the fed's new exit principles jul 2014 - socgen

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ECONOMICS

23 July 2014

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American Themes

A guide to the Feds new exit principles what we know so far

There are many questions regarding the Feds exit. On the question of when, our central scenario remains for a Q3 2015 liftoff, followed by a faster normalization than currently

implied by the market. In this piece, however, we focus on the how, i.e. on the logistics of normalizing policy. The FOMC is still deciding on the new set of exit principles and has

promised to deliver a new package before year-end. Here is what we know so far and what

it means for the markets.

IOER takes center stage The FOMC is essentially conceding on its ability to control the fed

funds rate. Instead, the interest on excess reserves (IOER) will play a central role during the

tightening cycle, with the fixed-rate reverse repo rate (ON RRP) playing a supporting role. The

fed funds target will play a background role, with the FOMC continuing to announce a range

rather than a specific level.

Reverse repos to play second fiddle The FOMC plans to maintain the current 20 bp spread

between IOER and the ON RRP. In contrast to our earlier expectations, the Fed seems reluctant

to rely too heavily on the repo facility in draining liquidity. The primary concern is that dealing

directly with non-bank counterparties could reduce liquidity available to banks and corporations,

particularly during periods of financial stress.

A cleaner liftoff Maintaining a wide spread between ON RRP and IOER means that the repo

rate will not be adjusted ahead of the liftoff and that all rates will rise in a parallel move on the

same day. This goes against our earlier assumptions and reduces the risk of premature

tightening of financial market conditions.

Less-than-perfect control of the fed funds rate At liftoff, we expect the IOER to be set at

0.50%, the ON RRP at 0.30%, and the fed funds target range at 0.25-0.50%. Whether the repo

rate will serve as a firm floor on fed funds will depend on the size limits imposed on the facility. In

any case, we expect the effective funds rate to trade closer to the ON RRP than the IOER.

Slower balance sheet normalization Balance sheet normalization will take considerably longer

than envisioned in the 2011 exit principles. The Fed no longer intends to sell assets and has

pushed back the timeframe for ending reinvestments until after the liftoff. Assuming that all

reinvestments are ceased in early 2016, we estimate that the size of the Feds balance sheet will

be normalized in roughly 6.5 years. If anything, the risk is that it takes longer.

The new exit sequence:

Source: SG Cross Asset Research/Economics

Market implications: What it means: SG timeframe:

1. Liftoff Rates on all Fed facilities to move up in parralel: IOER hiked to 0.5%, ON

RRP boosted to 0.3%, fed funds target range raised to 0.25%-0.50%,

effective fed funds rate to trade around 0.35%.

Active tightening Q3 2015

2. End of

reinvestments

We estimate that ending reinvestment in early 2016 would normalize the

Fed's balance sheet by 2022. In the early years, this would be equivalent

to a $30bn/month reverse QE, split about 70%/30% between Treasuries

and MBS securities. The effective supply of Treasuries would increase by

about $200bn/year.

Passive

tightening

about two

quarters later

Chief US Economist

Aneta Markowska

(1) 212 278 66 53 [email protected]

This document is being provided for the exclusive use of EDWARD MERMEL (SGCIB)

American Themes

23 July 2014 2

Box 1: Exit Strategy Principles Then and now

June 2011 guidance Subsequent changes in guidance SG view

1. As the first step toward

normalization, the Fed will cease

reinvesting mortgage principal

repayments.

The FOMC has signaled that this will likely come

after the first rate increase. The Committees

intention is to use rates as the primary tool in the

tightening process, with balance sheet

normalization occurring passively in the

background. Ending MBS reinvestments ahead of

the first rate increase would send the wrong

message, and risk a premature tightening in

financial conditions.

We now assume that MBS reinvestments will be

halted in 1H 2016, about six months after the

first rate increase.

2. At the same time, or sometime

thereafter, the Fed will modify

forward guidance on the fed funds

target and will initiate reserve

draining operations.

The latest FOMC minutes hint that there will be no

reserve draining operations ahead of the tightening

cycle. Instead, the Fed will rely heavily on the IOER

and the ON RRP facility in setting the floor under

the fed funds rate and guiding it to desired levels.

With no MBS runoff or reserve draining

operations ahead of the first hike, the FOMC will

have to verbally signal that the tightening cycle

is imminent. This may be done by dropping the

reference that the unemployment rate remains

elevated. We believe that the signal is most

likely to come in Q1 2015, about six months

ahead of the first hike.

3. The next step in the normalization

process will be to raise the fed funds

target. This will be supported by

adjustments to the interest rate on

excess reserves (IOER) and by

ongoing reserve draining operations.

According to the June 2014 FOMC minutes, the

IOER will play a central role during the

normalization process, with the ON RRP facility

playing a supporting role in putting a firm floor

under money market rates. The FOMC seems to

prefer a wide spread of about 20 bps between the

two rates.

The fed funds rate target will continue to play a

role in the new communications framework, but its

role will most likely be secondary. Many FOMC

participants prefer to maintain a range rather than

a specific target. The Fed is also examining the

possibility of changing the calculation of the

effective funds rate.

We expect the liftoff in rates to take place in the

third quarter of 2015. This will involve raising the

IOER from 0.25% to 0.50%, raising the ON RRP

rate from 0.05% to 0.30%, and raising the target

range on the fed funds rate from 0-0.25% to

0.25-0.50%. We expect the effective fed funds

rate to trade around 0.35% after the first hike.

Note: Given that the IOER is likely to take on a

central role during the normalization process,

the FOMC may at some point redefine the dot

plot which currently refers to the participants

forecasts for the fed funds rate.

4. Sometime after the first rate hike,

the Fed will begin selling agency

securities. The pace of sales is

expected to be steady, but could be

adjusted up or down in response to

material changes in the outlook.

Various FOMC officials have signaled that outright

asset sales are now extremely unlikely. Instead, the

Fed will ultimately allow the balance sheet to

shrink by ending the reinvestment policy in both

MBS and Treasury securities. Most FOMC

participants favor ending reinvestments after liftoff.

Our working assumption is that both MBS and

Treasury reinvestments will cease in 1H 2016,

roughly six months after liftoff.

5. The Feds agency holdings are to be

eliminated within a 3-5 year window.

This would normalize the size of

overall SOMA holdings over a period

of 2-3 years.

The timeframe for asset sales is no longer relevant

given the reliance on natural runoff of the Feds

balance sheet.

Based on the above assumption, we estimate

that the Feds balance sheet would reach a

normal size about 6.5 years later, i.e. by the end

of 2022.

Source: Federal Reserve Board, SG Cross Asset Research/Economics


American Themes

23 July 2014 3

Q1: What are exit principles, and why do they need changing?

Since 2007, US monetary policy has been anything but normal. The Federal Reserve was

forced to develop and deploy tools that did not exist prior to the crisis. As a result, the Feds

balance sheet has undergone a major transformation and many observers have expressed

skepticism about the Feds ability to normalize policy in an orderly fashion. To counteract

some of the skepticism and to provide transparency about its intentions, in June 2011, the

FOMC published its original set of exit principles, detailing the sequence and logistics of

exiting extraordinary stimulus. At that time, the focus was on winding down the balance sheet,

which would begin with ending MBS reinvestment, followed by reserve drain, the first rate

hike, and finally by asset sales. The FOMC planned to normalize the size and composition of

its balance sheet i.e. return to a short-duration Treasury-only portfolio within five years.

But then came operation twist and QE3 which significantly increased the size and duration of

the Feds security holdings. New research has also shed new light on the transmission of QE,

and on the optimal exit sequence. Moreover, the FOMC has recognized that raising rates may

prove challenging in the context of a large balance sheet, and that the tools developed in the

early phases of exit planning may not be effective in putting a firm floor under the fed funds

rate. As a result, the Fed has recently developed a fixed-rate overnight reverse repo facility

(ON RRP) more on this later but it has yet to decide on the extent to which it will rely on

this tool in the normalization process.

In light of these developments, the 2011 exit principles have become quite stale and are in

need of an overhaul. The FOMC has been working on a new package and held extensive

discussions about medium-term policy issues during the last two FOMC meetings. Chair

Yellen has promised to deliver the finalized set before the end of the year, but the latest FOMC

minutes have shed some valuable light on the Feds current thinking. In this note, we piece

together what we know about the new exit principles ahead of the final report to be delivered

by the FOMC later this year. We offer a summary in Box 1, and a more detailed analysis in the

Q&A that follows.

Chart 1a: The Feds assets Chart 1b: The Feds liabilities

Source: Haver Analytics, SG Cross Asset Research/Economics Source: Haver Analytics, SG Cross Asset Research/Economics

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

00 02 04 06 08 10 12 14

USD bln

Other Assets

Gov't and Agency Security Holdings

QE3

QE2

QE1

exitprinciples published

Twist

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

00 02 04 06 08 10 12 14

USD bln

Other Liabilities

Currency in circulation

Term deposits + Reverse repo agreements

Reserve Balances

Short answer:

Exit principles detail

the Feds strategy for

policy normalization.

Last published in

2011, the old

principles have

become stale given

further balance sheet

expansion.


American Themes

23 July 2014 4

Q2: Why cant they hike the old-fashioned way?

The Fed has traditionally controlled the price of money by manipulating the supply. This is

somewhat counterintuitive, because the FOMC has generally expressed its policy stance via a

fed funds rate target. But the rate itself is set by market forces. More specifically, its daily

fluctuations are driven by the demand for reserves (aka federal funds). So how was the Fed

able to control rates in this policy regime? By accurately predicting demand for reserves, and

expanding/contracting the supply of reserves via open market operations so that the fed funds

market would clear at or very close to the Feds target rate. As shown in chart 2, during the

pre-crisis period the effective fed funds rate fluctuated around the target within very narrow

range.

Post-crisis, the Fed is no longer able to control the supply of reserves because the

subsequent rounds of quantitative easing have caused an explosion from an average of $2bn

before 2008 to more than $2.5 trillion today (see chart 1b). This massive oversupply is putting

tremendous downward pressure on overnight rates. Since selling assets prior to the first rate

increase is not a viable option, the FOMC had to develop new tools that would allow it to

manage the level of short-term rates more effectively.

Chart 2: Short-term rates pre- and post-crisis

Source: Bloomberg, SG Cross Asset Research/Economics

Q3: The Interest on Excess Reserves (IOER) was supposed to serve as a floor. Why is it

not enough?

The IOER was introduced in October 2008, marking an early attempt by the Fed to maintain

control of overnight rates in the presence of a large balance sheet. It is a rate paid to

depository institutions on their reserve balances held at the Fed. Unlike the fed funds rate, the

IOER is explicitly set and controlled by the Federal Reserve. This is its main advantage in the

context of policy normalization.

In theory, the IOER should have set a floor under the effective fed funds rate because banks

should not lend to each other below the rate they can otherwise receive from the Fed.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14

%

Fed Funds Effective

Fed Funds Target

Discount Rate (ceiling)

Interest On Excess Reserves (floor)

Oct 17,2008: The Fed starts paying interest on reserves

Short answer:

Because in the

presence of a large

balance sheet, the Fed

is no longer able to

control the supply of

reserves.

Short answer:

The largest lenders of

reserves are not

eligible to receive

interest on reserves.

And, new regulatory

costs are preventing

banks from borrowing

in fed funds and

closing the spread to

IOER.


American Themes

23 July 2014 5

However, the floor-based system has proven quite porous. As shown in chart 2, since 2008

the effective fed funds rate has been trading consistently below the IOER. There are two

reasons for this:

First, as demonstrated in chart 3, some lenders in the federal funds market (notably GSEs

and Federal Home Loan Banks) are not eligible to earn interest on their reserve balances

and have been willing to lend below the floor. This represents an arbitrage opportunity for

banks which can theoretically borrow at fed funds and lend to the Fed at IOER. Yet, for

reasons outlined below, banks are unable to fully exploit this opportunity.

Second, various new regulations are increasing balance sheet costs for banks and driving

a wedge between the fed funds rate and the IOER. For example, in 2011 the Federal

Deposit Insurance Corp began to assess insurance premiums based on total assets

rather than domestic deposits. Since loans to the Fed constitute an asset, FDIC-insured

banks now incur a cost when borrowing in fed funds and depositing the proceeds at the

Fed. This friction prevents banks from taking full advantage of the theoretical arbitrage

opportunity and leads to a spread between the IOER and the funds rate. (Note that this

does not apply to foreign banks which do not take deposits in the US. This is why foreign

institutions hold a disproportional portion of excess reserves created by QE). Newly

proposed limits on leverage (Supplementary Leverage Ratio, or SLR) and liquidity

(Liquidity Coverage Ratio, or LCR) are likely to further increase balance sheet costs and

reduce the Feds control of the fed funds rate. Since the rules have not been finalized yet,

it is too early to assess their impact.

Chart 3: An illustrative chart of money market flows

Note: For the purposes of this discussion, we limit the chart to overnight wholesale funding. Other significant sources of

funding for banks are deposits and term wholesale loans.


Why can the Fed not simply let the effective fed funds rate trade slightly below the IOER and

call it a day? If the spread between the two rates was always constant, the Fed would simply

have to over-calibrate the IOER, with the only downside being a slightly higher cost to the

taxpayers. However, the Feds bigger concern is the possibility that the spread may widen as

it attempts to raise rates. In this scenario, the FOMC would not be able to tighten at the pace

that it desires, and its credibility would come into serious question.


American Themes

23 July 2014 6

This is why the Fed has continued to expand its toolkit and devise new facilities for controlling

short-term rates. We summarize the tools in Box 2. Other early efforts include the creation of a

Term Deposit Facility (TDF), which is similar to the IOER but would involve term loans and thus

theoretically move funds out of reserves. However, like the IOER, this facility is also restricted

to banks and therefore unlikely to plug the leaky floor. The Fed could also drain liquidity by

taking term loans via the repo market, especially since it significantly expanded its

counterparty list beyond Primary Dealers in 2010. However, the rate on traditional repos is

determined through a competitive auction and not explicitly set by the Fed. As a result, both

of these tools are unlikely to overcome the challenges associated with the IOER and give the

Fed near-perfect control of the fed funds rate.

Box 2: The Feds toolkit for controlling rates

Source: Federal Reserve Board, SG Cross Asset Research/Economics

Q4: What exactly is the ON RRP rate and why is it more effective than IOER?

In order to set a firm floor under the fed funds rate, the Fed needed to create a facility that

would allow it to lend overnight to a broad range of counterparties at a pre-determined rate.

The solution: a fixed-rate overnight repo rate facility (ON RRP). Under this program, the Fed

can deal not only with banks and Primary Dealers, but also with Government Sponsored

Enterprises, Federal Home Loan Banks, money market funds and investment managers (there

are currently 142 counterparties on the Feds approved list). Allowing all cash-rich institutions

to lend directly to the Fed should eliminate much of the leakage in the IOER, giving central

bankers a stronger hold on overnight rates, even in the presence of significant excess liquidity.

Description Rate setting

mechanism

Term Counterparties Issues

Fed funds rate An overnight rate at which banks borrow

reserves from one another. Banks in an

excess reserve position generally lend

to those who find themselves short

relative to their reserve requirement.

Set by the market, but

Fed intervenes on supply

via open market

operations.

O/N banks -> banks In light of the large balance sheet and vast

excess reserves, the Fed can no longer

control the fed funds rate the "old

fashioned way".

Interest on

excess reserves

(IOER)

An overnight rate paid to depository

institutions on their reserve balances (i.e.

unsecured loans to the Fed). Introduced

in October 2008.

Administered by the Fed. O/N Fed -> banks The IOER was supposed to set a floor

under the fed funds rate, but the floor has

proven leaky because the largest lenders

in the fed funds market (GSEs) are not

eligible to receive interest on reserves.

Term deposit

facility (TDF)

A rate paid on unsecured term loans to

the Fed. The facility was introduced in the

early years of the crisis in order to drain

reserves from the system during policy

normalization.

Rate may be determined

through a single-price

auction format, a fixed-

rate format, or a floating-

rate format.

up to 84 days Fed -> banks Only depository institutions can participate

in the facility. This significantly limits its reach

and is unlikely to work as an effective floor.

Term Treasury

reverse repo rate

(Term RRP)

A repo rate paid by the Federal Reserve

on collateralized term loans. This is part

of the Federal Reserve's longstanding

toolkit, however in 2010 the Fed began

to expand the counterparty list beyond

primary dealers.

Rate determined through

a competitive auction

format.

up to 65

business

days

Fed -> primary

dealers, banks,

GSEs, mmkt funds

and investment

managers

This facility improves on the shortcomings

of the TDF in that it allows the Fed to deal

with broader range of counterparties. The

downside is the traditional auction format

which does not give the Fed explicit control

of the rate.

Overnight fixed-

rate reverse repo

(ON RRP)

A rate paid on collateralized overnight

loans to the Fed. The facility was

introduced in 2013 in an effort to shore

up the Fed's control of overnight rates in

the presence of large balance sheet

(and leaky IOER). Only Treasury

collateral to be used.

Rate determined through

a fixed-rate auction

format.

O/N Fed -> primary

dealers, banks,

GSEs, mmkt funds

and investment

managers

This facility overcomes the shortages of

the TDF and Term RRP and could give the

Fed a tight grip on overnight rates.

However, this comes at a cost: dealing with

nontraditional counterparties on a large

scale could drain liquidity from the banking

system, especially during periods of

financial stress.

Short answer:

The key distinction is

that the ON RRP rate

can be accessed by a

much broader range of

counterparties while

still giving the Fed

explicit control of the

rate.


American Themes

23 July 2014 7

The Fed launched the ON RRP facility in 2013 and since then has conducted a number of

operational exercises. The rate is currently set at 0.05%, and the per-counterparty size limit

has increased steadily from $0.5bn to $10bn per day. There is currently about $115bn

outstanding under the ON RRP facility. Most market participants, including ourselves, believed

that the Fed would rely heavily on this facility during policy normalization. However, the latest

FOMC minutes suggest some reluctance, with the Fed instead preferring to use a mix of tools.

Q5: The FOMC seems reluctant to rely heavily on the ON RRP facility. Why?

There is no question that the ON RRP facility could be quite helpful in reinforcing the floor

under overnight rates. However, it could also fundamentally reshape the Feds role in financial

intermediation. As demonstrated in chart 3, traditionally only banks had direct access to the

Feds lending and deposit facilities, while borrowing funds from a wide range of counterparties

via a wide variety of instruments. The repo facility would allow those counterparties to bypass

the banks and lend directly to the Fed. This could represent a real challenge during periods of

financial stress, because cash-rich lenders could shift investments toward the facility,

reducing the liquidity available to banks and corporations, and thus magnifying a liquidity

crunch. Even in normal times, the facility could drain liquidity from the banking system if the

rate is set too high and the size of the ON RRP loans increases substantially. For these

reasons, the Fed does not want the ON RRP facility to become a permanent feature of its

operating framework.

After extensive discussions, the FOMC has concluded that the ON RRP should play a

secondary role during the normalization process while the IOER takes on a lead role. To

prevent the ON RRP facility from getting too big, the Committee is leaning toward setting a

relatively wide spread between two rates. The latest FOMC minutes suggested a figure around

20 basis points, which is in line with the current rate levels on the two facilities (0.05% and

0.25%, respectively). Fed officials also plan to constrain the size of the repo facility, either by

counterparty or in aggregate. This is in contrast to the initial plans to run the auctions at full

allotment.

Q6: Where does that leave the fed funds rate?

The Feds reluctance to rely more extensively on the repo rate means that it has to accept

less-than-perfect control of the fed funds rate. Targeting a specific level of fed funds is

therefore out of the question until the balance sheet is fully normalized. The FOMC has

acknowledged as much, noting in the latest minutes that it will probably continue to announce

a target range. This also means that the fed funds rate will not completely disappear from the

FOMC statement, but it will play a background role.

The inability to control market rates is only one reason for abandoning the fed funds target.

Another reason is that the rate is no longer as meaningful as it used to be, and it may never

return to its former glory. The volume of transactions in the fed funds market has shrunk

considerably in recent years. We estimate the current volumes to be about $50bn per day vs.

about $200bn per day prior to the crisis. Recall that the fed funds rate market has traditionally

involved banks borrowing reserves from one another in order to meet their reserve

requirements. Today, most banks are sitting on vast excess reserves and have no need to

borrow in the fed funds market. Most of the lending1 is done by the Federal Home Loan

1 See Whos lending in the Fed Funds Market?, Liberty Street Economics/Federal Reserve Bank of New York

Short answer:

Allowing non-

traditional

counterparties to lend

directly to the Fed

could reduce liquidity

available to banks and

corporations,

particularly in periods

of financial stress.

Short answer:

The Fed is essentially

throwing in the towel

on the fed funds rate,

choosing to focus on a

rate that it can control,

i.e. the IOER. The

funds rate will

probably continue to

be part of the

statement, but in a

background role, and

with a target range.


American Themes

23 July 2014 8

Banks, and the borrowers2 are comprised primarily of foreign banks exploiting the arbitrage

opportunity between the fed funds market and the IOER (recall that foreign banks are not

subject to FDIC charges and therefore do not incur the same balance sheet costs on the

transaction as US banks). There is also a wide dispersion in prices paid for overnight fed

funds, with some transactions printing as low as 0.01%, and some printing above 0.30%, i.e.

through IOER.

For the reasons outlined above, the FOMC is also examining the possibility of changing the

calculation of the effective fed funds rate in order to obtain a more robust measure of

overnight bank funding rates. The Fed is reportedly looking into including Eurodollar

transactions, i.e. dollar loans between banks outside US markets. Today, this definitional

change would have no impact on the level because overnight Libor currently trades in line with

the effective fed funds rate, i.e. at 0.09%. However, historically Libor has traded higher by

about 7 bps, so in the long run this calculation change could push fed funds marginally higher.

Even if the Fed were to expand the definition of the fed funds rate, we are not certain that it

will be able to control the rate as it used to, for three reasons:

1. We estimate that the balance sheet will remain abnormally large for nearly another

decade (more on this later). Until then, banks will remain in excess reserve positions and

will have little to no need to borrow in the fed funds market.

2. As mentioned earlier, new regulations on leverage and liquidity are poised to further

increase balance sheet costs. This will discourage banks from borrowing in the fed funds

market, potentially widening the spread between the funds rate and the IOER.

3. The new regulations on liquidity (Liquidity Coverage Ratio (LCR), wholesale funding limits,

etc.) may permanently alter the nature of the fed funds market, even after the balance

sheet is fully normalized. In light of the new rules, banks may no longer be willing to start

the day structurally short reserves and expect to square their positions over the course of

the day, i.e. engaging in the type of activity that traditionally led to trading in the fed funds

market. Hence the funds rate may still be marginal, although more representative of a

market rate sometime in the future.

Q7: What will the liftoff look like?

Now that the FOMC has clarified certain elements of its new exit strategy, we can begin to

sketch the liftoff with greater precision. In contrast to our earlier expectations, we now believe

that all short-term rates will rise in parallel on the same day: the IOER will be lifted from 0.25%

to 0.50%, the ON RRP rate from 0.05% to 0.30% and the fed funds target will be probably be

raised from 0-0.25% to 0.25-0.50%.

Earlier, we believed that the repo rate may have to begin to be lifted early in order to narrow

the spread with IOER and constrain the fed funds rate to a narrower range. This posed the risk

of premature tightening of financial conditions. However, in light of the recent guidance, it is

clear that the FOMC is aiming for a very clean liftoff. Our central scenario continues to be for

Q3 2015.

2 See Whos borrowing in the Fed Funds Market?, Liberty Street Economics/Federal Reserve Bank of New York

Short answer:

At the time of the

liftoff, all rates/rate

targets will move up in

parallel, with the IOER

set at 0.50%, the ON

RRP rate at 0.30%,

and the fed funds

target range at 0.25%-

0.50%.


American Themes

23 July 2014 9

Where will the effective fed funds

trade immediately after the liftoff?

Assuming that the size of the repo

facility is ramped up further, we

expect the 0.3% repo rate to serve as

a relatively firm floor for the fed funds

market. However, the Fed may want

to give itself some wiggle room,

setting the bottom of the range

slightly below the repo rate. The

ceiling is more difficult to determine,

given the uncertain balance sheet

costs associated with FDIC fees and

other regulatory restrictions. But we

would expect the funds rate to trade

closer to the repo rate than the IOER,

i.e. around 0.35%.

Q8: What will happen to the dots?

The FOMCs guidance regarding the appropriate pace of policy firming i.e. the dots is

currently expressed in terms of the target fed funds rate. However, if the Fed shifts the primary

focus to the IOER and continues to set a target range on the fed funds rate, it would make

sense to express its guidance in the same format.

Given the various leakages discussed earlier, it is clear that the IOER will have to be over-

calibrated relative to the desired fed funds rate during policy normalization. Therefore

expressing the appropriate monetary policy stance in terms of the IOER should theoretically

move the entire dot plot up by about 15 basis points. However, the actual impact on the

FOMC projections is not that obvious. Since they are expressed in 25-bps intervals, the 15-

bps adjustment is borderline and falls within the margin of error. More importantly, the Feds

rate projections are driven by a number of factors the economic outlook, changes in the

reaction function and changes in the FOMC compositions and any of these could overwhelm

the shift to IOER-based projections. Of course, the FOMC could choose to maintain a status

quo and continue to express its guidance in terms of the fed funds rate, but in our view this

would lead to unnecessary confusion about what the dots mean, further undermining their

usefulness.

Q9: Does the balance sheet matter anymore?

In a floor-based system of managing overnight rates, the size of a central balance sheet is

theoretically irrelevant. However, there are a number of reasons to eventually scale back the

size of the Feds security holdings:

Normalizing the balance sheet will allow the Fed at some time to return to the traditional

way of managing overnight rates and eliminate the need to deal with leaky floors.

Permanent intervention in credit markets can distort price signals, leading to sub-optimal

allocation of capital and sub-optimal economic outcomes.

Chart 4: Short-term rates after the liftoff


IOER (50bps)

IOER less balance sheet costs (???)

ON RRP (30 bps)

possible range for the effective fed funds rate

Short answer:

With IOER taking

center stage in the

normalization process,

it would make sense

to express rate

guidance in the same

format. All else equal,

changing the dot

plot from fed funds to

IOER should push the

projections up by

about 15 bps.

Short answer:

The balance sheet is

theoretically irrelevant

in a floor-based

system of managing

overnight rates.

However, there are

other reasons to

normalize the size and

return to a Treasury-

only portfolio.


American Themes

23 July 2014 10

Holding on to purchased assets indefinitely also constitutes monetization which can

adversely impact long-term inflation expectations.

Lastly, a large balance sheet exposes the central bank to potential losses. Though

technically booked as deferred assets (rather than eroding the Reserve Banks capital)3,

these earnings shortfalls could undermine the Feds political independence and

credibility.

For these reasons, the FOMC plans to eventually normalize the size and composition of its

asset portfolio.

Q10: How long will it take to normalize?

Currently, the FOMC has a policy of reinvesting all principal repayments on its holdings (but

not interest payments, which are transferred over to the Treasury at year-end, net of the Feds

operating costs). In the 2011 exit principles, the Fed said that it would begin the normalization

process by ending its reinvestment policy and that this process would commence before the

first rate increase. This would be followed by outright asset sales which would begin

sometime after the liftoff. The FOMC planned to normalize the size and composition of its

balance sheet within five years of the initial asset sale.

Chart 5: Feds security holdings projections assuming end of reinvestments in early 2016

Source: Haver Analytics, SG Cross Asset Research/Economics

It is now clear that the normalization process will take longer. First, Fed officials have already

indicated that they no longer intend to conduct any asset sales. They have also pushed back

the timeframe for ending reinvestments, which is now expected to commence after the first

rate increase. In the scenario depicted in chart 5, we assume that both MBS and Treasury

reinvestments cease in early 2016, i.e. about six months after the initial liftoff. Under these

assumptions, we expect the size of the Feds SOMA (System Open Market Account) holdings

to normalize within 6.5 years. However, we note that merely ending reinvestments will results

in a very uneven pace of reductions. Chart 6 shows the projected maturity profile of the Feds

Treasury holdings after the tapering process comes to completion. Note that the maturing

amounts fluctuate from $6bn to $40bn in the early years of normalization and the FOMC may

want to devise some kind of smoothing scheme to even out the runoff.

3 See The Federal Reserves Balance Sheet and Earnings: A primer and projections, Federal Reserve Board

0.0

0.4

0.8

1.2

1.6

2.0

2.4

2.8

3.2

3.6

4.0

4.4

00 02 04 06 08 10 12 14 16 18 20 22

$ tln Treasuries

Agency Debt

MBS

Pre-crisis Trend

SG Forecast

Short answer:

Assuming that the Fed

ceases reinvestments

in both Treasury and

MBS securities in early

2016, it will take about

6.5 years to normalize

the size of the balance

sheet. In the early

years, this would be

equivalent to a reverse

QE of $30bn/month.


American Themes

23 July 2014 11

Chart 6: Projected maturity profile of the Feds Treasury holdings

Source: Federal Reserve Bank of NY, SG Cross Asset Research/Economics

Ending reinvestments will constitute outright monetary tightening, as it will shrink the Feds

balance sheet at a fairly rapid pace. If anything, the Fed may choose to slow down the

process by allowing only a portion of the maturing securities to run off. We estimate that in

2016, about $370bn in securities would roll off the Feds balance sheet in the absence of

reinvestment. This is comprised of $215bn in maturing Treasuries, $17bn in maturing agency

bonds, and an estimated $140bn in MBS securities. This is equivalent to a reverse QE of

about $30bn/month.

It is also worth noting that ceasing reinvestments will effectively increase the net supply of

Treasury and MBS paper that will have to be financed by private investors and/or foreign

central banks. In chart 7, we show our projections for Treasury supply net of Feds buying.

Note that FY2014 is the sweet spot in terms of the supply/demand balance, with the deficit

continuing to shrink and the Fed still buying a good amount of Treasury debt. This dynamic

will begin to go into reverse FY2016 and beyond: the fiscal deficit is projected to expanding

modestly after reaching a trough in FY2015, and with the Fed no longer rolling over maturing

securities, the Treasury will have to issue that much more to the public.

Chart 7: Projected Treasury supply, net of Feds reinvestments

Source: Haver Analytics, SG Cross Asset Research/Economics

0

10

20

30

40

50

60

70

US

D b

ln

Maturity profile of the Fed's Treasury portfolio

12 month moving average

206

339386

220 218

145

782

1,778

1,488

1,128 1,126

847

650628

711 738748

861

951

-

500

1,000

1,500

2,000

$bn

Treasury supply

Net of Fed buying


American Themes

23 July 2014 12

Global Head of Research

Patrick Legland

(33) 1 42 13 97 79 [email protected]

CROSS ASSET RESEARCH ECONOMICS Global Head of Economics

Michala Marcussen

(44) 20 7676 7813

[email protected]

Euro area

Michel Martinez

Anatoli Annenkov

Yacine Rouimi

(33) 1 42 13 34 21 (44) 20 7762 4676 (33) 1 42 13 84 04 [email protected] [email protected] [email protected]

United Kingdom

Brian Hilliard

(44) 20 7676 7165 [email protected]

North America

Aneta Markowska

Brian Jones

(1) 212 278 66 53 (1) 212 278 69 55 [email protected] [email protected]

Asia Pacific China India

Klaus Baader

Wei Yao

Claire Huang

Kunal Kumar Kundu

(852) 2166 4095 (33) 1 57 29 69 60 (852) 2166 5436 (91) 80 6716 8266 [email protected] [email protected] [email protected] [email protected]

Japan Korea

Takuji Aida

Kiyoko Katahira

Suktae Oh

(81) 3-5549-5187 (81) 3 5549 5190 (82) 2 2195 7430 [email protected] [email protected] [email protected]

Latin America Inflation

Dev Ashish

Herv Amourda

Shivangi Shah

(91) 80 2802 4381 (91) 80 2808 6779 (91) 80 3087 8603 [email protected] [email protected] [email protected]

Poland Czech Republic Czech Republic Czech Republic

Jaroslaw Janecki

Jiri Skop *

Marek Drimal *

Jana Steckerov * (48) 22 528 41 62 (420) 222 008 569 (420) 222 008 598 (420) 222 008 524 [email protected] [email protected] [email protected] [email protected]

Russia Slovakia

Evgeny Koshelev *

Viktor Zeisel *

(7) 495 725 5637 (420) 222 008 525

[email protected] [email protected]

Research Associates

Harriett Beattie Tutku Siva Kizildag Emmanuel Claessens

* Contributions from other SG Group entities: Komercni Banka, Rosbank, BRD.


American Themes

23 July 2014 13

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the fed's new exit principles jul 2014 - socgen

Documents

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