Wednesday, August 26, 2015

What Will a Fed Tightening Look Like?

The Federal Reserve has created quite a situation for itself with the three bouts of Quantitative Easing (the QE's). They appear to be considering raising the fed funds rate at the September meeting, but the rout of stock markets worldwide has many now arguing that the action should be postponed, on the assumption that an apparent tightening of policy would only make things worse.

Ironically, even those who've long been calling for a return to "normal" short rates are now becoming a bit reluctant to see it happen, for fear that both the economy and markets are on the verge of going south and that their longstanding advice will get the blame if the market declines continue.

How Would the Fed Tighten?

This isn't a question with a simple answer. It used to be, but no longer. In the "old days" prior to implementation of the QE's all the Fed would do is intervene directly in the fed funds market by selling some of its securities to the banking system. It would do so when funds were trading at, say, 3%, thereby signaling that 3% (or something higher) was the new floor to the fed funds rate. The funds market would adjust to that signal immediately and begin to trade in a higher range. Should it drop to 3% again, the Fed would simply sell more securities.

However, this only worked because banks needed to hold a specific level of bank reserves to meet their reserve requirements and because there were never more than a few hundred million dollars worth of excess reserves in the system. Thus, by draining only that few hundred million, the Fed could ensure that funds traders would be scrambling to meet their reserve obligations by the end of the reserve week, bidding up the fed funds rate in the bargain.

Now, however, with $2.5 trillion of excess reserves in the system, the Fed can't raise the fed funds rate with a simple draining operation as they used to be able to do. Say they try to signal a move to a 0.5% funds rate by selling a billion dollars worth of their portfolio thereby draining a billion dollars from the banking system. Would it matter? Not at all. The banks would still be sitting on almost $2.5 trillion in excess reserves, on which the Fed currently pays them interest at a .25% rate. If the Fed tries to get fed funds to trade at 1/2% the banks will hit any bid over 1/4% because that would be a better rate than what they're currently earning on their excess reserves at the Fed. With $2.5 trillion available for hitting the bid, the banks will win that battle and funds will not trade above 0.25%.

So, What's the Answer?

Clearly, the Fed has to somehow neutralize the $2.5 trillion in excess reserves if they're to effect a tightening in the form of raising the fed funds rate. They have two obvious ways to do this. The Fed can either sell enough securities to directly drain the entire amount, or they can offer to pay the banks a higher interest rate on their excess reserve position. Since selling $2.5 trillion worth of long maturity debt into what would surely be a deteriorating market would be highly impractical, over the short term at least, it's obvious that the Fed will instead raise the rate they pay on reserves, probably to the upper end of the new target range, since it will become a ceiling for the funds rate, as outlined above.

Thus, rather than the market being clued to an eventual tightening by a Fed open market operation, as in the not-all-that-distant past, instead the Fed will just announce that it's raising the interest rate it's paying on reserves. That will be the tightening. It will be a simple announcement, rather than an open market operation.

Some Implications of Raising the Interest Rate Paid on Reserves

Those of you who've read the earlier posts here will be aware that I think that paying interest on reserves, and particularly on excess reserves, was a huge mistake. That said, such interest is now being paid and that has several implications.

First, as described above, a tightening will now very likely take the form of an announcement that the Fed is raising the interest paid on reserves. Now, the vast majority of the public, and this includes a reasonably large majority of investors I suspect, will have no idea what that announcement means. It could actually be phrased in such a way as to sound quite innocuous, as in, "The Fed is announcing that the rate it will pay on reserves held by the banking system will be increased to 1/2 percent as of today." Accompany that with some gibberish about maintaining the health of the banking system and an added note that it's leaving the discount rate unchanged, and many investors might not even realize it's a tightening until it's explained to them later. Meanwhile, the fed funds rate might even continue to trade well under 0.5% for a bit, further confusing the matter.

Second, if you've read the post preceding this one covering the massive increase in demand deposits in the banking system, you might realize by now that the only reason for the increased level is the existence of the ZIRP (Zero Interest Rate Policy). If ZIRP disappears, then so does the rationale for the massive increase in demand deposits. That means that as the Fed gradually raises short term interest rates the level of demand deposits in the banking system will plummet.

Finally, and again drawing on the previous post, whereas I believe the dramatic falloff in the growth of demand deposits in the banking system since February of this year could well indicate that the economy is either already in, or is soon entering, a recession, the plummeting demand deposit balances that will occur when the Fed raises rates will not carry the same meaning. Instead, it will simply mean that the level of demand deposits will be returning to what it would have been had ZIRP not made people indifferent between short-term savings account and checking accounts. That is, once they can earn interest on their savings accounts again, they will begin again to minimize their demand balances.

But, because the Fed most likely doesn't agree with the analysis here, there's a significant danger that it will misinterpret a sharp drop in the level of demand deposits and somehow seek to counteract it. I doubt they'll be able to stop demand deposits from falling, but should they manage to find a way they could indeed open the doors to a significant rise in the inflation rate.


Thus, if a tightening is to occur, it's likely to take the form of an announcement that the Fed will be paying a modestly higher rate on bank reserve positions. That rate is currently 1/4%. From all indications, it will probably be raised to 0.5% if the Fed goes through with a tightening.

They will also probably begin to intervene in the fed funds market entering sooner to do reverse repurchase agreements with quasi-bank entities at a somewhat higher rate. Currently those funds trade between zero and 0.25%. This is a fairly technical issue, but it could confuse people because fed funds will often trade well below 0.5% at times. It involves the repurchase facility the Fed recently established to do business with entities that don't have direct access to the banking system's fed funds market.

One final note, from the perspective of a proponent of the strong form of monetary policy: This wouldn't really constitute a tightening at all. It would just be the beginning of a restoration of normalcy to the banking system, a restoration that will be necessary if the Fed is to ever again be able to utilize its normal operating tools, that is, those used for decades prior to the implementation of the QE's.

By the way, that meager 1/4 percent increase in the rate the Fed would be paying on reserves will cost them over $6 billion in additional interest payments per year, a tidy sum that might explain why all of this has taken so long to materialize (as suggested in The Fed's Massive Conflict of Interest.)

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