How Will the Federal Reserve Adjust Its Balance Sheet During Policy Normalization? 12/10/2015

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1 FOR PROFESSIONAL INVESTORS How Will the Federal Reserve Adjust Its Balance Sheet During Policy Normalization? 12/10/2015 INTRODUCTION Market participants remain highly focused on prospects for the Federal Open Market Committee (FOMC) to begin raising short-term rates at its meeting next week. Lost in this fixation on lift-off is the outlook for the Federal Reserve s other policy tool, the balance sheet. This is understandable since the Committee has made clear that it will delay balance sheet adjustments until later in the tightening cycle. Still, the Committee is likely to provide guidance next week on when and how it will begin reducing the size of its Treasury and MBS portfolios. As such, this note reviews the Committee s framework for the balance sheet as a policy tool, and discusses the levers the Committee can use to reduce the size of the balance sheet during policy normalization. Most importantly, we highlight the likely impact of balance sheet reduction on the supply of Treasuries and MBS that will need to be absorbed by the private sector. The Committee's preference is to relegate QE to an emergency or auxiliary role in a future easing cycle. Therefore it will delay shrinking the balance sheet until it is confident that the policy rate is sufficiently off of zero. Thus balance sheet reduction might not begin until the rate of interest on excess reserves (IOER) is at least 1 percent, and possibly as high as 1.5 percent. Once balance sheet run-off begins, it will be accomplished through gradual adjustments to the reinvestment policy for maturing Treasury and MBS proceeds. We do not anticipate outright sales of securities. A gradual approach to shrinking the balance sheet will limit the amount of additional Treasury and MBS supply to be absorbed by the market over the next two years to around $400 billion in par terms, and about half that amount in ten-year equivalent terms. Such a change to supply should not have a significant impact on fixed income markets. However, a firming inflation outlook could lead to a more rapid end to the reinvestment policy, which would pressure the Treasury term premium higher at the same time that investors would be discounting a steeper path for the federal funds rate. STEVE FRIEDMAN SENIOR INVESTMENT STRATEGIST STEVEN.FRIEDMAN@BNPPARIBAS.COM

2 How Will the Federal Reserve Adjust Its Balance Sheet During Policy Normalization? Dec THE BALANCE SHEET AS A POLICY TOOL Broadly speaking, FOMC participants view QE as an effective policy tool when short-term rates are at or close to zero. Still, judging by public comments, the Committee is aware that in practice QE has often been less effective than theory would dictate. There appears to be some disagreement about why this is the case. Some likely believe that it is generally an imperfect substitute for short-term interest rate policy. For others, headwinds persisting since the financial crisis may have impaired the transmission of policy to the real economy. For this second group of FOMC participants, QE may not be much less effective than interest rate policy; the effectiveness of both tools can be constrained in the aftermath of a crisis. Where there tends to be broader agreement is on the costs of QE, which are seen as increasing with every round of purchases. The costs are two-fold. First, the Committee believes that the ability to control short-term interest rates during tightening is lower when excess reserves are at very high levels. 1 Second, QE has led to a number of political and reputational challenges for the Committee over the years. While these challenges have not meaningfully impacted the Fed s independence or credibility, the Committee would still rather avoid these costs in the future. Given that the cost-benefit tradeoff of QE is viewed as increasingly unattractive, the Committee would prefer to rely on interest rate policy in future easing cycles, and relegate asset purchases to an auxiliary or emergency role. This approach argues for tightening policy primarily by raising short-term interest rates and holding the balance sheet constant, at least until the Committee is confident that it has significantly reduced the risks of returning to the zero bound over the medium term. Through this strategy, the Committee would be able to address a weakening economic outlook first by cutting interest rates, as opposed to resorting to QE immediately. Once the Committee is confident that it has built up sufficient ammunition to cut rates in the next easing cycle, it will still only gradually reduce the size of the balance sheet, for a number of reasons. First, while the stock theory of asset purchases implies that only expectations for the size of the balance sheet should matter, in practice the Committee is likely not fully confident that there will be no flow effects that is, the process of Treasury and MBS supply being added back into the market could lead to higher rates and higher volatility. Second, the signaling channel can work in the opposite direction; a faster liquidation of the balance sheet could be interpreted as a very confident economic outlook, leading to a steeper-than-desired path of policy rates discounted in market pricing. Finally, a more rapid pace of balance sheet normalization implies that balance sheet policy has little effect on financial conditions. Such an interpretation would lessen the credibility of future QE, should it be needed. STRATEGY FOR BALANCE SHEET NORMALIZATION Reflecting the above considerations, a delayed start and gradual pace of balance sheet normalization would have the following broad contours: Timing: Like interest rate policy, the start of balance sheet reduction will be dependent on the outlook. As such, the Committee is very unlikely to communicate a reduction in the size of the balance sheet at a certain point of time after lift-off. Instead it may communicate that it will begin to reduce the balance sheet only when it is confident in not returning to the zero bound over the intermediate-term. Governor Brainard made such an argument in a recent speech. To this end, the Committee may specify that balance sheet normalization would not start at least until a certain level of short-term interest rate firming has occurred. New York Fed President Bill Dudley discussed this possibility in July, and while he mentioned a 1 or 1.5 percent policy rate as a threshold, it was clear from his remarks that he had not yet decided on what would constitute a reasonable amount of room above zero. 1 At the end of the day, a central bank should be able to control the price of overnight money if it is willing to use all available instruments to their fullest. But doing so could impose excessively high costs. For example, the Federal Reserve could aim to achieve a specific level for the federal funds rate (as opposed to a range) during policy normalization, but doing so would require exceptionally large reverse repo operations and/or rapid asset sales to permanently drain liquidity. This approach could destabilize markets and jeopardize achieving policy goals.

3 How Will the Federal Reserve Adjust Its Balance Sheet During Policy Normalization? Dec Method: The Committee s September 2014 Policy Normalization Principles and Plans make clear that reinvestments, as opposed to asset sales, will be the primary tool for adjusting the size of the balance sheet. In fact the September 2014 document notes that the Committee does not anticipate MBS sales as part of normalization. There is no specific mention of Treasuries, possibly because the Committee had previously indicated that it plans on returning to an all-treasury portfolio (hence obviating the need for Treasury sales). Alternatively, the Committee may want to preserve some optionality for Treasury sales if raising the policy rate and ending reinvestments over time does not sufficiently tighten financial conditions. 2 Pace: Treasury and MBS reinvestments are likely to be phased out over a period of six to nine months in order to control the pace of balance sheet adjustment. This is particularly important during normalization in order to avoid lumpy and unpredictable changes in the size of the balance sheet. For example, over the next two years, the amount of monthly maturing Treasuries ranges from $2 billion to almost $40 billion with a median of $13.5 billion. In addition, MBS prepayments can vary considerably from month to month, and most importantly, a negative economic shock could lead to lower interest rates and higher MBS refinancing/prepayment activity. Without some sort of target amount or cap on monthly runoff, the MBS portfolio would shrink most rapidly (and thus tighten policy) at times when runoff is least desired. In short, in the initial stage of balance sheet normalization the Committee will want to isolate the use of this policy tool from patterns of maturing Treasuries and mortgage refinancing activity, both of which would otherwise impose arbitrary decision rules on policy. Pace Adjustments over Time: While phasing out reinvestments may resemble reverse QE tapering, with incremental declines in reinvestments as the outlook improves, the policy is very unlikely to be on auto-pilot. Should downside risks to the economy increase, halting further adjustments to the reinvestment policy would likely be the first policy response. This would prevent any further tightening of financial conditions from balance sheet reduction, and would serve as a powerful signal of the likely direction of policy going forward. Should the outlook then deteriorate, the Committee would continue to hold the balance sheet steady while beginning to reduce the target range for the federal funds rate. Composition: Over the years of QE and exit preparations, Committee members have expressed a range of views regarding the relative merits of owning Treasury vs. MBS securities. During QE3 (including tapering), the Committee bridged their views by buying roughly equal amounts of both assets. I would expect a similar approach to ending reinvestments, with an intention of maintaining a roughly similar amount of runoff of both portfolios (while recognizing that the level of MBS prepayments in the portfolio will vary with mortgage rates and is beyond the Committee's control). ADJUSTMENTS TO REINVESTMENT POLICY Given a desire to rely mainly on interest rate policy during normalization as well as during the next easing cycle, the Committee could allow for a gradual end of reinvestments by announcing a target or maximum monthly amount of total portfolio reduction. This amount could be increased at each subsequent policy meeting, conditioned on the outlook continuing to match the FOMC s projections, until the Committee believes that markets have adjusted smoothly to the additional Treasury and MBS supply in the market. The phasing out of reinvestments could occur over six to nine months, assuming the economy evolves in line with the Committee s projections. Stretching out a reduction of reinvestments over a longer period does not make much sense given the relatively small amounts involved. For example, with monthly Treasury redemptions averaging around $17 billion over the next two years, and assuming MBS prepayments step down to a $20 to $25 billion per month pace over the next two years, phasing out reinvestments over just a six-month period would mean monthly adjustments to the pace of runoff of no more than $7 billion. It is important to keep in mind that there will still be some lumpiness in monthly balance sheet reduction even with a target or maximum allowable amount, because there will be some months when Treasury redemptions or MBS prepayments run low. There are ways to help reduce this lumpiness. For example, the Committee could decide that in months where Treasury redemptions are quite low, they would 2 The Committee has also discussed the option of selling shorter-dated securities if use of its money market tools, such as reverse repo operations, does not lead to sufficient control over the federal funds rate.

4 How Will the Federal Reserve Adjust Its Balance Sheet During Policy Normalization? Dec allow for a larger amount of redemptions on the MBS portfolio, up to the monthly limit on total balance sheet runoff. I use this approach in the estimations below. 3 HOW DOES THE END OF TREASURY REINVESTMENTS ADD SUPPLY TO THE MARKET? When the Federal Reserve has maturing Treasury securities from its portfolio, it aggregates the amount maturing and reinvests the proceeds into newly issued (or reopened) coupon securities settling on the same day. Since in most instances there is more than one auction settling, the Fed will distribute maturing proceeds into all the securities settling on a pro rata basis. For example, the Fed had just $326 million maturing on the settlement day for the November quarterly refunding auctions of 3-, 10- and 30-year securities. Since the size of the 3-year note auction, $16 billion, was 25 percent of the total refunding package, 25 percent of maturing Fed proceeds were rolled into the 3-year note. Once full reinvestment ends, the Treasury Department is not compelled to automatically increase auction sizes by the amount of maturing proceeds from the Federal reserve s portfolio that are no reinvested. However, for a given debt financing need, it is reasonable to assume that over time Treasury would need to increase its issuance to the private sector by the amount of maturing proceeds. One can also assume that Treasury would seek to maintain the proportion of issuance that is currently in each coupon security. 4 I use these simplifying assumptions in the next section. POTENTIAL SUPPLY EFFECTS OF ALTERNATIVES FOR ENDING REINVESTMENTS The table below shows the potential supply effects through the end of 2017 of a number of alternatives for ending reinvestments, in both par and 10-year equivalent terms. The alternatives use various start dates for adjusting the current policy of fully reinvesting maturing proceeds, and different horizons for phasing out the policy. In Alternatives 1 and 5, the reinvestment policy is halted altogether. In alternatives 2, 3 and 4, reinvestments are phased out over a number of months. This gradual move towards full balance sheet run-off is consistent with excerpts from FOMC minutes and commentary from policy-makers. The analysis assumes that the allowable amount of monthly portfolio runoff increases by a set amount at each meeting until it reaches $45 billion per month, after which the cap is lifted and the balance sheet is in full run-off mode. The $45 billion cap is not a completely arbitrary assumption once the cap reaches that level it would rarely be binding given monthly Treasury maturities and assumptions for MBS prepayments from the Federal Reserve s portfolio. 5 In any event, the objective of the analysis is not to identify the specific approach to phasing out reinvestments that the Committee will adopt, but rather to ballpark the likely supply effects of adjustments to reinvestment policy under a reasonable set of assumptions. 3 Such an approach would allow for better control over reductions in the size of the balance sheet at the expense of increase volatility in the MBS supply to be absorbed by the private sector. 4 One complication is that Treasury has signaled a desire to increase bills as a percent of debt outstanding, which could require cuts to auction sizes for one or more coupon securities. Such a change would impact the proportion of issuance in coupon securities and the amount of duration added back to the market as the Federal Reserve winds down reinvestments. 5 The analysis assumes that as rates rise, MBS prepayments shift down from an average monthly pace in 2015 of close to $30 billion, to roughly a $25 billion monthly pace next year and $20 billion in 2017.

5 How Will the Federal Reserve Adjust Its Balance Sheet During Policy Normalization? Dec Additional Supply to be Absorbed by Market Under Different Options for Ending Reinvestments, $Billions Source: BNPP IP A number of observations emerge from this analysis. Whether a phase-out of reinvestments occurs over a shorter or longer period of time has very little impact on the amount of duration that will be added back into the market. The impact on duration mostly depends, not surprisingly, on how quickly the balance sheet enters full run-off mode. For example, under Alternative 3, a 9-month phase-out of reinvestments would not begin until October of next year. Such a strategy, which is most reflective of market expectations as captured in the Federal Reserve Bank of New York s October Survey of Market Participants, would add just $233 billion in 10-year equivalents to financial markets, as opposed to roughly $370 if the balance sheet were to enter full run-off mode in July. It is worth highlighting that Alternative 4 is consistent with comments from Governor Brainard and President Dudley, that is, delaying an adjustment to the reinvestment policy until the policy rate is sufficiently off of the lower bound. MARKET IMPACT In the New York Fed s October Survey of Market Participants, respondents assigned on average an almost 90 percent probability to some form of balance sheet run-down during policy normalization, with the median respondent indicating that an initial change to reinvestment policy would come nine months after lift-off. According to the stock theory of central bank asset purchases and sales, gradual balance sheet runoff should already be largely discounted in asset prices given that expectations for a change in policy are so high. However, there are at least two reasons why practice should differ from the theory. First, it is very unlikely that investors have modal forecasts for full runoff of past rounds of QE-related asset purchases. For example, in the aforementioned New York Fed survey, the median respondentsassigned a 25 percent probability of a return to the zero bound during the two years after liftoff. In a separate question, respondents also assigned an average 26 percent probability to the IOER rate being no higher than 50 basis points by the end of Responses to both these questions imply non-negligible probabilities to balance sheet runoff halting (or not even starting) over the next year, and possibly additional QE being announced by the end of This would indicate that should the economic outlook actually improve, market expectations for the amount of balance sheet runoff over the next few years could increase substantially. As expectations for runoff increase (for example, if investors began to expect Alternative 1 or 2), the term premium embedded in Treasuries would rise at a time when markets will also be discounting a steeper expected path of policy rates. We also cannot fully ignore the possibility of flow effects associated with balance sheet runoff, that is, the process of Treasury and MBS investors absorbing additional supply could lead to higher rates. In the case of Treasuries, supply effects could also be reflected in lower stop-out prices in auctions. Should supply effects occur, they would be expected to increase over time as the phasing out of reinvestments comes to an end.

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