http://www.cumber.com/commentary.aspx?file=061509.asp&n=l_mc
Interest Rates and the Policy Squeeze
June 15, 2009 Bob Eisenbeis, Chief Monetary Economist
As Treasury and mortgage rates have risen, the question arises whether the Federal Reserve will accelerate its purchases of government debt and mortgage-related securities to force interest rates down closer to the 4.5% target that had been announced for mortgage rates some while ago. But the prospect of purchasing more Treasuries is now exposing significant tensions within the Federal Reserve, for several reasons.
First, as the Fed’s balance sheet has expanded, the market and others have begun to worry and focus on the Fed’s exit strategy and how it will be executed. Indeed, Chairman Bernanke has made repeated references to the fact that consideration is being given to various exit strategies, but to date few specifics have been forthcoming, aside from simply listing some of the options available to the Fed. It is clear, however, that because of the lag effects of monetary policy, the Fed will have to change policy well in advance of clear evidence of actual inflation having taken hold if it is to be successful in containing inflation. Furthermore, policy action will require a rapid and preemptive sale of assets to mop up the liquidity the Fed has injected into the system in the form of high-powered money.
A Fed policy reversal will have to take place in the presence of higher-than-desired unemployment, and probably a barely recovering housing market and only the glimmer of a resurgence of real economic growth. Politically, changing policy in that environment will be a difficult sell to both the public and the Congress, and will have to be done well in advance of the actual policy move. These two key constituents who have to be convinced of the merits of the policy change have demonstrated repeatedly their willingness to tolerate higher inflation in the short run, if it means more jobs. Unfortunately, the lessons of the 1970s and 1980s are easily forgotten.
Second, as FOMC members talk about the recent rise in Treasury rates in speeches, they don’t point out that most, if not all, of the increase in nominal interest rates has been due to an increase in inflation expectations as inferred from TIPS, and not due to increases in real rates that might signal a recovery in growth prospects.1 This means that we may already be observing the beginnings of the unhinging of inflation expectations. Therefore, the window for policy action may be closing quickly.
Third, as the Fed’s holdings of Treasuries increases as a proportion of the outstanding supply, some policy makers are concerned about causing volatility in rates and prices should the Fed have to engage in large sales. This is what the System Open Market Desk seeks to avoid on a day-to-day basis. In the past the SOMA desk has attempted to spread its holdings of Treasuries out across different issues so as to avoid dominating a large portion of any issue. This will be more difficult if the Fed continues lengthening the maturities of its holdings, because issue size is smaller at the long end of the maturity spectrum. Selling into thinner markets means the price effects and increases in interest rates are likely to be larger and the likelihood of capital losses to the Fed will increase. At some point the perception of the impacts of the potential losses on the Fed’s reported capital structure will become an issue. Keep in mind that the Fed is not marking its balance sheet to market.
Fourth, market size is a two-edged sword. If confining Fed purchases to Treasuries is most desirable when the objective is to minimize price effects and volatility of Fed portfolio moves, then this also means that efforts to drive down long-term rates through additional purchases will require huge purchases of securities. So far, purchases of Treasuries have not resulted in lower rates, and it may be likely that the volume of purchases to accomplish that aim would be sufficiently large that the Fed’s balance sheet might have to increase significantly. Those securities would then have to be returned to the market at some time in the future. The Fed’s security purchases will also generate even more high-powered money, further exacerbating both the inflation risks and the exit strategy problem.
Finally, it is hard to believe that letting existing securities holdings simply run off, selling non-Treasury assets or paying interest on reserves are considered as serious or viable policy alternatives to preemptive sales of Treasuries. Studies conducted back when the Fed was worried about the disappearance of Treasuries suggested that there were no alternative markets deep enough to substitute effectively for the Treasury market, as far as the Fed was concerned for day-to-day implementation of monetary policy, without its actions having strong effects on asset prices. This problem has surely become more severe during the current financial crisis. Hence, one can't easily rely upon the sale of significant quantities of non-Treasury assets, as Chairman Bernanke has suggested, without seriously disrupting those markets. As a result, exit strategies that attempt to rely upon either sales of Treasuries or simply passively waiting until the other assets mature will pose a serious threat to the Fed’s ability to pursue as aggressive or anticipatory an exit as it may desire.
Similarly, the argument that the payment of interest on reserves can be used as an effective tool seems weak. At present, the rate paid on reserves is ¼ percent on both required and excess reserves, while the Fed Funds Target rate is a range of between 0 and ¼ percent and the discount rate is ½ percent. Conceptually, the rate paid on reserves should set a floor on the effective Fed Funds rate, since any institution could borrow in the Fed Funds market at between 0 and ¼ percent and set up a riskless arbitrage by keeping those funds at the Fed earning ¼ percent. However, as the Fed begins to move its funds rate target up to cut off the threat of inflation, it will also have to move both the discount rate and the rate it pays on reserves up in parallel. But this doesn’t sterilize reserves. The only way to do that would be to keep pushing up the rate paid on reserves until it met or even exceeded the discount rate, but this would then create an arbitrage incentive for institutions eligible to borrow at the discount window. For a long time, the discount rate was set above the funds rate target; and to prevent the obvious arbitrage, institutions were discouraged from using the discount window except in dire need, hence the stigma that has been long associated with discount window borrowing. Pushing the rate paid on reserves above the discount rate would require abandoning the current discount window borrowing environment, which the Fed has been attempting to encourage as a buffer to deal with short-term liquidity needs.
What does this mean from an investor perspective? Put it all together and I think we are looking at the sudden realization that the reliance upon anchored inflation expectations is a weak and fleeting reed to rely upon. Markets aren’t stupid, and attention has already turned to inflation risks and the market has begun to price those risks. Add to this dilemma the prospects for the flood of Treasuries on the market that will be necessary to fund the huge federal deficits associated with implementation of the stimulus program, and the implications for interest rates seem obvious. If the market front runs the potential supply of Treasuries, as is likely, then interest-rate increases will accelerate even without the Fed executing its exit strategy, making the withdrawal of liquidity it had injected even more problematic. If the Fed monetizes the debt in an attempt to keep interest rates low, then they are bound to fail on two fronts – both inflation and interest rates will increase. The increase in rates and flood of Treasuries will also crowd out private-sector debt. All in all, it looks like we are in for a period of rising rates, inflation, and slower growth than would have been the case without the heroic rescue. The only question is when it will start.
1 It is recognized that TIPS are an imperfect indicator of inflation expectations, but the recent trend seems to be clear.
Interest Rates and the Policy Squeeze
June 15, 2009 Bob Eisenbeis, Chief Monetary Economist
As Treasury and mortgage rates have risen, the question arises whether the Federal Reserve will accelerate its purchases of government debt and mortgage-related securities to force interest rates down closer to the 4.5% target that had been announced for mortgage rates some while ago. But the prospect of purchasing more Treasuries is now exposing significant tensions within the Federal Reserve, for several reasons.
First, as the Fed’s balance sheet has expanded, the market and others have begun to worry and focus on the Fed’s exit strategy and how it will be executed. Indeed, Chairman Bernanke has made repeated references to the fact that consideration is being given to various exit strategies, but to date few specifics have been forthcoming, aside from simply listing some of the options available to the Fed. It is clear, however, that because of the lag effects of monetary policy, the Fed will have to change policy well in advance of clear evidence of actual inflation having taken hold if it is to be successful in containing inflation. Furthermore, policy action will require a rapid and preemptive sale of assets to mop up the liquidity the Fed has injected into the system in the form of high-powered money.
A Fed policy reversal will have to take place in the presence of higher-than-desired unemployment, and probably a barely recovering housing market and only the glimmer of a resurgence of real economic growth. Politically, changing policy in that environment will be a difficult sell to both the public and the Congress, and will have to be done well in advance of the actual policy move. These two key constituents who have to be convinced of the merits of the policy change have demonstrated repeatedly their willingness to tolerate higher inflation in the short run, if it means more jobs. Unfortunately, the lessons of the 1970s and 1980s are easily forgotten.
Second, as FOMC members talk about the recent rise in Treasury rates in speeches, they don’t point out that most, if not all, of the increase in nominal interest rates has been due to an increase in inflation expectations as inferred from TIPS, and not due to increases in real rates that might signal a recovery in growth prospects.1 This means that we may already be observing the beginnings of the unhinging of inflation expectations. Therefore, the window for policy action may be closing quickly.
Third, as the Fed’s holdings of Treasuries increases as a proportion of the outstanding supply, some policy makers are concerned about causing volatility in rates and prices should the Fed have to engage in large sales. This is what the System Open Market Desk seeks to avoid on a day-to-day basis. In the past the SOMA desk has attempted to spread its holdings of Treasuries out across different issues so as to avoid dominating a large portion of any issue. This will be more difficult if the Fed continues lengthening the maturities of its holdings, because issue size is smaller at the long end of the maturity spectrum. Selling into thinner markets means the price effects and increases in interest rates are likely to be larger and the likelihood of capital losses to the Fed will increase. At some point the perception of the impacts of the potential losses on the Fed’s reported capital structure will become an issue. Keep in mind that the Fed is not marking its balance sheet to market.
Fourth, market size is a two-edged sword. If confining Fed purchases to Treasuries is most desirable when the objective is to minimize price effects and volatility of Fed portfolio moves, then this also means that efforts to drive down long-term rates through additional purchases will require huge purchases of securities. So far, purchases of Treasuries have not resulted in lower rates, and it may be likely that the volume of purchases to accomplish that aim would be sufficiently large that the Fed’s balance sheet might have to increase significantly. Those securities would then have to be returned to the market at some time in the future. The Fed’s security purchases will also generate even more high-powered money, further exacerbating both the inflation risks and the exit strategy problem.
Finally, it is hard to believe that letting existing securities holdings simply run off, selling non-Treasury assets or paying interest on reserves are considered as serious or viable policy alternatives to preemptive sales of Treasuries. Studies conducted back when the Fed was worried about the disappearance of Treasuries suggested that there were no alternative markets deep enough to substitute effectively for the Treasury market, as far as the Fed was concerned for day-to-day implementation of monetary policy, without its actions having strong effects on asset prices. This problem has surely become more severe during the current financial crisis. Hence, one can't easily rely upon the sale of significant quantities of non-Treasury assets, as Chairman Bernanke has suggested, without seriously disrupting those markets. As a result, exit strategies that attempt to rely upon either sales of Treasuries or simply passively waiting until the other assets mature will pose a serious threat to the Fed’s ability to pursue as aggressive or anticipatory an exit as it may desire.
Similarly, the argument that the payment of interest on reserves can be used as an effective tool seems weak. At present, the rate paid on reserves is ¼ percent on both required and excess reserves, while the Fed Funds Target rate is a range of between 0 and ¼ percent and the discount rate is ½ percent. Conceptually, the rate paid on reserves should set a floor on the effective Fed Funds rate, since any institution could borrow in the Fed Funds market at between 0 and ¼ percent and set up a riskless arbitrage by keeping those funds at the Fed earning ¼ percent. However, as the Fed begins to move its funds rate target up to cut off the threat of inflation, it will also have to move both the discount rate and the rate it pays on reserves up in parallel. But this doesn’t sterilize reserves. The only way to do that would be to keep pushing up the rate paid on reserves until it met or even exceeded the discount rate, but this would then create an arbitrage incentive for institutions eligible to borrow at the discount window. For a long time, the discount rate was set above the funds rate target; and to prevent the obvious arbitrage, institutions were discouraged from using the discount window except in dire need, hence the stigma that has been long associated with discount window borrowing. Pushing the rate paid on reserves above the discount rate would require abandoning the current discount window borrowing environment, which the Fed has been attempting to encourage as a buffer to deal with short-term liquidity needs.
What does this mean from an investor perspective? Put it all together and I think we are looking at the sudden realization that the reliance upon anchored inflation expectations is a weak and fleeting reed to rely upon. Markets aren’t stupid, and attention has already turned to inflation risks and the market has begun to price those risks. Add to this dilemma the prospects for the flood of Treasuries on the market that will be necessary to fund the huge federal deficits associated with implementation of the stimulus program, and the implications for interest rates seem obvious. If the market front runs the potential supply of Treasuries, as is likely, then interest-rate increases will accelerate even without the Fed executing its exit strategy, making the withdrawal of liquidity it had injected even more problematic. If the Fed monetizes the debt in an attempt to keep interest rates low, then they are bound to fail on two fronts – both inflation and interest rates will increase. The increase in rates and flood of Treasuries will also crowd out private-sector debt. All in all, it looks like we are in for a period of rising rates, inflation, and slower growth than would have been the case without the heroic rescue. The only question is when it will start.
1 It is recognized that TIPS are an imperfect indicator of inflation expectations, but the recent trend seems to be clear.
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