Normalization of U.S. Monetary Policy

Transcription

1 Financial Engineering Practitioners Seminar Allan M. Malz Dept. of Industrial Engineering and Operations Research Columbia University Sep. 12, 2016

2 2/29 Overview Normal monetary policy and the Fed s crisis response After the crisis: money markets and the Fed s exit strategy

3 3/29 Normal monetary policy and the Fed s crisis response Normal monetary policy and the Fed s crisis response Monetary policy before the crisis The Federal Reserve s crisis response After the crisis: money markets and the Fed s exit strategy

4 4/29 Normal monetary policy and the Fed s crisis response Monetary policy before the crisis The framework of monetary policy before the crisis Instruments Intermediate targets Objectives Objectives: ultimate goals enshrined in dual mandate (actually triple) Federal Reserve Act, sec. 2A, as amended [M]aximum employment, stable prices, and moderate long-term interest rates. Intermediate target: prices or quantities the Fed can directly influence in pursuit of objective Target: effective (realized) federal funds rate Conceptually: set target rate so as to achieve consistency of market interest rates with unobservable equilibrium real interest rate Money stock almost nowhere and never an intermediate target Instruments: tools fully under central bank control, usually Balance sheet liabilities: vary reserves, banks deposits at Fed Communication and signaling: consistency of public s expectations with policy intentions

5 5/29 Normal monetary policy and the Fed s crisis response Monetary policy before the crisis Monetary operations in normal times Funds rate Money markets Long-term rates State of economy Vary quantity of reserves to bring effective fed funds rate near target Federal funds market: Secondary market in reserve balances to facilitate clearing, satisfy reserve requirements Open market operations (OMOs) add or drain reserves from the money market by varying securities held as assets Keep fed funds market a bit tight (structural deficiency of reserves) and supply reserves day-to-day via OMOs to hit target Induces banks to borrow and lend funds from one another active funds market Pre-crisis monetary puzzles, both what worked and what didn t: Weak funds rate-reserves relationship ( liquidity effect ) The conundrum: low and declining long-term rates despite rapid rise in target rate Transmission of monetary policy to economy Interest rates rather than money stock as intermediate target

6 6/29 Normal monetary policy and the Fed s crisis response Monetary policy before the crisis Reserves and the fed funds rate Left panel: target fed funds rate (black plot, left axis), percent, daily. Nonborrowed reserves of depository institutions (purple plot, right axis), not seasonally adjusted, $ bill., weekly. Nonborrowed reserves equal total reserves less total discount window borrowings from the Federal Reserve. Right panel: target (black plot) and effective (purple plot) fed funds rates, percent, daily. Sources: Bloomberg LP; Board of Governors of the Federal Reserve System, H.3 release, Table 3.

7 7/29 Normal monetary policy and the Fed s crisis response The Federal Reserve s crisis response Overlapping stages of Federal Reserve action Traditional tools and communication beginning Aug. 10, 2007 Target rate cuts: first on 18Sep2007, by 50 bps to 4.75% Communication: 16Dec2008 exceptionally low levels...for some time ; 18Mar2009 for an extended period Emergency lending programs to support systemically-important intermediaries (primary dealers, AIG, money funds), markets (wholesale funding, securitization) Fed balance sheet does not expand initially Composition change nontraditional assets (credit policy) Unconventional monetary policy from late 2008 Interest on reserves (IOR) paid to banks from 06Oct2008 Zero interest-rate policy (ZIRP): zero bound reached 16Dec2008 Target funds rate range 0 25 bps Large-Scale Asset Purchases (LSAPs) from early 2009 Expansion of balance sheet in three phases

8 8/29 Normal monetary policy and the Fed s crisis response The Federal Reserve s crisis response Federal Reserve balance sheet liabilities assets Mortgage-backed securities Treasuries, agencies Emergency credit Central bank swaps Bills, repo Currency Other Fed deposits Reserves Domestic reverse RP Assets and liabilities of Federal Reserve System, $ trillions, weekly (Wednesdays) Source: Federal Reserve Board, H.4.1 release.

9 9/29 After the crisis: money markets and the Fed s exit strategy Normal monetary policy and the Fed s crisis response After the crisis: money markets and the Fed s exit strategy Money markets after the crisis Exit strategy

10 10/29 After the crisis: money markets and the Fed s exit strategy Money markets after the crisis Key money market instruments Federal funds traded among banks, government-sponsored enterprises (GSEs), esp. Federal Home Loan Banks (FHLBs) Trades change holders, not aggregate volume of reserve balances Overnight interest swaps (OIS) pay realized compounded return on funds rate minus strike or fixed rate Repurchase agreements or repo: short-term loan collateralized by securities in possesion of lender or third-party custodian Triparty and GCF repo: easier daily clearing via custodian Eurodollars: unsecured USD deposits outside U.S, LIBOR benchmark Commercial paper (CP) a key source of non-u.s. banks dollar funding Money market mutual funds (MMMFs) invest in money market instruments and create demandable liabilities

11 11/29 After the crisis: money markets and the Fed s exit strategy Money markets after the crisis The shrunken money market: overview Short-term wholesale funding markets grew dramatically up to crisis Trading and issuance volumes much lower since crisis Funding and market liquidity generally lower across markets Yet money markets awash in liquidity Declining integration: different money market rates track each other less closely E.g. lower correlation of daily changes Largely, but not completely, integrated incomplete arbitrage Integration crucial for transmission of policy rates to market rates Profound regulatory changes post-crisis Shifts in market participants Greater MMMF role in short-term intermediation, e.g. eurodollars Declining and broken model of broker-dealer role Short-term borrowing less attractive to banks New tools introduced by Federal Reserve

12 12/29 After the crisis: money markets and the Fed s exit strategy Money markets after the crisis Impact of regulatory changes Pervasive changes in regulation with direct impact on wholesale funding markets: Liquidity regulation, esp. Liquidity Coverage Ratio (LCR) Requires holding specified high-quality liquid assets (HQLA) U.S. capital charges, e.g. Supplementary Leverage Ratio (SLR), GSIB Surcharge FDIC deposit insurance assessment base: assets minus capital rather than deposits Money fund reform penalizes institutional prime funds Money market intermediation involves intensive use of balance sheet Repo dealing, fed funds intermediation: low profit margin, low risk Higher capital charges disincentive balance sheet use by banks Shift away from short-term assets bearing credit and liquidity risk Rise in CP communicated to near substitutes, e.g. dollar funding via foreign-exchange markets Operating deposits have low cost under LCR, migrate from money funds Countervailing pressures on repo rates: substitution out of CP vs. reduction in bank intermediation

13 13/29 After the crisis: money markets and the Fed s exit strategy Exit strategy What does exit mean? Remove extraordinary accommodation and normalize rates Raise target and market rates from zero to normal long-run level Reduce Fed balance sheet to pre-crisis size Create environment in which normal monetary operations effective Initiated with tapering reduction of pace of LSAPs in 2013 Fundamental question: what is best sequencing of exit steps? Reduce Fed balance sheet volume via asset sales or run-off first? Would reverse purported salutary effects of LSAPs, raise long rates Do it the hard way: rates first, then balance sheet Initiate rate hikes while maintaining large balance sheet Large volume of liabilities corresponding to asset purchases Requires sterilization: exchange for non-monetary liabilities Some central banks issue bonds, e.g. to offset foreign-exchange reserve accumulation But not contemplated by Fed Keep money multiplier low via IOR

14 14/29 After the crisis: money markets and the Fed s exit strategy Exit strategy Evolution of exit strategy Initially set out in testimony Feb. 10, 2010, minutes June 2011 ( Exit Strategy Principles ) 1. Reduce pace of asset purchases (tapering) 2. cease reinvesting some or all payments of principal 3. modify...forward guidance...and...initiate temporary reserve-draining operations 4. Gradually sell MBS Runoff without sales mooted: June 2013 press conference Asset purchases to end well before rate hikes: Mar Formal announcement of revised approach to sequencing Sep ( Policy Normalization Principles and Plans ) 1. Tapering near done, so no discussion of pace of purchases 2. Cease reinvestment at indeterminate future date, but no sales 3. Desire to shift Fed assets to Treasuries as MBS pay down 4. Funds rate remains intermediate target; range, not a point 5. IOER as key tool to control funds rate, limited use of ON RRP Continuation of reinvestment reiterated Dec. 2015

15 15/29 After the crisis: money markets and the Fed s exit strategy Exit strategy Normalization: new tools to control overnight rate Overnight reverse repos (ON RRPs): test exercises since Sep Conducted with wider range of counterparties than OMOs, including MMMFs, GSEs Put high-quality collateral into market firming of repo market Fixed amount or full allotment at fixed award rate (5 10bps) Using Fed portfolio of Treasury securities only Interest on excess reserves (IOER) introduced in 2008, new role now Canbepaidonlytobanks,notGSEs Then, a floor: keep rates near 25 bps, rather than dropping to zero Now, a ceiling and a magnet : draw rates near target Term Deposit Facility (TDF), 7 or 28 days Banks only Can be used to satisfy regulatory liquidity requirements Cannot be used for clearing

16 16/29 After the crisis: money markets and the Fed s exit strategy Exit strategy Corridor system for funds rate during exit Corridor or channel system widely used by central banks Standing facilities with administered rates set minimum and maximum of corridor ON RRP floor, IOERceiling on effective fed funds rate IOER set at upper limit of target range IOER as primary tool to draw rates up toward target Wide ON RRP-IOER spread should active funds trading Fed funds rate remains target, supported by system of administered rates until normalization Draw effective funds rate closer and closer to upper limit of target range as reserves drained Actual fed funds rate should get closer to IOER Draining can however be temporary e.g. ON RRP, TDF Switch of liabilities, reducing reserves, but not balance sheet size

17 17/29 After the crisis: money markets and the Fed s exit strategy Exit strategy A new permanent framework? No return soon or perhaps anytime to open market operations in the funds markets as main tool Would require vast reduction in reserves via bond sales Current normalization principles imply very long process Exit strategy makes no reference to permanent changes in operating framework But indications that some elements of exit strategy may become elements of new framework Discussion of potential alternatives to funds rate as target rate GC repo, ON RRP rate mooted New benchmark Overnight Bank Funding Rate (OBFR) since 01Mar2016, includes both fed funds and Eurodollar transactions Concern about ON RRPs as safe-haven asset ON RRPs availability may make system more run-prone But $300 bill. cap lifted 16Dec2015, now limited only by size of portfolio, FOMC reluctance LSAPs as enduring new tool

18 18/29 Normal monetary policy and the Fed s crisis response After the crisis: money markets and the Fed s exit strategy Macroeconomic risks Disruption risk

19 19/29 Macroeconomic risks Normalization: overview of the challenges Macroeconomic risks in a historically unprecedented post-crisis economic environment Technical risks involving the use of new operational tools in drastically transformed markets Political challenges bound up with both of the above Potential for policy reversals Raising IOER higher payments to banks, esp. foreign branches Realized losses on sales, high IOER could reduce/eliminate remittances to Treasury

20 20/29 Macroeconomic risks Macroeconomic normalization risks Historically low real interest rates makes judging the current state of the economy and forecasting more difficult Is there a new economy? Safety trap and secular stagnation Uncertain level of equilibrium real interest rate Uncertain amount of stimulus currently in place A great deal, if LSAPs work via portfolio balance effect Asymmetrical and reversal risks Communication challenges: gap between market, policymaker views Forward guidance and FOMC projections indicate rate hikes the market doesn t believe and subsequently do not occur Gap may represent greater pessimism in market than on FOMC Persistence of the conundrum? Low and declining 2s-10s spread Market volatility (e.g., taper tantrums, risk-off ) cuts both ways Volatility aids exit by tightening financial conditions (inverse of Fed put?) Low volatility may ordain more aggressive tightening ( Yellen collar, risk-on increases likelihood of further tightening)

21 Macroeconomic risks U.S. real interest rates nominal rate overreacts to inflation 6 Laubach-Williams r * market-implied real rate nominal rate lags behind inflation Laubach Williams short-term natural rate r based on their Measuring the natural rate of interest, Review of Economics and Statistics 85(4), 2003, , estimates downloadable at Mar Dec. 2015, quarterly. Market-implied real rate is the 5-year U.S. TIPS yield from July 1997 (Bloomberg ticker USGGT05Y) and the 5-year nominal yield (Bloomberg ticker USGG10YR) minus a 10-year moving average of annual CPI-U All Items inflation rates centered on the current month Jan June 1997; monthly. Vertical shading represents dates of NBER business cycles. 21/29

22 22/29 Macroeconomic risks The conundrum in the U.S. term structure yr. conundrum 5 2-yr Yield of on-the-run 2- and 10-year U.S. Treasury notes, daily. Vertical shading represents dates of NBER business cycles. Source: Bloomberg L.P.

23 Macroeconomic risks FOMC and market view of future rates 3 18Mar2015 FOMC 16Mar2016 FOMC Markers: median of FOMC participants projections of future Fed funds rate from quarterly Summary of Economic Projections (SEP). Medians computed by Bloomberg XLTP function, SEP data available at Purple and orange plots: forward rates (OIS curves) on the specified dates. 23/29

24 24/29 Macroeconomic risks Asymmetrical risks of error at near-zero rates Lift-off too slow: could lead to inflation scare E.g. sparked by rise in commodity prices, acceleration in wage growth And exceeded by rise in nominal bond yields More aggressive subsequent tightening needed to preserve credibility But counter-inflation policy well understood Lift-off too fast: inflation falls short of goal Bond yields fall or remain low, lower real growth Need to ease again while still near zero bound Requires return to unconventional monetary policy tools with balance sheet still large Discussion of adoption by Federal Reserve of additional easing tools Helicopter money Negative interest rates Purchases of additional security types Attendant political and communication nightmare

25 Disruption risk U.S. money market rates Q4 14Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 16Q1 16Q2 16Q3 funds DTCC GCF repo IOER ON RRP All rates in basis points, daily. Sources: Bloomberg LP, Federal Reserve Bank of New York. 25/29

26 26/29 Disruption risk Dormancy of the fed funds market Trading volume much lower than pre-crisis Dominated by FBOs borrowing from GSEs to earn IOER: U.S. commercial banks: reduced participation, ample liquidity, less need to borrow funds GSEs, esp. FHLBs: bulk of lending in shrunken market U.S. offices and branches of foreign banks (FBOs): nearly half the borrowing Deviations from target rate greater Fed funds market soggy, more prone to clear below target rate Hence targets expressed as 0 25 or bps ranges Average deviations of effective from target funds rate (or upper bound of range, bps): Normal monetary operations ineffective Mean Std. dev. 03Jan Aug Aug Mar Mar Jan

27 27/29 Disruption risk Incomplete arbitrage in funds market GSEs eligible to hold deposits at Fed, but as government entities, cannot receive IOER from Fed Willing suppliers of o/n funds below IOER Arbitrage opportunity for commercial banks: Borrow from GSEs, lend to Fed until funds=ioer But: U.S. banks face new or increased regulatory costs FBOs not subject to SLR, FDIC assessment Fed funds can be used to satisfy HQLA requirements Fed funds below comparable money market rates Trades lower than repo, a secured rate IOER has not acted as floor for funds rate, becomes ceiling during normalization

28 28/29 Disruption risk Potential for accidents during exit How tightly can Fed control rates during exit? 17Dec2015 hike went smoothly, rates well within new range Generally low use of ON RRP: banks withdraw from repo, but money funds shrinking Spread of funds over ON RRP rising Indicates signaling as key mechanism, similar to pre-crisis era But only the first 25 bps up to now Money rates generally rising due to regulatory reform costs Regulatory impact may be one-time adjustment Concern: ON RRPs as safe-haven asset availability of ON RRPs may make system more run-prone But $300 bill. cap lifted Dec. 2015, now limited only by size of Fed portfolio, FOMC reluctance

29 29/29 Disruption risk Overnight reverse repo facility use Q4 14Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 16Q1 16Q2 16Q3 Accepted bids, $bill., daily. Source: Federal Reserve Bank of New York.