The FED's Exit Strategy

[flow5]

www.financialsense.com/node/7967

"But because the long and variable lags in the effectiveness of policy, waiting until inflation actually occurs will be too late"

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta.

Milton Friedman's research: that money acts thru "long & variable lags", is of course a myth, when the rate-of-turnover of money (velocity), is also considered. But Eisenbeis has some interesting comments on shrinking the FED's balance sheet:

Before the financial crisis, banks holdings of excess reserves were less than 4% of their total reserve holdings, whereas today they are 96%. So an increase in required reserves to even 90% would not be binding, and there would be little or no impact upon bank lending costs, nor would it affect in any way the 25 basis points the banks are receiving for holding those reserves at the Fed. At the same time, as the economy improves, there would be no effect on the increase in the opportunity cost of holding reserves instead of accommodating demands for funds.

The high level of required reserves could also function as a speed bump, limiting the pace at which lending could increase without the need for the FOMC to abruptly and rapidly increase its policy rate to prevent the economy from overheating. But most importantly, the policy would give the Fed substantially more flexibility in how it managed the shrinkage in its asset portfolio. Right now, its two main options are to either hold assets to maturity or to sell them into the market. Holding assets to maturity would be virtually impossible, if it has to rely solely on increasing its policy rate as the main tool for tempering what might otherwise be an overheating economy, since selling assets would the main tool the Fed would have to push rates up.

Selling assets to raise interest rates would also require the Fed to recognize capital losses and reduce its book-value capital, of which it has precious little. It would also avoid having to use the accounting gimmick it put in place to defer recognition of those capital losses – in other words, eliminate having to employ phony accounting to pretend it was book value solvent when it was not. Raising reserve requirements to the suggested levels effectively sterilizes the bulk of the excess reserves on the Fed's balance sheet, and by implication the assets in its portfolio, and would permit it to hold to maturity most if not all of the assets it has acquired as a result of its liquidity policies, quantitative easing, and efforts to support the housing market.

Some policy makers follow the absorption rate of excess reserves into required reserves as an important indicator of how quickly bank credit and the money supply are increasing. Use of that indicator would not be affected, since there would still be ample excess reserves that could be employed to accommodate needed bank credit as the economy begins to pick up, while at the same time tempering the speed at which the banking system in the aggregate could expand credit and the money supply.

The real benefit of the policy being suggested, however, lies in the use of both a quantity-limiting policy tool (reserve requirements) and a price tool (the Federal Funds rate) to control the pace of the recovery and limit the acceleration in inflation. Furthermore, it would enable the Fed to explicitly articulate an exit strategy for reducing its portfolio over time and commit to financial markets that it will phase down reserve requirements at a pace that is in accordance with a rule or formula that will not unduly constrain bank lending and that is geared to both the maturing of its portfolio and the pace of the recovery. One could envision, for example, a pace of reduction that allowed for a larger amount of excess reserves initially but that gradually declined as the economy expanded, so as to use increases in market rates and bank lending rates to dampen what might otherwise be an overheating economy and an undesired increase in inflation.

The FOMC could then reduce the interest rate paid on only excess reserves to lower the attractiveness of holding the residual excess reserves as a marginal stimulus for banks to begin lending without impacting the total volume of reserves. The FOMC would still also have the ability to employ changes in the target Fed Funds rate, but in this case using two policy instruments rather than one solves many problems that would otherwise be associated with the strategy that was put forth last year, which placed almost exclusive reliance upon manipulation of market expectations and a gradual increase in the funds rate.

[bimetalaupt]

Flow5,
It looks like the German members of ECB are in the same mode as the FED.. Looks like they too have issures with the leadership...I still hold to making Axel Weber Head of the ECB..Current head is a joke!!..

just a thought,
Bruce

[sil0730]

Thursday triggered a sell in the DOW. This is the fifth sell signal since Ben got involved. The first four were greeted by a "next" day reversal spike with a considerable move to the upside. Thursday's sell signal was the strongest of the five. Market direction trends come in three or five momentous waves. I see a lot of deterioration in the market. Can "BEN" do it again?...I think so...Ben has to!

[Aman A.K.A. Ahamburger]

Like I have been saying for over two years now the Fed May Decide Not to Sell Securities.  They will hold them until they mature, and pay the UST back 3.1+ trillion with interest added into that.  This is almost a story about recycling.  

[bimetalaupt]

Feb 28, 2013 1:24:09 GMT -5 Aman A.K.A. Ahamburger said:

Like I have been saying for over two years now the Fed May Decide Not to Sell Securities.  They will hold them until they mature, and pay the UST back 3.1+ trillion with interest added into that.  This is almost a story about recycling.  

A+++,
 Remember the effect of the reverse repo in the summer of 2011.

It was a disaster I am sure Ben B. would like to forget..Market crashed with this test of the system.. And it was not large enough to make it worth his efforts.. You know the banksters made money on that.

Worth studying...

BiMetalAuPt

[flow5]

Sober Look have a very interesting post on how the Fed can drain the excess reserves and exit QE by repo out its assets and keep rolling them. While I don’t want to go into the whole floor debate again, it’s worth posting their conclusion:

If the Fed rolls these repo positions over time, the reserves will stay “drained” but the securities will still be owned by the Fed – until they pay down or mature. In effect the Fed would sterilize some or all of its securities purchases. Which means that draining the reserves does not have to entail the painful process of active portfolio unwind. And draining excess reserves is in fact a more likely exit strategy than some economists have been expecting

The Fed has started lending out more (via the NY Fed
AM Draining excess reserves via repo"

And yes, not exactly the repo rate, but I do think there’s some connection. Here’s the explainer for the securities lending program:

Dealers that have elected to participate in the program may submit bids via FedTrade. The bid rate represents the lending fee rate that a participant is willing to pay in order to borrow the security. It is not a repo rate. Because the program operates on a borrow-versus-pledge basis, the bid rate may be considered equivalent to the spread between the general collateral rate and the specials rate for the borrowed security.

There’s a lot of merit to Sober Look’s idea, though it might have its limits.

Assuming the Fed won’t have the GC repo rate trading too far from IOER, repoing out all of its assets continuously might not be an option. It could generate pressure on GC repo rates as the Fed’s portfolio is quite large. Still, Interesting idea when that time comes since markets might be more than capable of absorbing the flow.

[flow5]

Frances Coppola

"We have the same “unwind” problem in the UK, of course: the BoE has currently holds I think around 40% of the total gilt stock, so returning those to the private sector will be quite a headache. Personally I’m not convinced we will ever return more than a small percentage of them: the UK is in for a very long slump, I suspect (not least because of idiotic government policy), so draining excess reserves is going to be economically unjustifiable for years to come. But we do interest remittance differently: unrealised mark-to-market losses on gilts will be borne by the Treasury in the form of reduced quarterly interest remittance, rather than by the Bank of England. It’s sort of a cash margin scheme. So the Bank of England will be fully protected from losses on the gilt portfolio when it unwinds, and the Treasury will fund future losses by borrowing now (while it is cheap) rather than when they are realised (when borrowing will be potentially more expensive). Rather clever, I thought"

JKH says:

02/23/2013 at 4:56 PM

Hi Frances,

Very clever indeed – if I understand it correctly – the Bank of England basically builds up a retained earnings/loss reserve equivalent to unrealized losses – so that it is unconstrained in an institutional accounting sense from selling bonds at a loss. And the hold back of the ‘reserve’ forces Treasury to issue more debt now at low rates to cover the budget deficit.

I think a good part of the eventual exit for both the Fed and the BoE will consist of maturing bonds instead of selling them. Realized and unrealized losses end up being zero on that component.

That said, the Fed certainly faces a measure of risk from potential interest margin compression due to short funding (there’s that word funding again). The starting spread and running profit rate as well as the portfolio of permanent zero cost currency funding is a hedge for most if not all of that erosion though. Bank interest rate gaps can be slow moving over time – but have a habit of coming up and biting you very suddenly. But I think the Fed is particularly well protected, because it doesn’t face the same kind of customer liability optionality that commercial banks do. And rates may remain low for a long time. But it is interesting that they’re taking a very sizeable interest rate position at the institutional level – gargantuan in fact. My expectation is that they’re running risk scenarios and profit simulations constantly on this stuff, and that it’s very well managed from that perspective. The combined effect of accrual bond interest, reserve short funding costs, zero cost currency, and any realized losses on bonds will determine the Fed profit trajectory over time. And they do care about the profit result profile, even though it has no bearing as a consolidated government “solvency” concern"

[grits]

I have a feeling that people in for a major shock when this unwinds. 

[flow5]

"Fortunately, there is a solution to the Fed’s exit problem that does not involve selling securities. It employs one of the Fed’s oldest policy tools: raising reserve requirements."

ftalphaville.ft.com/2013/04/04/1447942/the-reserve-requirement-confusion/?

"The decline in the use of reserve requirements is startling. Under pressure from the banks to keep costs down, required reserves at the Fed had withered to only $40bn before the financial crisis broke, equal to less than 0.5 per cent of the banks’ liabilities, far below the ceilings set by the Monetary Control Act of 1980."

"Another attractive feature of higher reserve ratios is that it allows the government to modify and in some cases eliminate the liquidity and capital ratios dictated by new Basel III banking regulations. Reserves are deposits at the Fed that can be turned into currency on demand and as such are the world’s most liquid asset. The higher reserve levels achieved by this policy will satisfy many of the liquidity requirements in the Basel Agreement."
 
"The bottom line is that by increasing required reserves and bringing the Fed’s third policy tool out from hibernation, the Fed’s exit strategy can be made far easier. And since these reserves satisfy many of the Basel III provisions, this policy can be a win-win for the Fed, the banking industry and the US economy"

</SPAN></FONT></P></SPAN></P>

[Aman A.K.A. Ahamburger]

Feb 28, 2013 1:55:03 GMT -5 bimetalaupt said:

Feb 28, 2013 1:24:09 GMT -5 Aman A.K.A. Ahamburger said:

Like I have been saying for over two years now the Fed May Decide Not to Sell Securities.  They will hold them until they mature, and pay the UST back 3.1+ trillion with interest added into that.  This is almost a story about recycling.  

A+++,
 Remember the effect of the reverse repo in the summer of 2011.

It was a disaster I am sure Ben B. would like to forget..Market crashed with this test of the system.. And it was not large enough to make it worth his efforts.. You know the banksters made money on that.

Worth studying...

BiMetalAuPt

BiMetal,

 I have been thinking about this for a while, first I do agree that bankers and savvy investors made money off the correction in 2011.  Since housing was just bottoming at that point, it was premature to think that interest rates could slow start to rise back then.  I think the consequence of thinking that it was okay to reduce stimulus in 2011 was the market freaking out in 2012 when they were talking about stopping QE, even thought they could have.

 At this point the housing market is in full recovery mode, tax receipts are coming in above estimates, the job markets is growing, and factory activity is holding up. With the ability to hold securities until maturity and use said funds to fund market operations, tapering off bond purchases are a real possibility in the next 6-12 months for the FED.  In any event, because of oil and gas production, farming, a recovering housing market, manufacturing, and the growing trend of urban revival, it's a sure bet that the USA won't follow Japan's path into decades of stagnation. 

You can bet that the bankers and savvy investors will make money off of that as well. 

Have a great memorial day, God Blessed America,

A+++