doesn’t want any. So it is with Richard H. Clarida, the Columbia University economist turned vice chairman of the Federal Reserve Board.
In a Feb. 22 speech, Clarida invited the public’s comments as the central bank undertakes a top-to-bottom reappraisal of the way it does business. Then he said this: “The fact that the system is conducting this review does not suggest that we are dissatisfied with the existing policy framework.” A comprehensive description of that framework duly followed. So admirably clear was his message that it might have curled your hair.
It might, indeed, except for 10 years’ familiarity with once-heretical ideas. “Quantitative easing” seemed wild-eyed enough at the time it was hatched in 2008. Who objects now?
Clarida acknowledged no doubts. He said that radical monetary policy has worked, that it will continue to work, and that it may well become more radical. He contended that low interest rates are here to stay and that new policy “tools” must be sharpened and kept at the ready. As to potential adverse consequences of administered rates and the mind-control games meant to “anchor” our collective expectations of the future, he mentioned none.
The Mike Pence of the Fed, Clarida was pushing no novel agenda of his own. His interest-rate worldview is the institutional one. It springs from the contention that the natural level of rates since the financial crisis has naturally and irresistibly fallen.
Certainly, rates are astoundingly low—Bank of America Merrill Lynch recently was able to count $11 trillion of bonds worldwide quoted at yields of less than zero. Clarida said that the decline in the so-called neutral rate of interest “is widely expected to persist for years.”
Just who has made bold to forecast the course of this conceptual rate of interest (you can’t see it and you can’t trade it), Clarida didn’t say. But he did warn of the consequences of its collision with the so-called zero bound.
At zero percent, he said, the Fed would be hard-pressed to ensure that the inflation rate stays put in the neighborhood of 2%. That you can’t have no inflation, the vice chairman takes as a revealed truth.
Creditors, and any who lived through the Great Inflation of the late 1960s through the early 1980s, might disagree. They might prefer an inflation rate of nil.
William McChesney Martin, the longest-serving Fed chairman, said in August 1955, “We can never recapture the purchasing power of the dollar that has been lost.” Martin, who, in the Great Depression, witnessed an actual, virulent deflation, was nonetheless adamant that defending the integrity of the currency was job No. 1.
Whether the policies of the current Fed, led by Jerome Powell, are well or poorly advised is, to a degree, a matter of opinion. But the value proposition confronting today’s bondholders is a question of fact. At a 2% rate of inflation, the real, after-tax return on a 2.68%-yielding 10-year Treasury note is hardly enough for the tip jar.
Nor are the monetary-policy options now under discussion calculated to improve the lender’s odds. Batting around big ideas, the policy makers are weighing the advisability of seeking to deliver a 2%-plus rate of inflation over the course of the business cycle. Shortfalls from the target in recession would be neutralized by overshoots during the subsequent expansion. “Persistent inflation shortfalls carry the risk that longer-term inflation expectations become poorly anchored or become anchored below the stated inflation goal,” Clarida tried to explain.
Yet the term “persistent inflation shortfalls” from that 2% target exactly describes the postcrisis record of Fed policy making. Still not doubting their ability to control events, the mandarins keep searching for a bigger bag of tricks.
Clarida broached the idea of establishing a “temporary ceiling for Treasury yields at longer maturities by standing ready to purchase them at a preannounced floor price.” It was, in fact, how the Fed operated during World War II. Listening to the economist talk about emergency measures, it’s easy to forget that the nation is no longer fighting a two-ocean war.
This column would opine that artificially low interest rates never fail to store up trouble—facilitating leverage, they promote not growth, but larger balance sheets. It would opine, further, that the central bank is playing with fire by actively seeking to depreciate the dollar, a currency that, whatever its current lofty status in the world, is a piece of paper of no defined value. And it is our opinion that the Federal Reserve should at least consider the appealing course of letting the market alone.
As for the absence of anything resembling a margin of safety in vast portions of today’s fixed-income markets, it’s no opinion, but a most worrisome fact.
https://www.barrons.com/articles/factors-are-coming-to-fixed-income-etfs-51551443400
Last Monday, the Federal Reserve embarked on a yearlong listening tour to discover the concerns of the American people. The whole shebang of modern monetary methods—manipulated interest rates, levitated asset values, the supposed necessity of a 2% inflation rate—is on the table for constructive criticism.
But you know how it is with constructive criticism. The friend who asks to hear it really doesn’t want any. So it is with Richard H. Clarida, the Columbia University economist turned vice chairman of the Federal Reserve Board.
In a Feb. 22 speech, Clarida invited the public’s comments as the central bank undertakes a top-to-bottom reappraisal of the way it does business. Then he said this: “The fact that the system is conducting this review does not suggest that we are dissatisfied with the existing policy framework.” A comprehensive description of that framework duly followed. So admirably clear was his message that it might have curled your hair.
It might, indeed, except for 10 years’ familiarity with once-heretical ideas. “Quantitative easing” seemed wild-eyed enough at the time it was hatched in 2008. Who objects now?
Clarida acknowledged no doubts. He said that radical monetary policy has worked, that it will continue to work, and that it may well become more radical. He contended that low interest rates are here to stay and that new policy “tools” must be sharpened and kept at the ready. As to potential adverse consequences of administered rates and the mind-control games meant to “anchor” our collective expectations of the future, he mentioned none.
The Mike Pence of the Fed, Clarida was pushing no novel agenda of his own. His interest-rate worldview is the institutional one. It springs from the contention that the natural level of rates since the financial crisis has naturally and irresistibly fallen.
Certainly, rates are astoundingly low—Bank of America Merrill Lynch recently was able to count $11 trillion of bonds worldwide quoted at yields of less than zero. Clarida said that the decline in the so-called neutral rate of interest “is widely expected to persist for years.”
Just who has made bold to forecast the course of this conceptual rate of interest (you can’t see it and you can’t trade it), Clarida didn’t say. But he did warn of the consequences of its collision with the so-called zero bound.
At zero percent, he said, the Fed would be hard-pressed to ensure that the inflation rate stays put in the neighborhood of 2%. That you can’t have no inflation, the vice chairman takes as a revealed truth.
Creditors, and any who lived through the Great Inflation of the late 1960s through the early 1980s, might disagree. They might prefer an inflation rate of nil.
William McChesney Martin, the longest-serving Fed chairman, said in August 1955, “We can never recapture the purchasing power of the dollar that has been lost.” Martin, who, in the Great Depression, witnessed an actual, virulent deflation, was nonetheless adamant that defending the integrity of the currency was job No. 1.
Whether the policies of the current Fed, led by Jerome Powell, are well or poorly advised is, to a degree, a matter of opinion. But the value proposition confronting today’s bondholders is a question of fact. At a 2% rate of inflation, the real, after-tax return on a 2.68%-yielding 10-year Treasury note is hardly enough for the tip jar.
Nor are the monetary-policy options now under discussion calculated to improve the lender’s odds. Batting around big ideas, the policy makers are weighing the advisability of seeking to deliver a 2%-plus rate of inflation over the course of the business cycle. Shortfalls from the target in recession would be neutralized by overshoots during the subsequent expansion. “Persistent inflation shortfalls carry the risk that longer-term inflation expectations become poorly anchored or become anchored below the stated inflation goal,” Clarida tried to explain.
Yet the term “persistent inflation shortfalls” from that 2% target exactly describes the postcrisis record of Fed policy making. Still not doubting their ability to control events, the mandarins keep searching for a bigger bag of tricks.
Clarida broached the idea of establishing a “temporary ceiling for Treasury yields at longer maturities by standing ready to purchase them at a preannounced floor price.” It was, in fact, how the Fed operated during World War II. Listening to the economist talk about emergency measures, it’s easy to forget that the nation is no longer fighting a two-ocean war.
This column would opine that artificially low interest rates never fail to store up trouble—facilitating leverage, they promote not growth, but larger balance sheets. It would opine, further, that the central bank is playing with fire by actively seeking to depreciate the dollar, a currency that, whatever its current lofty status in the world, is a piece of paper of no defined value. And it is our opinion that the Federal Reserve should at least consider the appealing course of letting the market alone.
As for the absence of anything resembling a margin of safety in vast portions of today’s fixed-income markets, it’s no opinion, but a most worrisome fact.
https://www.barrons.com/articles/factors-are-coming-to-fixed-income-etfs-51551443400
3
AD
2019 Mar 3, 1:09pm
AD
2019 Mar 3, 1:09pm
Kakistocracy says
So the peak was $2.8 trillion, now is $1.6 trillion of US debt on the Federal Reserve's balance sheet.
Considering that $1.2 trillion was unloaded by the Fed, maybe the effect is not so bad. However, consider the S&P 500 has been moving sideways since about November 2017. It also moved sideways for about a year going into the great recession of 2008/2009.
I would note that reserves have already declined appreciably from their peak, falling by $1.2 trillion to a current level of around $1.6 trillion.
So the peak was $2.8 trillion, now is $1.6 trillion of US debt on the Federal Reserve's balance sheet.
Considering that $1.2 trillion was unloaded by the Fed, maybe the effect is not so bad. However, consider the S&P 500 has been moving sideways since about November 2017. It also moved sideways for about a year going into the great recession of 2008/2009.
Some of the recent decisions that the Federal Open Market Committee (FOMC) has made regarding the balance sheet and lay out a rough framework for some further issues that are on the horizon.
In January, after much discussion, including in previous meetings, the FOMC announced its intent to continue operating in a framework of ample reserves.2 In this regime, active management of the reserve supply is not needed. The Federal Reserve controls the level of the federal funds rate and other short-term interest rates primarily through the use of administered rates, including the rate paid on reserve balances and the offered rate on overnight reverse repurchase agreements. This regime is sometimes referred to as a floor system, because the administered rates place a floor under the rate at which banks and others will lend in the federal funds market. In adopting this framework, the Committee stated its intention to continue operating as it has for the past decade.
The announcement was an important step in our normalization process. And we are now set up to make further decisions on the eventual size and composition of our balance sheet. Before providing more context on those decisions, let me first provide a little more detail around our decision to remain in the current framework of ample reserves.
The most important factor in the decision was that the current system has worked very well. It has supported the achievement of our dual-mandate objectives of maximum employment and price stability. And it has shown itself to be flexible and well suited to maintaining interest rate control through various changes in money markets, bank regulation, and the Federal Reserve's balance sheet. Since the FOMC began lifting interest rates in December 2015, money market rates have generally moved closely with the federal funds rate, which in turn has followed changes in administered rates.
Now that the decision on the operating framework has been made, a natural next step is to contemplate the appropriate size of the Fed's balance sheet and reserves and the process for getting there. In line with the requirements of operating with ample reserves--and boosted by the growth in nonreserve liabilities--the Fed will maintain a larger balance sheet and reserve supply relative to the pre-crisis period, with the goal of remaining on the flat portion of the reserve demand curve. I would note that reserves have already declined appreciably from their peak, falling by $1.2 trillion to a current level of around $1.6 trillion. At the same time, we have seen a substantial increase in our nonreserve liabilities, such as currency in circulation and the Treasury General Account balance. In our statement on Policy Normalization Principles and Plans, we outlined an intention to hold no more securities than necessary to implement monetary policy efficiently and effectively.3 As the balance sheet continues to shrink, we are now in the process of determining that necessary size.
Ultimately, the size of the balance sheet will be determined by a number of factors, including demand for nonreserve liabilities, such as currency (which has been rising), and, importantly, the quantity of reserves necessary to remain reliably on the flat portion of the reserve demand curve. Survey results suggest that banks have greatly increased their demand for reserves in the post-crisis period. Responses to the September 2018 Senior Financial Officer Survey report that banks would be comfortable with a level of reserves in the system in the neighborhood of $800 billion, taking into consideration the level of interest rates at the time.4 In part, this increased demand reflects a response to regulatory changes introduced after the crisis. These changes include, importantly, the Liquidity Coverage Ratio (LCR), which has improved banks' liquidity resilience by requiring firms to hold sufficient high-quality liquid assets to cover potential outflows during times of stress. Reserves, along with Treasury securities, are favored under the LCR, and, consequently, firms currently meet a sizable fraction of their LCR requirements by holding reserves.
Notwithstanding survey results, the level of reserve demand remains quite uncertain. It is possible that, over time, the preferences of banks will shift, or that demand will prove more price elastic than banks are currently expecting. As I have discussed previously, bank holdings of reserves to meet LCR requirements could shift toward Treasury securities, as aggregate reserves decline, without much upward pressure on the federal funds rate.5 That said, even if uncertain, it is probably safe to say that reserve demand is much higher than before the crisis.
As we work to calibrate ample reserves, there are some tradeoffs that are worth noting. For example, we could operate with a level of reserve balances at the lower end of what might be considered ample. In that case, there would likely be occasions when unexpected declines in the supply of reserves or increases in the demand for reserves would require an open market operation to offset temporary upward pressures on the federal funds rate. Alternatively, we could operate with an average supply of reserves large enough to keep the federal funds rate determined along the flat portion of the reserve demand curve even with an unexpected shift in the supply of or demand for reserves. This approach would be operationally convenient but would also leave the size of the balance sheet and reserves larger than necessary most of the time. In my view, it might be appropriate for us to operate somewhere in between these two extremes, with a sizable quantity of reserves large enough to buffer against most shocks to reserve supply. On those few days when that buffer is likely to be exhausted, we could conduct open market operations to temporarily boost the supply of reserves.
With so much uncertainty over the level and slope of the reserve demand curve, a degree of caution is warranted. As outlined in the minutes of the January FOMC meeting, the Committee has discussed ending the reduction in the Fed's aggregate asset holdings sometime in the latter half of this year, with still-ample reserves in the system.6 At that point, one option discussed, without any decision being made at this point, is to hold the level of total assets roughly fixed for a time. Even as the total size of the balance sheet remains fixed, the composition of the liabilities would gradually change, in part as demand for currency grows in line with the economy. Over time, the gradual increase in nonreserve liabilities would displace reserves as the overall balance sheet remains fixed. This plan would substantially reduce the pace of the decline in reserves, allowing us to gradually approach our assessment of the appropriate amount of reserves for the efficient and effective implementation of monetary policy. Of course, in the longer run, once we reach our preferred level of reserves, the balance sheet would have to resume growth to match a continued increase in demand for nonreserve liabilities.
I would like to wrap up with a brief discussion of some of the other decision points we will encounter as we continue the process of normalizing our balance sheet. In particular, what does the Committee judge to be normal in regard to the type and duration of assets that we will hold? On composition, in line with our previously announced normalization principles, I favor a return to a balance sheet with all Treasury securities, allowing our mortgage-backed securities (MBS) holdings to run to zero. In those principles, we also state that while we do not expect sales of MBS as part of the normalization process, later we would be open to limited sales to reduce or eliminate residual holdings of MBS. In regard to duration, moving to shorten the duration of our holdings could increase the Fed's ability to affect long-term interest rates if the need arose. However, it might be preferable to have the composition of our Treasury holdings roughly match the maturity composition of outstanding Treasury securities, minimizing any market distortions that could arise from our holdings. Over the course of our upcoming meetings, I look forward to what promises to be an interesting discussion on these issues with my colleagues.
Finally, in assessing our balance sheet policy, it is important to point out that the Fed remains entirely focused on meeting its statutory dual-mandate objectives of maximum employment and price stability. The normalization of the balance sheet is not a competing goal. If ever it appears that our plans for the balance sheet are running counter to the achievement of our dual-mandate objectives, we would quickly reassess our approach to the balance sheet
Vice Chairman for Supervision Randal K. Quarles
https://www.federalreserve.gov/newsevents/speech/quarles20190222a.htm
NOTE: Additional details in the footnotes of the above link.
#FederalReserve #MonetaryPolicy #Economics