Monetary and Fiscal Policy: The Impact on Interest Rates

Transcription

1 Guggenheim Securities, LLC Monetary and Fiscal Policy: The Impact on Interest Rates March 2017

2 Monetary Policy High level overview of the Federal Reserve Guggenheim Securities, LLC 2

3 Monetary Policy: Design and Purpose of the Federal Reserve Capital Requirements: Intended to ensure that banks maintain strong capital positions that will enable them to absorb losses and maintain investor confidence in the face of unexpected shocks. Design Established through the Federal Reserve Act in 1913 To furnish an elastic currency, i.e. flexible money supply Monetary policy objectives Maximum employment, stable prices, moderate long-term interest rates Establish effective supervision of banking in the United States Purpose Conduct monetary policy Maintain stability of the financial system Supervision & regulation of financial institutions Payment & settlement system safety & efficiency Consumer protection & community development Guggenheim Securities, LLC 3

4 Monetary Policy: Design and Purpose of the Federal Reserve Federal Reserve leadership = 7 member Board of Governors in DC and 12 regional districts. Board reports to Congress, provides guidance to system, and oversees regional banks Monetary policy set by Federal Open Market Committee (FOMC), comprised of: All 7 governors (presidential appointees w/ 14y terms; 2 seats vacant, Gov. Tarullo leaving in April) President of the NY Fed (appointed by FRBNY Board of Directors) 4 of the remaining 11 bank presidents (on a rotating basis; appointed by regional FRB Board of Directors) Janet Yellen has served as Chair of the Board and the FOMC since February 2014 (Chair term ends 2018) Guggenheim Securities, LLC 4

5 Monetary Policy: Current Composition of the FOMC Janet L. Yellen, Board of Governors, Chair William C. Dudley, New York, Vice Chairman Lael Brainard, Board of Governors Charles L. Evans, Chicago Stanley Fischer, Board of Governors Patrick Harker, Philadelphia Robert S. Kaplan, Dallas Neel Kashkari, Minneapolis Jerome H. Powell, Board of Governors Daniel K. Tarullo, Board of Governors 2017 Committee Members 2017 Committee Members Alternate Members Alternate Members Janet L. Yellen, Board of Governors, Chair Marie Gooding, First Vice President, Atlanta William C. Dudley, New York, Vice Chairman Jeffrey M. Lacker, Richmond Lael Brainard, Board of Governors Loretta J. Mester, Cleveland Charles L. Evans, Chicago Stanley Fischer, Board of Governors Michael Strine, First Vice President, New York John C. Williams, San Francisco Patrick Harker, Philadelphia Robert S. Kaplan, Dallas Neel Kashkari, Minneapolis Jerome H. Powell, Board of Governors Daniel K. Tarullo, Board of Governors Alternate Members Marie Gooding, First Vice President, Atlanta Jeffrey M. Lacker, Richmond Guggenheim Securities, LLC 5

6 Monetary Policy: The Dual Mandate Federal Reserve monetary policy mandate: Revised in 1978 (Humphrey-Hawkins Full Employment Act) Fed seeks to achieve Maximum employment (4.7 to 5.0% in longer run) Stable prices (2% percent core PCE inflation in longer run) Moderate long term interest rates (largely a function of stable macro environment) Unemployment Rate Core PCE Jan-13 Sep-13 May-14 Jan-15 Sep-15 May Jan-13 Sep-13 May-14 Jan-15 Sep-15 May-16 Source: Bloomberg Guggenheim Securities, LLC 6

7 Monetary Policy Tools: Fed Funds This is the preferred traditional method for controlling short rates. The fed funds rate is interest rate at which institutions lend their deposits held in accounts with the Fed to one another on an overnight and unsecured basis. This method relied on the scarcity of reserves. Banks compete for reserves to meet reserve requirements The Fed would adjust the level of reserves through temporary open market operations The Desk would attempt to keep the effective fed funds rate (EFFR) close to the desired target Following the financial crisis, the Fed flooded the banking system with excess reserves, a byproduct of the Fed s quantitative easing programs that expanded the balance sheet. Bank demand for fed funds declined The Fed accelerated its ability to pay interest on these excess reserves in order to maintain some level of control over the reserves in the banking system Guggenheim Securities, LLC 7

8 Monetary Policy Tools: IOER (ceiling) In order to greater control the fed funds rate, the Fed uses a combination of IOER and the RRP facility to act as upper and lower bounds on the corridor. To raise rates Fed primarily relies on interest rate on excess reserves (IOER) IOER serves as a magnet that pulls the effective fed funds rate (EFFR) higher EFFR been relatively stable within range, except on monthly and quarterly end dates EFFR has drifted higher in range with reduced excess reserves Foreign banks used to be very involved with IOER arbitrage trade Money fund reform reduced foreign bank involvement due to higher borrowing costs IOER RRP "Corridor" Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Source: FRBNY Fed Funds Effective IOER RRP Guggenheim Securities, LLC 8

9 Monetary Policy Tools: RRP (floor) The New York Fed conducts overnight RRP operations daily in order to maintain the floor on the fed funds rate. Liquidity in the fed funds market is still insufficient for the Fed to adequately control short rates. This is the result of the level of excess reserves in the banking system as well as regulatory changes for banks and traditional fed funds participants. MMF, GSEs, banks, & dealers can place funds overnight with the Fed ON RRP amounts are currently limited only by Fed s Treasury holdings ~$2 trillion available to collateralize investments ON RRP expected to remain key tool to control short rates Bills trade through ON RRP since not all investors have access to facility (leaky floor) Repo typically trades above ON RRP rate ON RRP usage increases as repo gets closer to facility rate Guggenheim Securities, LLC 9

10 Monetary Policy Tools: Balance Sheet Chair Yellen has indicated that the FOMC prefers to adjust the size and composition of the balance sheet in a passive manner. Impact on Fed balance sheet from financial crisis & large scale asset purchases FOMC directed the NY Fed to purchase securities through permanent open market operations Largely securities purchases but also included temporary lending programs Fed increased securities holdings in an effort to stimulate economy after FF reached 0% On asset side, Fed Treasury and agency MBS portfolios grew by the largest amount (Approximately 2.46 trn in Treasury and 1.75 in agency MBS) On liability side, Fed financed purchases through creation of excess reserves Guggenheim Securities, LLC 10

11 Monetary Policy Tools: Balance Sheet Capital Requirements: Intended to ensure that banks maintain strong capital positions that will enable them to absorb losses and maintain investor confidence in the face of unexpected shocks. Guggenheim Securities, LLC 11

12 Fiscal Policy: Back in the Mix Fiscal policy has the potential to marginally increase or decrease economic growth. The markets appear optimistic that a Trump administration can successfully pursue pro-growth policies with the republican congress. Potential Pro-growth policies: Tax reform (individual/corporate) once passed into law, positive effects to increases in aggregate demand Regulatory overhaul cost/benefit analysis is a useful exercise Infrastructure spending potential long term benefits to productivity Potential Low-growth policies: Protectionist policies that result in retaliatory tariffs and trade wars Immigration policies that hamper long-term productivity Complicated tax reform with mixed group of benefactors (e.g., border adjustment tax, interest deductions) Programs resulting in large deficit increase without accompanying growth will put upward pressure on long-term interest rates and temper potential GDP estimates Guggenheim Securities, LLC 12

13 Financing Fiscal Policies will be key: How to pay for programs Revenue neutral Cuts in existing programs used to offset new expenditures Lower tax rates but reduce deductions to maintain current effective tax rate Deficit spending increase amount of Treasury issuance to finance new programs Gauging the net effect of mix of fiscal policies will have an impact on Fed s reaction function: Policy too stimulative could lead to economy overheating and push economy into a recession faster (Fed may need to raise rates faster only to cut them in a downturn) Policy too restrictive could hamper efforts to increase GDP, reducing the pace of rate hikes from the Fed Guggenheim Securities, LLC 13

14 Tying It all Together Monetary Policy Progress on the dual mandate continues, employment near goal, and inflation moving Uncertainty over near-term impact of fiscal policy has Fed taking gradual approach Fiscal Policy Pro-growth policies (tax reform, infrastructure projects) Larger deficits and potential trade wars could counteract benefits of pro-growth policies Outlook for Interest Rates Fed will most likely raise rates 1 or 2x in 2017 Rate path beyond 2017 highly dependent on net impact of fiscal policy and health of economy. Goal is to reach the neutral rate (r*) Guggenheim Securities, LLC 14

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