Over the past several months I have written about the difficulty the Fed will have in raising interest rates given the amount of excess reserves in the system. By “difficulty” I mean the need to utilize different (and quite untested) tools than have been used in the past. Here are parts I, II, and III.
Until I explored this topic of how the Fed will increase rates I had only read about this concern from Dr. North, and even then I did not understand the whats or whys. This is not to say that there was not more out there, just that I hadn’t seen it.
While I watch or read almost nothing of the mainstream business news, even here I have not seen any mention of this issue – only bated breath while waiting for the omnipotent Fed to speak. I have seen more discussion on this recently, and more that adds to my understanding; therefore I have decided to revisit this topic.
Tyler Durden asks: what’s the big deal about a 0.25% rate increase? He sets the stage by pointing directly to the interest on excess reserves (IOER) (emphasis in original):
…the Reverse Repo-IOER corridor is the most important component of the Fed's rate hike strategy, one which better work or otherwise the Fed will be helpless to raise rates with some $3 trillion in excess liquidity sloshing around, and what little credibility it has will be gone for good.
It better work, or else the Fed is helpless.
What is a “Reverse Repo”?
The Fed uses repurchase agreements, also called "RPs" or "repos", to make collateralized loans to primary dealers. In a reverse repo or "RRP”, the Fed borrows money from primary dealers. The typical term of these operations is overnight, but the Fed can conduct these operations with terms out to 65 business days.
The Fed would borrow money from primary dealers – its largest member banks, from whom the Fed bought (and still holds) junk securities. The Fed would borrow the money it created from nothing in the first place; the Fed would collateralize this borrowing with the same assets that it bought from the primary dealers in the first place. Think about the circularity of that!
The Fed uses these two types of transactions to offset temporary swings in bank reserves; a repo temporarily adds reserve balances to the banking system, while reverse repos temporarily drains balances from the system.
Of course, today’s environment is not one of “temporary swings.” The Fed has delivered a world comprised of significant excess reserves. This reverse-repo transaction would drain reserves; however, given the amount of excess reserves in the system this wouldn’t seem to have much effect either way – at least not if done in relatively small increments (as would have always been past practice).
Repos and reverse repos are conducted with primary dealers via auction. In a repo, dealers bid on borrowing money versus various types of general collateral. In a reverse repo, dealers offer interest rates at which they would lend money to the Fed versus the Fed's Treasury general collateral, typically Treasury bills.
It is the dealers offering the interest rates at which they would lend to the Fed; this isn’t the Fed setting rates, it is the Fed praying for rates. As the Fed is paying the dealers 0.25% on excess reserves, presumably the dealers would offer a rate not less than this. Call the starting point 0.26% (except now the dealers will hold an asset as collateral for the loan to the Fed that is something not-as-secure as a deposit with the Fed).
But it seems clear that the Fed will not control the rate; the Fed can only control the nominal amount of securities offered to the dealers. The bidders will determine the rate they are willing to accept. The more the Fed offers to the market, presumably the higher the rate. As this is the case, the question is opened – how much liquidity must the Fed be willing to drain to move the rate up a quarter-point?
And for this, I return to Durden:
And much more importantly, what are the liquidity implications from such a move. For the answer we go to the repo market expert, Wedbush's E.D. Skyrm. Here are his thoughts:
Where will General Collateral trade when the fed funds target range is moved 25 basis points higher to .25% to .50%? In the most simple method, GC has averaged about .15% for the past month, which implies a GC rate around .40% after the Fed move.
However, given the unprecedented amount of liquidity in the financial system, there's a belief the Fed will have problems moving overnight rates higher.
In order to move GC 25 basis points higher, in a very rough estimate, the Fed needs to drain between $310B and $800B in liquidity.
Up to eight hundred billion dollars of liquidity drained for a 0.25% move! Not a very subtle policy tool.
So we come back to the interest paid on excess reserves (IOER). But apparently this isn’t fool-proof either:
A significant portion of the U.S. financial system is comprised of money market funds, government-sponsored enterprises, hedge funds and other financial institutions which are not banks. Though they hold substantial cash, they cannot hold deposits at the Fed and earn the IOER. So if the Fed raised IOER, these cash-rich institutions might be willing to lend funds at rates below IOER, which could push the fed funds rate below the Fed’s target—and indeed that’s what’s been happening over the past six years.
Broader financial markets are in control of rates, not the Fed. This is most certainly true in this time of unprecedented excess reserves.
Goldman Sachs both confirms and adds to the list of concerns about these two possible policy tools:
Given some limitations to both IOER and the RRP facility, the Fed will employ both tools in conjunction. The IOER function is constrained by limited counterparty eligibility, which is restricted to depository institutions only – the Fed cannot remunerate overnight deposits of money market mutual funds (MMFs) or government-sponsored entities (GSEs).
The RRP facility, which has 145 eligible counterparties spanning primary dealers, banks, MMFs, and GSEs, will act as a more complete floor for overnight rates. However, the RRP facility also faces its own limitations: Fed leadership has communicated its discomfort with the facility’s potential to attract too many flows during flight to quality episodes as financial intermediaries withhold wholesale funding and instead participate in RRP.
Can you imagine the money market funds flooding to the Fed next time the buck is about to break?
So why doesn’t the Fed just drain the excess reserves and get itself out of this self-imposed hell? Goldman Sachs offers a politically safe answer (emphasis added):
Although the Fed has communicated its intention to reduce the size of its balance sheet over time and create a Treasury-only portfolio, we do not expect any actions to meet this intent any time soon. The Minutes of the July 2015 FOMC meeting indicated that “Participants generally favored continuing reinvestment during the early stages of normalization, initially using only increases in the target range for the federal funds rate to reduce monetary policy accommodation.” Fed officials have communicated their concerns that asset sales pose the risk of sending unintended hawkish policy signals, along with the potential to create unexpected financial market reactions. Accordingly, we do not expect any balance sheet normalization until mid-2017.
I don’t think the financial market reactions to this are “unexpected”; the reactions are at best unknown, and at worst…bad. Basically, the Fed doesn’t want to drain liquidity because the Fed doesn’t want to drain liquidity – this is the Goldman analysis.
I offer my reason, and it is two-fold: first, the non-treasury assets (meaning the mortgage-backed securities and other garbage bought by the Fed to bail out the banks) – despite presumably carrying coupons of better than the 0.25% IOER – are not wanted by the banks. This suggests that, even after six years of asset price inflation, these assets are not yet worth what the Fed paid for them in the first place (if they are even worth much of anything). Second, the excess reserves provide systemic insurance – the excess liquidity provides a liquidity cushion in the system that was unavailable in 2008. With this insurance, I suspect that the Fed believes that markets will not be subject to the same daily meltdown of prices due to the lack of liquidity that occurred at that time.
How much liquidity will the Fed have to drain to achieve even a 0.25% short-term rate increase? What will be the impact of this (up to $800 billion) liquidity drain on financial assets? What will be the impact to other, longer-term rates? What will be the public reaction to and political fallout from an announced increase in the IOER?
These questions – none of which have ever been answered via prior experience – are behind the current conundrum in which the Fed finds itself. Who knows how they will be answered?
I can say with certainty: no one. We all get to find out together.