ECONOMIC WEEKLY. Excess Reserves. Reverse Repos Deposits with Fed Banks. Currency in Circulation. Capital & Other Liabilities

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1 JANUARY 11, 2019 ECONOMIC WEEKLY FOMC Discusses the Fed Balance Sheet December s FOMC minutes included the start of a discussion of the Fed s balance sheet that will continue at least through the first half of this year. The discussion was limited to the end-game. It does not seem to have occurred to any participant to question the current roll-off rate. At least, if anyone did, it did not make it into the minutes. Nevertheless, there are plenty of questions about the balance sheet yet to be settled, several of which were discussed at December s meeting. This week, we delve into the balance sheet discussion in the Economic Weekly, while Jim Vogel discusses balance sheet roll-off in the context of the fourth-quarter s market volatility in The Weekly Report. The most critical balance sheet question the Fed has yet to answer is how much to shrink it. The Fed staff was always skeptical of shrinking it as much as possible, and participants are beginning to see the logic of ending run-off while there are still excess reserves. As the reserve balance shrinks, the money markets are becoming livelier. Some at the Fed worry they could grow unruly if reserves fall too far. The FOMC discussed remediation strategies, as well as the composition of the balance sheet once it is right-sized. CONTENTS FOMC Discusses the Fed Balance Sheet ECONOMICS Chris Low, Chief Economist chris.low@ftnfinancial.com page 1 The Week Ahead page 7 This Week s Numbers page 7 Rebecca Kooshak, Economic Analyst rebecca.kooshak@ftnfinancial.com $4.5t Fed Balance Sheet Assets vs Liabilities & Equity $4.0t $3.5t $3.0t $2.5t $2.0t MBS & Agencies Excess Reserves Reverse Repos Deposits with Fed Banks $1.5t Treasuries $1.0t $0.5t $0.0t Other Assets Assets Source: Federal Reserve, Bloomberg, FTN Financial Currency in Circulation Capital & Other Liabilities Liabilities & Equity How big is just right? The ultimate size of the balance sheet is a pressing issue because keeping it bigger requires ending QT sooner, possibly as soon as the middle of next year. The FOMC has committed to allowing securities to roll off until the Fed hold[s] no more securities than necessary to implement monetary policy efficiently and effectively. They intentionally left themselves quite a bit of wiggle room to define efficiently and effectively. Disclosures are on the last page of this report. FTNFINANCIAL.COM

2 ECONOMIC WEEKLY JANUARY 11, 2019 During quantitative easing, the goal of which was to depress long-term interest rates by increasing the Fed s bond holdings, developments on the asset side of the balance sheet determined the size of the Fed s liabilities. Under QT, quantitative tightening, developments on the liability side of the balance sheet will determine the size of the asset side. The FOMC inflated the asset side of its balance sheet to $4.5 trillion in three rounds of quantitative easing between 2008 and Reinvestment kept the balance sheet stable at $4.5 trillion until late 2017, when the Fed began to allow some maturing securities and redeemed mortgage-backed securities to roll off without replacing them. Since October 2017, the balance sheet has shrunk by $500 billion. $5.0Tn $4.5Tn $4.0Tn $3.5Tn $3.0Tn $2.5Tn $2.0Tn $1.5Tn $1.0Tn $0.5Tn Assets on the Fed Balance Sheet Treasuries MBS & Agencies All other assets $0.0Tn Source: Federal Reserve and Bloomberg If the balance sheet were to return to its pre-crisis size, about $860 billion, there would still be another $3.2 trillion in roll-offs to go. But the Fed must hold enough assets to cover its liabilities, and the Fed s necessary liabilities have grown steadily and considerably since the first round of QE began. As a result, the balance sheet will be bigger than it was. The combination of required reserves, currency in circulation, and deposits mostly Treasury deposits has grown to about $2.5 trillion and will continue to grow at about the same rate as the economy. These, plus $100bn or so in reverse repos, establish the floor for balance sheet size. Excess reserves fund the rest of the assets, including those accumulated during quantitative easing. When considering quantitative easing and how much remains to be unwound, it s useful to watch excess reserves rather than the entire size of the balance sheet since it was excess reserves that funded QE. Once excess reserves revert to a desirable level more on that later QT will be finished. As the below chart shows, the Fed has already effectively reversed the entirety of QE3 due to the buildup of cash in circulation and Treasury deposits since the balance sheet began to grow in Page 2 of 11

3 ECONOMIC WEEKLY JANUARY 11, 2019 $3.0t Excess reserves at the Federal Reserve $2.5t $2.0t $1.5t $1.0t $0.5t $0.0t Source: Federal Reserve, Bloomberg Before the crisis, banks worked hard to avoid excess reserves, but that has changed in the past decade. The Fed pays interest on reserves now, making them more attractive, and bank capital and liquidity requirements mean banks must hold cash-equivalent assets like reserves. The Fed is starting to believe the financial system might benefit from some level of excess reserves, in part because it would help prevent squeezes in the fed funds market. Banks traditionally borrow fed funds when they fall short of reserve requirements usually because a big loan fails to come in or a trade fails to settle. With most banks carrying at least some excess reserves, demand for fed funds is low and stable. But as the balance sheet has shrunk and volume has returned to the fed funds market, the fed funds rate has drifted higher, suggesting demand for fed funds is returning. Indeed, since December 19, the fed funds effective rate has been anchored at 2.40%, the same as the IOER, suggesting lenders eligible to lend fed funds but ineligible to deposit reserves at the Fed no longer have adequate cash to meet all of the demand for fed funds. Banks have to cover the rest, and will do so only if they can match the rate they get from the Fed. The Fed has cut the IOER by 5bp relative to the upper bound of the fed funds target range twice in an effort to push the effective fed funds rate toward the center of the fed funds range. 2.45% Fed funds rate and target range 2.20% IOER 1.95% 1.70% Top of range 1.45% Effective FF rate Bottom of range 1.20% Jan '18 Apr '18 Jul '18 Oct '18 Jan '19 Source: Federal Reserve and Bloomberg Page 3 of 11

4 ECONOMIC WEEKLY JANUARY 11, 2019 Strategies for reducing fed funds volatility As the balance sheet continues to shrink and excess reserves shrink along with it, the Fed expects the fed funds rate will rise above the IOER eventually. Participants discussed the degree to which they should allow the fed funds rate to rise. In discussing the transition to a long-run operating regime, participants commented on the advantages and disadvantages of allowing reserves to decline to a level that could put noticeable upward pressure on the federal funds rate, at least for a time. Certainly it would not be the end of the world if the fed funds rate became more volatile, but it is not necessarily optimal for a smoothly functioning banking system. For one thing, if the cost of funds is less predictable, the cost of loans will have to rise to cover possible losses. It would also require bigger Fed repo and reverse-repo operations. It s not clear how much bigger because the money market landscape has changed since QE was introduced. Bank funding needs tend to spike at year end. Before the crisis, investment banks were able to help out because they used non-calendar fiscal years, meaning they could carry more assets over the turn of the year. But, when the investment banks applied for bank charters during the crisis, the Fed made them change to calendar-year reporting like every other bank. No one knows how much that will affect the money markets because banks have not required much year-end funding given the big excess reserve balances they now carry at the Fed. But we will find out if the Fed shrinks its balance sheet enough. Reducing reserves close to the lowest level that still corresponded to the flat portion of the reserve demand curve would be one approach consistent with the Committee s previously stated intention, in the Policy Normalization Principles and Plans that it issued in 2014, to hold no more securities than necessary to implement monetary policy efficiently and effectively. However, reducing reserves to a point very close to the level at which the reserve demand curve begins to slope upward could lead to a significant increase in the volatility in short-term interest rates and require frequent sizable open market operations or new ceiling facilities to maintain effective interest rate control. These considerations suggested that it might be appropriate to instead provide a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve so as to promote the efficient and effective implementation of monetary policy. [emphasis added] Portfolio management in the run-off endgame Participants then turned to strategies for maintaining control of the fed funds rate during the transition to a regime with lower excess reserves. Several participants suggested they could always tweak the IOER lower or they could use the discount window to put a ceiling on the funds rate. The discount rate is a penalty rate set 50bp above the fed funds target ceiling. As a result, should the fed funds rate surge more than 50bp above the ceiling tomorrow, banks could borrow at 3% directly from the Fed. Some participants commented on the possibility of slowing the pace of the decline in reserves in approaching the longer-run level of reserves. Standard temporary open market operations could be used for this purpose. In addition, participants discussed options such as ending portfolio redemptions with a relatively high level of reserves still in the system and then either maintaining that level of reserves or allowing growth in nonreserve liabilities to very gradually reduce reserves further. These approaches could allow markets and banks more time to adjust to lower reserve levels while maintaining effective control of interest rates. Several participants, however, expressed concern that a slowing of redemptions could be misinterpreted as a signal about the stance of monetary policy. Page 4 of 11

5 ECONOMIC WEEKLY JANUARY 11, 2019 Some participants expressed an interest in learning more about possible options for new ceiling tools to provide firmer control of the policy rate. Note that while some news outlets reported some participants suggested slowing the pace of asset roll-off, it s clear from this context the discussion was limited to slowing the roll-off pace only when the balance sheet is close to optimal size. Also, some participants are reluctant even to do that because market participants might mistake the reduction as a policy signal. Traders would love to know how big the balance sheet will eventually be, in part because it would make it possible to estimate the total quantity of assets the Fed will allow to roll off. It seems the FOMC has received the message, because: Participants considered it important to present information on the Federal Reserve s balance sheet to the public in ways that communicated these facts. In discussing the long-run level of reserve liabilities, participants noted that it might be useful to explore ways to encourage banks to reduce their demand for reserves and to provide information to banks and the public about the likely longrun level of reserves. Presumably, this communication will come later this year. Until then, based on the current roll-off rate, the smallest balance sheet/latest end of QT combination would be around $2.8 trillion in the second half of If the Fed wants to maintain a cushion of excess reserves, however, roll-offs could end with a $3.5 trillion balance sheet as soon as the middle of next year. Final tweaks, once the portfolio is right sized The FOMC finished its discussion with several issues coming into play once the portfolio run-off is finished. First is the duration of the portfolio. Several participants noted that a portfolio of holdings weighted toward shorter maturities would provide greater flexibility to lengthen maturity if warranted by an economic downturn, while a couple of others noted that a portfolio with maturities that matched the outstanding Treasury market would have a more neutral effect on the market. One could argue the Fed should reduce the maturity of its portfolio because the Fed s portfolio traditionally consisted of shorter-dated paper. It s encouraging no one made that argument because doing something just because it s how you used to do it does not necessarily lead to an optimal outcome. Rather, several participants appear to be thinking of shortening the duration of the portfolio as a way of winding the spring to allow another Operation Twist portfolio extension. OT flattened the curve far more effectively than QE. The others, who favor a portfolio with maturities matching the composition of the market because it would have a more neutral market effect, may be thinking about the still-low term premium. Some at the Fed believe the extension of the SOMA portfolio beyond T-bills explains the negative term premium in 10-year yields and the flatness of the yield curve. Of course, if long yields were significantly lower than a market-neutral rate, people would be lining up to borrow at longer maturities, which does not appear to be the case. The fact borrowing is not running amok suggests the low term premium may reflect market forces, including weak fixed-rate loan demand. The other issues discussed relate to the Fed s mortgage holdings. First, the minutes make clear the MBS portfolio will continue to roll off when the portfolio is right sized. Eventually, the Fed will replace all of its MBS holdings with Treasuries. If the Fed relies on passive roll-offs, however, it could take a decade Page 5 of 11

6 ECONOMIC WEEKLY JANUARY 11, 2019 or more for the mortgage portfolio to shrink to nothing, especially during periods when rates rise and redemptions slow, like now. The Assistant SOMA manager noted mortgage roll-offs will fail to hit their caps into the foreseeable future barring a drop in mortgage rates. As a result: Several participants commented on the possibility of reducing agency MBS holdings somewhat more quickly than the passive approach by implementing a program of very gradual MBS sales sometime after the size of the balance sheet had been normalized. Note the modifier very gradual. These participants are clearly aware how alarming talk of portfolio sales could be and want to alleviate those fears. One way to achieve this goal and keep the market impact predictable might be to sell the difference between the amount rolling off and the cap. In other words, ensure the sales would be both small and perhaps more importantly predictable. Bottom line: Can we get some clarity? When the Fed first committed to shrinking its balance sheet, the endgame thought to be sometime in the misty future between 2020 and 2022 was far enough off, the FOMC could leave all sorts of details to be decided later. There were benefits to doing so. For one thing, the Fed has been able to observe how the market has reacted since QT began though there is some disagreement over its effects, as discussed in The Weekly Report. Now that 2020 is just a year away, it s time to settle the two biggest remaining issues, the size and composition of the balance sheet once QT ends. In December, the FOMC began these discussions and appears to be leaning toward a relatively early QT end in the middle of next year, with a $3.5 trillion balance sheet and about $500bn in excess reserves. The liability side of the Fed balance sheet Factors absorbing reserve funds, capital and excess reserves Smallestbalance sheet with an excess reserve buffer. Smallestbalance sheet with no excess reserve buffer. $6.0Tn $5.0Tn $4.0Tn $3.0Tn $2.0Tn $1.0Tn Currency in Circulation Reverse Repurchase Agreements Deposits with Federal Reserve Banks Capital and Other Liabilities Excess Reserves Source: Federal Reserve, Bloomberg, FTN Financial $0.0Tn Once QT ends, portfolio reinvestment will resume. The Fed will replace maturing bonds as well as mortgage redemptions with Treasury securities. They have not yet decided whether to continue to reinvest at the next Treasury auction, as they are now, or to shorten the portfolio, presumably buying T-bills, as they did before the financial crisis. Nor has the FOMC decided whether to augment MBS redemptions with very gradual sales to speed the transition to a Treasury-only portfolio. We expect the Fed would like to answer these questions in short order, perhaps as soon as March or April, as the FOMC plans to tackle the zero-lower bound problem at FOMC meetings starting in June. Unfortunately, a very busy schedule and lack of information no one really knows what will happen to money markets when reserve balances shrink suggests some questions may be punted into next year. Chris Low, Chief Economist Page 6 of 11

7 THE WEEK AHEAD JANUARY 11, 2019 The Week Ahead This Week s Numbers CONSENSUS PRIOR HIGH LOW MEDIAN FTN Delayed Advance Goods Trade Balance - Nov -$77.2b -$73.1b -$78.0b -$76.1b $77.0b Delayed Wholesale Inventories MoM - Nov P 0.8% 1.0% -0.2% 0.5% 0.40% Delayed New Home Sales - Nov 544k 622k 535k 567k 560k Delayed New Home Sales MoM - Nov -8.9% 14.3% -1.7% 4.2% 2.90% Delayed Construction Spending MoM - Nov -0.1% 1.2% -0.5% 0.2% 0.10% Delayed Factory Orders - Nov -2.1% 1.6% -1.2% 0.3% 0.20% Delayed Trade Balance - Nov -$55.5b -$51.6b -$57.0b -$54.0b -$55.0b Delayed Wholesale Trade Sales MoM - Nov -0.20% Delayed Monthly Budget Statement - Dec -$204.9b $20.0b -$32.7b -$10.0b $5.0b Tuesday, January 15 PPI Final Demand MoM - Dec 0.1% 0.2% -0.3% -0.1% -0.2% PPI Ex Food and Energy MoM - Dec 0.3% 0.3% -0.1% 0.2% 0.1% PPI Ex Food, Energy, Trade MoM - Dec 0.3% 0.2% 0.2% 0.2% 0.1% PPI Final Demand YoY - Dec 2.5% 2.8% 2.3% 2.5% 2.4% PPI Ex Food and Energy YoY - Dec 2.7% 3.0% 2.6% 3.0% 2.9% PPI Ex Food, Energy, Trade YoY - Dec 2.8% % Wednesday, January 16 Import Price Index MoM - Dec -1.6% -0.7% -1.8% -1.3% -1.5% Import Price Index ex Petroleum MoM - Dec -0.3% 0.1% -0.2% 0.0% -0.2% Import Price Index YoY - Dec 0.7% -0.5% -1.3% -0.7% -0.9% Export Price Index MoM - Dec -0.9% 0.1% -1.2% -0.7% -0.8% Export Price Index YoY - Dec 1.8% % Federal Reserve Beige Book May be delayed Retail Sales Advance MoM - Dec 0.2% 1.2% -0.1% 0.2% 0.2% May be delayed Retail Sales Ex Auto MoM - Dec 0.2% 0.8% -0.2% 0.1% 0.0% May be delayed Retail Sales Ex Auto and Gas - Dec 0.5% 0.7% 0.2% 0.4% 0.3% May be delayed Retail Sales Control Group - Dec 0.9% 0.5% 0.2% 0.4% 0.4% May be delayed Business Inventories - Nov 0.6% 0.5% 0.0% 0.3% 0.4% Thursday, January 17 Philly Fed business outlook - January May be delayed Housing Starts MoM - Dec 3.2% 3.5% -4.5% 0.2% -0.2% May be delayed Building Permits MoM - Dec 5.0% 0.5% -5.9% -3.0% -2.0% May be delayed Housing Starts - Dec 1256k 1300k 1200k 1258k 1253k May be delayed Building Permits - Dec 1328k 1335k 1250k 1288k 1301k Friday, January 18 Industrial Production MoM - Dec 0.6% 0.5% -0.5% 0.2% 0.2% Capacity Utilization - Dec 78.5% 79.0% 78.1% 78.5% 78.5% U. of Mich. Sentiment - Jan P Review This week, the ISM non-manufacturing report fell more than expected to a still solid level, consumer credit rose more than expected, and FOMC minutes appeared more market friendly than the December 19th post-meeting press conference. Fed Chairman Jay Powell and a half-dozen other FOMC participants gave speeches reinforcing the inflation is muted, we can be patient message from Jay Powell that emerged at last week s American Economic Association panel discussion. Page 7 of 11

8 THE WEEK AHEAD JANUARY 11, 2019 December s ISM Non-Manufacturing Index registered 57.6%, a 3.1 point drop from November s 60.7 and lower than the 58.5 consensus. A 5.3% drop in the Business Activity Index led the headline number lower, albeit business activity reached an unsustainable high of 65.2 last month, and December s 59.9 still indicates strong expansion. The New Orders Index rose marginally from 62.5 to 62.7, possibly reflecting year-end budget spends and early orders from customers trying to avoid potentially higher tariff costs. Survey respondents reported the economy [is] still chugging along, despite the rise in interest rates and relentless political claptrap. Respondents indicated capacity constraints eased, though employment-resource challenges remain, and there is still concern about tariffs, despite the hold on increases by the US and China. November s consumer credit rose by $22.15b (6.72% rise SAAR) over October, exceeding the $17.5b consensus and reaching $3.98tn. Non-revolving credit led the increase with a $17.38bn rise (5.5% SA) to $2.94tn. Government-backed student loans accounted for much of the rise, adding $4.6bn (NSA). and personal or auto loans from credit unions added $2.3bn (NSA). Revolving credit rose $4.77bn (7.14% SA) to $1.0tn. Consumer credit rises faster than expected (Seasonally adj, monthly change) Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Source: Federal Reserve Revolving Non-revolving $35bn $30bn $25bn $20bn $15bn $10bn $5bn $0bn -$5bn -$10bn The Atlanta Fed s Q4 GDPNow forecast remains unchanged at 2.8%, while the NY Fed revised its Nowcast marginally lower from 2.49% to 2.48%. Preview Note: «= High Impact Event All times Eastern Standard Due to the government shutdown, both data collection and reporting will be delayed at the Department of Agriculture and the Commerce Department. (The latter funds the Census Bureau and the Bureau of Economic Analysis.) Some data already reported by these two departments are likely to be revised when subsequent reports are released. Page 8 of 11

9 THE WEEK AHEAD JANUARY 11, 2019 Congress fully funded the Bureau of Labor Statistics until September 2019, so monthly employment reports, CPI, PPI, and other BLS reports will continue without disruption. The Fed is self-funding and will continue to release data. The following statistics could be released at some point during the week. Delays are likely for a period after the government reopens. Advance Goods Trade Balance Wholesale Inventories Retail Inventories New Home Sales Construction Spending Factory Orders Durable Goods Orders and Shipments Trade Balance Wholesale Trade Monthly Budget Statement Monday, January 14 China: Trade Balance Exports and Imports 5:00am EU: Industrial Production 11:30am US: $39bn 3M and $36bn 6M Treasury Bill Auctions Tuesday, January 15 «UK: Expected Brexit Parliament Vote 2:45am France: CPI 5:00am EU: Trade Balance 8:30am US: Empire Manufacturing PPI «10:00am EU: ECB Governor Mario Draghi presents ECB Annual Report of 2017 to EU Parliament. 11:30am US: Minneapolis Fed President Neel Kashkari speaks. (FOMC voter in 2020) «1:00pm US: Kansas City Fed President Esther George speaks on economy and monetary policy. (FOMC Voter) «1:00pm US: Dallas Fed President Robert Kaplan speaks. (FOMC voter in 2020) 6:50pm Japan: Machine Orders PPI 8:30pm China: New Home Prices 11:30pm Japan: Tertiary Index Wednesday, January 16 2:00am Germany: CPI Page 9 of 11

10 THE WEEK AHEAD JANUARY 11, :30am UK: CPI Retail Price Index PPI House Price Index «8:30am US: Retail Sales (Census Bureau may be delayed) 8:30am US: Import and Export Price Index 10:00am US: Business Inventories (Census Bureau may be delayed) NAHB Housing Market Index «2:00pm US: Federal Reserve releases Beige Book 2:00pm US: Minneapolis Fed President Neel Kashkari speaks about financial crisis. «4:00pm US: Treasury International Capital «7:00pm Japan: BOJ Governor Haruhiko Kuroda gives keynote speech and Deputy Governor Masayoshi Amamiya gives opening remarks at G20 Symposium on demographic changes and macroeconomic challenges. Thursday, January 17 5:00am EU: CPI Construction Output 8:30am US: Philadelphia Fed Business Outlook Housing Starts (Census Bureau may be delayed) Building Permits (Census Bureau may be delayed) 10:45am US: Fed Governor Randy Quarles speaks. 11:30am US: 4W and 8W Treasury Bill Auctions 1:00pm US: $13bn 10Y TIPS Auction Friday, January 18 4:30am UK: Retail Sales 8:30am Canada: CPI «9:05am US: New York Fed President John Williams speaks on economy and monetary policy. (FOMC permanent voter) 9:15am US: Capacity Utilization Industrial Production 10:00am US: UMichigan Consumer Sentiment 11:00am US: Philadelphia Fed President Patrick Harker speaks. (FOMC voter in 2020) Rebecca Kooshak, Economic Analyst Page 10 of 11

11 THE WEEK AHEAD JANUARY 11, 2019 Although this information has been obtained from sources which we believe to be reliable, we do not guarantee its accuracy, and it may be incomplete or condensed. This is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. All herein listed securities are subject to availability and change in price. Past performance is not indicative of future results, while changes in any assumptions may have a material effect on projected results. Ratings on all securities are subject to change. The views expressed herein accurately reflect the author s personal views about the subject securities or issuers. No part of their compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in the Notes. FTN Financial Group, FTN Financial Capital Markets, FTN Financial Portfolio Advisors and FTN Financial Municipal Advisors are divisions of First Tennessee Bank National Association (FTB). FTN Financial Securities Corp (FTSC), FTN Financial Main Street Advisors, LLC, and FTN Financial Capital Assets Corporation are wholly owned subsidiaries of FTB. FTSC is a member of FINRA and SIPC FTN Financial Municipal Advisors is a registered municipal advisor. FTN Financial Portfolio Advisors is a portfolio manager operating under the trust powers of FTB. FTN Financial Main Street Advisors, LLC is a registered investment advisor. None of the other FTN entities including, FTN Financial Group, FTN Financial Capital Markets, FTN Financial Securities Corp or FTN Financial Capital Assets Corporation are acting as your advisor and none owe a fiduciary duty under the securities laws to you, any municipal entity, or any obligated person with respect to, among other things, the information and material contained in this communication. Instead, these FTN entities are acting for their own interests. You should discuss any information or material contained in this communication with any and all internal or external advisors and experts that you deem appropriate before acting on this information or material. FTN Financial Group, through FTB or its affiliates, offers investment products and services. Investment Products are not FDIC insured, have no bank guarantee and may lose value First Tennessee Bank. All rights reserved. Page 11 of 11