This post is a bit on the long side. If you want the executive summary, here goes. Recently, overnight financial markets have tightened up considerably, in the sense that the interest rate on excess reserves (IOER) is close to all overnight interest rates. The floor system of central bank intervention that the Fed designed, before interest rates went up in late 2015, is now working as floor systems should. Why are things working better? Because the Fed is finally phasing out its big-balance-sheet program, which was hindering the functioning of overnight markets. The FOMC has not seen the light yet, though. They love QE, and seem to be on a road to permanent big-balance-sheet.
First, let's review where the Fed's balance sheet was, where it is, and where it might be going. Between late 2008 and late 2014, the Fed purchased a large quantity of long-maturity Treasury securities and mortgage-backed securities (MBS), while paying interest on reserve balances at the IOER rate of 0.25%. Here's the time series of securities held outright by the Fed:
Well apparently that emergency lasted a very long time. The Fed did not begin increasing its target range for the fed funds rate until late 2015 - seven years after the financial crisis. And the reinvestment policy which held the nominal stock of the Fed securities constant was kept in place until October 2017. At that date, the Fed implemented a modest plan to reduce the size of the balance sheet through a phaseout in the reinvestment program. That is, there would be caps on the quantity of securities the FOMC would allow to mature without replacment, with the caps set to rise from $10 billion in October 2017 to $50 billion in October 2018. A $50 billion cap would bind infrequently given the current size of the Fed's portfolio, and would stop binding entirely as the size of the portfolio falls. As you can see from the chart, the balance sheet reduction program has become visible, but it will still take years for the balance sheet to fall to the point where it looks like pre-financial-crisis days, i.e. excess reserves close to zero.
But that gets us to the liabilities side of the Fed's balance sheet, which is actually where the action is, particularly in terms of this post. Before "liftoff" happened in October 2014, I wrote about how the implementation was supposed to work, in a large-balance-sheet world. The FOMC was uncertain about how liftoff would work, as they had never done anything like this before, and some idiosyncratic features of US financial markets made liftoff a tricky business. In theory, a floor system - when there are excess reserves outstanding in the financial system - should work in a very straightforward way. The Bank of Canada did this for a year-long period from Spring 2009 to Spring 2010, with no problems. In a floor system, the central bank sets IOER, and arbitrage in the overnight market should more-or-less equate all safe overnight interest rates to IOER.
But, in the US, some ill-informed people in Congress wrote the amendment to the Federal Reserve Act authorizing payment of interest on reserves in such a way as to deny government sponsored enterprises (GSEs) - including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks - interest on reserves. So, every day GSEs are looking for a place to park their overnight funds to earn some interest, rather than having these balances sit in reserve accounts earning zero. Over time, the arrangement that developed was for the GSEs to lend overnight on the fed funds market to whoever would give them the best price. Fannie Mae and Freddie Mac apparently dropped out of that game, leaving a fed funds market dominated by arbitrage trading between Federal Home Loan Banks, as lenders, and branches of foreign banks in the US, as borrowers. Why foreign banks? Because they had the lowest costs. This arbitrage was subject to frictions, thought to be "balance sheet costs." For example, a commercial bank that borrowed on the fed funds market and put those funds in its reserve account would have higher assets, and would therefore pay a higher deposit insurance premium, or would have to worry about satisfying capital requirements or other regulatory constraints. A foreign bank in the US has no retail deposit business, and thus is not paying a deposit insurance premium, implying lower costs of borrowing fed funds.
When liftoff occurred, the big concern was whether the fed funds rate would actually go up when IOER went up. In the immediate pre-liftoff period, the effective fed funds rate was typically in the range of .05-.15%. The IOER/fed funds rate differential of 10-20 basis points was thought to reflect balance sheet costs. But, would this differential persist, would it decrease, or would it increase? That uncertainty caused the Fed to buy insurance, in the form of the overnight reverse repurchase agreement (ON RRP) program. Every day, the Fed conducts a fixed-rate full-allotment program under which specified counterparties lend to the Fed, mainly overnight, with the lending secured by securities in the Fed's portfolio. Until recently, the ON-RRP rate was fixed at 25 basis points below IOER, the idea being that this puts a floor under the floor in the Fed's floor system - a subfloor, as it were. If you think that's unusual, you would be right.
So, what has been happening in overnight markets since December 2015? First IOER has been increased seven times. The first six were 25-basis point increases, and the last increase was 20 basis points, to 1.95% on June 15.
We can get more detail on the fed funds market from the New York Fed. The effective fed funds rate is an average (which only included brokered trades in the past, but I'm not sure what the coverage is now). There is always dispersion in interest rates in the market, and dispersion can get high when there is significant counterparty risk, as happened in the financial crisis. As you can see in the table, focusing on the last trading day listed, July 2, most of the trades are close to the mean. The effective fed funds rate was 1.91%, and 50% of the trades were within one basis point, plus or minus. But the 99th percentile was 2.06%, i.e. 15 basis points above the mean, which is substantial. That's also 11 points above IOER. What's going on here is that, in a system still flush with reserves, most trading on the fed funds market is between GSEs and banks that can earn interest on reserves. But there are still some banks that need to borrow overnight to meet a reserve requirement, for example. A bank might have to make a large payment late in the day, find itself short, have to scramble to find a lender, and end up paying a premium above IOER.
Also, here's the volume of daily trade on the fed funds market.
What's been happening with the Fed's ON-RRP facility?
Here's something interesting. The Fed is sustaining a substantial quantity of ON-RRPs to foreign entities - primarily official ones, i.e. governments and central banks:
Other than ON-RRPs, the primary liabilities on the Fed's balance sheet are currency and reserves:
Another interesting feature associated with the Fed's large balance sheet is the post-financial-crisis behavior of the Treasury's General Account with the Fed.
Of key interest are recent developments in overnight markets, related to some issues we have already discussed concerning the ON-RRP facility. Here, I'll use a figure from a paper by Sam Schulhofer-Wohl and James Clouse at the Chicago Fed:
Taking a closer look, the New York Fed has begun publishing data on repo rates and trading volume. Here's what the repo rate looks like from April 2 to July 2:
What's Going On?
It's clear that all overnight interest rates have tightened up. What was once a floor-with-subfloor, a leaky floor, or whatever, is now behaving like a floor system should, with IOER tying down overnight interest rates. And the ON-RRP rate, at 20 basis points below IOER now, is not attractive to overnight lenders. The ON-RRP program could now be discontinued, and it would make no difference.
Why is this happening? Well, you don't have to think too hard to figure that out. The tightening up of the overnight market coincides with the phasing-out of the Fed's reinvestment program. From the very first chart, you wouldn't think that would make much difference, if you thought that what is important about the big balance sheet is only its size. But clearly the flow of asset purchases by the Fed matters, and a cessation of the reinvestment program makes a big difference for this flow, which in turn has a large effect on the stock of on-the-run safe assets - which are the primary fodder for the overnight repo market. Thus, what we have been observing in overnight markets from liftoff until early this year was due to a shortage of collateral. This shortage was keeping the repo rate low relative to IOER, and causing anomalies in the behavior of the fed funds market. The IOER/fed funds rate margin was not caused primarily by "balance sheet costs," but by lack of good alternatives to the fed funds market for overnight lenders. Now that repo rates are close to IOER, the fed funds market has become more competitive.
The bottom line is that quantitative easing was messing up overnight markets. A program intended to ease something was just gumming up the financial plumbing. Low real interest rates (or a low neutral rate, as it's sometimes called in the Fed system) was stemming in part from what the Fed was doing to itself.
So, how is the Fed reacting to this? From the May FOMC meeting minutes:
The deputy manager then discussed the possibility of a small technical realignment of the IOER rate relative to the top of the target range for the federal funds rate. Since the target range was established in December 2008, the IOER rate has been set at the top of the target range to help keep the effective federal funds rate within the range. Lately the spread of the IOER rate over the effective federal funds rate had narrowed to only 5 basis points. A technical adjustment of the IOER rate to a level 5 basis points below the top of the target range could keep the effective federal funds rate well within the target range. This could be accomplished by implementing a 20 basis point increase in the IOER rate at a time when the Committee raised the target range for the federal funds rate by 25 basis points.Later in the minutes, it's stated that FOMC members thought such a change
would simplify FOMC communications and emphasize that the IOER rate is a helpful tool for implementing the FOMC’s policy decisions but does not, in itself, convey the stance of policy.The key problem here is that announcing the policy as a target range for the fed funds rate is starting to look silly. The cure for that problem isn't reducing IOER to five basis points below the top of the range. Further, the idea that that IOER does not "convey the stance of policy" is false. That's how a floor system works, and this one now appears to be approaching the point where it's working fine.
The FOMC's focus on the fed funds rate as a policy rate has always been questionable, and seems particularly wrongheaded in the large-balance-sheet period. The fed funds rate is unsecured, and so reflects substantial counterparty risk in times of crisis. In pre-crisis times the New York Fed intervened in the repo market (a secured credit market) to target the fed funds rate. That's pretty weird. Why not just target an overnight repo rate, like most other central banks do? Repo rates are safe rates of interest, uncontaminated by risk, and the New York Fed could pretty much nail the target every day through a fixed-rate full-allotment procedure.
In the post-crisis period, it got even worse, as trading in the fed funds market consists mostly of arbitrage trading, and the rate doesn't mean what it did pre-crisis. Some people in the Fed system seem wedded to the fed funds rate as a policy rate, but they should give that up and move on.
Finally, this recent WSJ article by Nick Timiraos discusses balance sheet issues. I thought this quote from Bill Nelson, in the article, was interesting:
“But it’s possible, to everyone’s surprise,“ he said, that reserves are in fact growing scarce, which would mean ”they’ve reached the point where they will need to stop the run-off."As well, Jim Bullard, President of the St. Louis Fed is quoted as follows:
Maintaining the existing framework “certainly looks like that’s the way we’re headed, but we should still have the debate.”First, no one should be thinking of this as a "scarce reserves" situation. Two trillion dollars of reserves is still a massive quantity of reserves. That's about 11% of annual GDP. I think people are looking at how overnight interest rates are tightening up and thinking that this somehow looks like pre-financial crisis times, which people often call (misleadingly) a regime of "scarce reserves." As I discussed above, what we're seeing isn't a problem of scarce reserves. It's a good thing - the scarcity in safe collateral is going away.
Unfortunately, FOMC decision-making is still being driven by the people who decided to implement the Fed's quantitative easing (QE) programs, and bought into those programs in a big way. Like Ben Bernanke, who continues to defend QE, the proponents seem not to have learned much from the episode. This was an experiment, and I think I'm learning that it was a mistake. The Fed could stick with a floor system, protect Bernanke's legacy, and live in denial. There are circumstances in which a large balance sheet could be useful. But not if that means turning good collateral into inferior bank reserves.
For the Treasury Account Balance with the Fed, see this FRED Blog post.ReplyDelete
The FRED blog post doesn't quite explain why the Treasury balances are large. Holding a buffer of liquid assets is useful for the Treasury to insure against unforeseen circumstances, such as the failure of a Treasury auction. The Treasury used to keep most of this buffer at private financial institutions (as the FRED blog points out) so as not to hamper the implementation of monetary policy with large deposits and withdrawals from the Treasury reserve account, which would have caused the stock of reserves and interest rates to fluctuate. With a floor system, those deposits and withdrawals don't matter - roughly, they're neutral. However, all this leaves the increase in average balances beginning in 2016 unexplained.Delete
Great post, Steve.ReplyDelete
So is it now fair to say that the whole ON-RRP program was overkill? You say that the ON-RRP program could be discontinued, and it would make no difference. Maybe that was always the case i.e. maybe the fed funds rate always would have gone up when IOER went up, even if the ON-RPP had never been implemented.
"Why is this happening? Well, you don't have to think too hard to figure that out. The tightening up of the overnight market coincides with the phasing-out of the Fed's reinvestment program...primary fodder for the overnight repo market. "
Ok, here's another theory for you. Maybe Trump's tax repatriation program is freeing up a bunch of U.S. Treasuries that had previously been frozen in overseas jurisdictions for tax reasons. Companies can now sell their hoards to honor tax obligations, reduce debt, reward shareholders, invest in projects, pursue acquisitions, etc. The buyers of will be financial institutions who had previously been starved of Treasury collateral.
Given the large balance sheet, it would have been better if the ON-RRP rate had been set equal to IOER. That would have mitigated the problem. Though then QE starts looking silly. Take Treasuries and MBS out of the market so they can't be used in the repo market, then have the Fed use them in the repo market.Delete
Don't know if your tax repatriation story works. I think the reverse repos held abroad takes pressure off the Treasury market. But that wouldn't explain why the overnight rates move up to the top of the band early this year.
"I think the reverse repos held abroad..."Delete
Not reverse repo. Companies are holding Treasuries and other highly rated bonds overseas.
"But that wouldn't explain why the overnight rates move up to the top of the band early this year."
Are you questioning the timing? Tax reform legislation only came into effect last December, and there would probably be some delay as companies devised strategies for repatriation and the selling off of their Treasury positions. That would be consistent with the GC repo rate moving up to be in-line with fed funds/IOER later in spring rather than earlier.
Sorry, I was just pointing out what's in the fifth chart. Anything affecting the supply and demand for Treasuries (and close substitutes) will matter. Tax repatriation may make no difference, as much of that is just accounting tricks that move the tax home, with no implications for where the assets actually reside, or the demand for liquid safe assets. In the fifth chart, the increase in reverse repos issued by the Fed and held abroad should reduce the demand for Treasuries, thus working in the right direction, but the timing is wrong. The increase happened in early 2016.Delete
Stephen - insightful post. Hoover Institution had a related conference on the floor/corridor debate in May, in case you are not aware of. https://www.hoover.org/events/currencies-capital-and-central-bank-balances-policy-conferenceReplyDelete
Still trying to dig through the complicated picture, but just a couple of minor comments: in the latest minutes the Fed seems to suggest that the rise in o/n repo rate is associated with a substantial increase in the net supply of Treasury bills. Compare the numbers (SOMA holdings against T-Bill net supply), my guess is the latter indeed might have a larger impact on the amount of safe collateral.
In terms of the repatriation story, while it's true that the offshore earnings were pretty much already invested in Treasury securities, these position may unwind as the repatriated earnings can be used to fund, say, merger/acquisition and buybacks. I guess this also alleviates the shortage of collateral a bit.
"...in the latest minutes the Fed seems to suggest that the rise in o/n repo rate is associated with a substantial increase in the net supply of Treasury bills."Delete
Yes, I saw that in the minutes. Treasury issuance was pretty strong, I think in April and May, but it was down in June. Generally, issuance is quite variable, and it's never shown up before in the overnight rates in this way, so I don't buy it.
See my next post.Delete
Since 2009, currency in circulation has grown at an average annual compound growth rate of 8 percent. This is well in excess of the posted rate of inflation. Much of this currency is undoubtedly moved overseas. But, even so, currency in circulation has doubled in 9 years. Is there any reason to be concerned that inflation will pick up, as it did in the 1970s as a result of this expansion in currency in circulation?ReplyDelete
One other point worth mentioning: The trend in growth in currency in circulation shows no breaks or reversals in that 9 year period, and it gives every indication that the trend will continue at the present average rate. What effect, if any, might this have on future commodity price levels (with the term 'commodity' interpreted broadly)?
It's useful to look at currency outstanding by denomination. A lot of that growth is in the stock of $100 bills: https://www.federalreserve.gov/paymentsystems/coin_data.htmDelete
According to the information found at the URL referenced, the distribution of money by denomination is dominated by $100 bills by value. The next largest in value is $20 bills. Annual compound growth rates, by volume, by denomination since 2010 (as determined by OLS regression) are as follows (r-squared in brackets): $100 - 8.4%/yr (0.9939); $50 - 3.69%/yr (0.9272); $20 - 4.96%/yr (0.9865); $10 - 2.30%/yr (0.9253); $5 - 3.67%/yr (0.9678); and, $1 - 3.23%/yr (0.9988).Delete
If one assumes that the demand for $100 bills is primarily related to the drug trade and that there are three intermediaries between the domestic user and the foreign producer, and each intermediary skims 10% of the take he receives (a Markov process assumed), 27% of the users' $100 bills withdrawn from domestic financial institutions remain in the domestic economy and the balance of 73% makes its way into the off-shore economies.
For year-end 2017, that model would put the value of $100 bills in domestic circulation at roughly $340 billion compared to roughly $320 billion of value in all other denominations. The weighted average growth rate of the domestic portion of currency in circulation, allowing 8.4%/yr ACGR for $100 bills and 3.5%/yr ACGR for all other lesser denominations in the aggregate, approximates 6%/yr ACGR over the past 7 years. Though not as impressive as an 8%/yr ACGR, 6%/yr is still impressive. Of course, this picture is founded on a series of untested assumptions (sand?) and as a result it can only be considered to be a thought-experiment (gendankenexperiment).
The value weighted-average ACGR for denominations of $1 to $50 for the period commencing 2011-01-01 through 2017-12-31 is 4.33%/yr, leading to a weighted average ACGR of 6.33%/yr, when the figures are pushed through a spreadsheet calculator.
Even at 4% per year, the expansion of currency in circulation is double the Federal Reserve's target for inflation (howsoever one measures inflation). Then, again, one must consider that the foreign-held component of currency in circulation must eventually feed back through commodity prices (whether the commodities be resource commodities or engineered commodities) as a result of the ever greater amounts of dollars in circulation in off-shore economies where the commodities originate from.
If Milton Friedman was correct in stating that inflation is almost everywhere a monetary phenomenon, then we are probably looking at a day of reckoning such as we once faced in 1981-2. On the other hand, if the New Monetarist view of inflation based on Fisher's postulate holds, then we can avoid that day of reckoning by keeping nominal interest rates low (close to the ZLB) forever. We have, perhaps, another ten years to find out. (Après nous, le déluge?)
Steve, very interesting post.ReplyDelete
I have several questions regarding your general conclusion nicely summarized by this statement " The IOER/fed funds rate margin was not caused primarily by "balance sheet costs," but by lack of good alternatives to the fed funds market for overnight lenders."
First, in general, does this observation mean that given sufficient collateral for overnight lenders, the limited access to the Fed's balance sheet should not be an important financial friction? That is, arbitrage should reduce spreads among short-term rates to very small values even if only a few financial firms have access to the Fed's balance sheet?
Second, maybe the gumming up of overnight markets worked inadvertently to help the Fed. Here's how: Fed LSAPs create the IOER spread over other short-term interest rates. This causes the relative return on excess reserves to go up and raises their demand by banks. This heightened demand effectively "sterilizes" or encumbered the large stock of excess reserves.
"First, in general, does this observation mean that given sufficient collateral for overnight lenders, the limited access to the Fed's balance sheet should not be an important financial friction? That is, arbitrage should reduce spreads among short-term rates to very small values even if only a few financial firms have access to the Fed's balance sheet?"Delete
Yes, I think so. I'm surprised by this, as it goes against what I think we knew.
"Second, maybe the gumming up of overnight markets worked inadvertently to help the Fed. Here's how: Fed LSAPs create the IOER spread over other short-term interest rates. This causes the relative return on excess reserves to go up and raises their demand by banks. This heightened demand effectively "sterilizes" or encumbered the large stock of excess reserves."
This is more complicated than it might seem, as it involves how nominal interest rates (and which ones) feed through to inflation. I think it's a misconception to think that you want to somehow "encumber" the reserves to make sure they don't leak out and cause inflation. Any number of bad policy proposals stem from that notion (remember term deposits - that was about encumbering reserves). I think it's best to think of these interest differentials as reflecting inefficiency, and that it's best to get rid of them.
Thanks Steve. Yes, I am surprised on the first point as well (and need to go revise a paper based on this observation).Delete
On the second point, I agree with you that it's best to get rid of the spreads. I was just wondering if the Fed accidentally stumbled into a way of encumbering the reserves given that is what they initially wanted to do with IOER. Sometimes it is better to be lucky than smart.
Suppose they had set the ON-RRP rate equal to IOER. I think that would have mostly undone the scarcity (and undone the policy too I think), but there would have been a lot of takeup on the ON-RRP facility - likely most of the reserves would have turned into ON-RRPs. But we wouldn't think that did any harm, I think, as the ON-RRPs are just reserves by another name.Delete
Fred has discontinued some ON-RRP time series. However, by using New York Fed's data set, I created a chart including the value of ON-RRP outstanding and the effective fed funds rate:ReplyDelete
Could be useful. Thanks for the post.
Been thinking a bit more about your post and have a follow-up question. The Fed has not held treasury bills for some time, so the reinvestments of principal it was previously doing was in medium-to-longer term treasury securities. Thus, its flow of asset purchases was not on treasury bills. But aren't treasury bills the most widely used with repos?
I'm not sure where to find numbers on this. My impression is that Treasuries of any maturity work in a repo transaction. Long maturities are associated with larger haircuts, but as haircuts go, I think the differences aren't that big. I think on-the-run is preferred to off-the-run, and on-the-run is going to be lean toward bills as most of what gets rolled over each month is bills. That said, there's fungibility, and I don't think the Treasury's behavior is invariant to what the Fed is up to. The Treasury has to float a given quantity of new debt every month, and it worries about satisfying the demand for particular maturities. If the Fed starts buying more long-maturity bonds, the Treasury would tend to adjust by issuing more bonds and less bills. Then when reinvestment stops, the Fed takes pressure off the bond market, and the Treasury issues more bills.Delete
One of the more interesting panel discussions I saw involved a bunch of debt managers (for the US, UK, German, Spanish, and Danish governments) talking about what they did. Spanish debt manager talked about responding to complaints by market participants about a shortage of long government debt caused by the ECB, which was buying it all.Delete
Thanks Steve! A very interesting discussion.Delete
Stephen, thanks for this stimulating discussion.ReplyDelete
I think you are right that the FOMC needs to consider switching to a repo interest rate benchmark. Going back to the early days of LSAP, Fed officials have expressed concern that structural changes in the fed funds market have decreased its relevance to financial firms and the economy. At around $80B per day, the fed funds market is dwarfed by the repo pools tracked by FRBNY’s TGCR and SOFR indexes ($350B and $700B per day, respectively). The Fed has shown a strong preference for secured lending since the crisis so a move to repo would be helpful there. Presumably it would also accelerate adoption of SOFR as a LIBOR replacement, a stated goal of Powell's.
However, I do wonder if hitching the policy target to the big repo pools puts the Fed on the hook, in some sense, for too large a universe of funding, or market dynamics that lie outside their direct control. As with LIBOR, it’s reasonable to expect that spreads between IOER and repo benchmarks will widen and narrow as money market conditions change, and presumably the Fed does not want to be always explaining small movements or temporary violations of target ranges.
Incidentally a switch back to a point target could be useful in that regard. The day-to-day volatility of SOFR is not much higher than fed funds was in the late 1990s.
"However, I do wonder if hitching the policy target to the big repo pools puts the Fed on the hook, in some sense, for too large a universe of funding, or market dynamics that lie outside their direct control."Delete
If the Fed can't control the overnight repo rate, they have a big problem. The approach before the financial crisis was to intervene in the repo market in order to influence what is going on in the fed funds market, and that seemed to work, more or less. The model the New York Fed people had in their heads for that implementation approach was a loanable funds model - fed funds rate is determined by by demand and supply of reserves, and the idea was to have some notion of the demand curve for reserves on a given day, and to intervene in the repo market so that the market would clear at the target fed funds rate. But what they were actually doing was moving the repo rate around day to day so as to hit the fed funds rate target. It's a lot easier just to target the repo rate as you can actually see it - it's the rate on the transactions you're actually engaged in.
"Incidentally a switch back to a point target could be useful in that regard. The day-to-day volatility of SOFR is not much higher than fed funds was in the late 1990s."
Yes, I agree.
Thanks for your reply. One small point of clarification specific to SOFR as a potential rate benchmark. The bilateral repo segment included as BGCR steps up to SOFR includes the activity of many smaller firms as collateral providing counterparties. If liquidity transmission were clogged in this channel, then by assumption dealer-facing OMOs would not be effective in combating a widening bimodality. The median would drift higher. It's hard to say whether this clogging scenario is likely to crop up over the coming years, but it's something potentially worth considering when devising an all-weather approach.Delete
Thanks for the information. It's really useful for everyone to know the institutional details of these markets. There's a view among some of the policymakers that these details aren't important for policy, but I don't think that's right.Delete