It s Getting More Complicated

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1 Investment Management Economic and Financial Market Commentary June 24, 214 It s Getting More Complicated We are entering a more complicated period in the conduct of monetary policy not just in terms of when the Fed will tighten, but how the Fed will tighten. This commentary will seek to navigate both of these topics. First the when question. As has been the case for the past few years, futures markets tell us that investors expect the first tightening to be about 12 months forward, and that Fed funds will rise by about 1 basis points in the first year of tightening. Nothing new there, except that today there is a bit more credibility to this forecast as the Fed itself is actually guiding investors to such an outcome in their frequent remarks. As a veteran Fed watcher, I am both pleased and amazed at the candor and transparency of today s Federal Reserve policymakers. It is a far cry from the world of smoke signals and nuanced gestures that announced policy changes in the 198s. I expect our current Chair will continue to tell us what she thinks is likely to unfold over a multi-year time frame, as well as the set of conditions that will likely foster a policy change. But just like the rest of us, she reserves the right to change her mind based on changing inputs. Clear and transparent Fed thinking is surely one of the key influences today muting market volatility. Rate (%) A Gradual Tightening Remains Priced Into the Yield Curve Sources: Bloomberg and BBH Analysis Fed Funds Futures. Jun-14 Nov-14 Apr-15 Sep-15 Feb-16 Jul-16 Dec-16 May-17 The when question remains quite difficult. Knowledgeable observers can make equally persuasive arguments on either side of the sooner vs. later debate. On the tightening sooner side of the ledger is the unambiguously more solid foundation supporting economic activity today. Households were not able to support an increase in their spending through real income growth in the early years of this expansion, but instead largely financed higher spending out of the extra cash flow that materialized via mortgage refinancing. Since then, steady job growth is finally Rolling 2-Year Average (Y-O-Y %) Income Gains Are Now Propelling a Self-Sustaining Expansion Real Personal Income Data reported as of quarter-end. Data as of March 31, 214. Sources: Bloomberg and BBH Analysis 1

2 lifting the nation s real income levels, which are supporting real household spending increases without exogenous sources like government transfers, lower debt service costs, or boosts from new debt loads. Another consideration favoring a sooner start to the tightening cycle is the need to begin the process now so that the Fed can get the Fed funds rate substantially above % over time in order to have room to lower interest rates materially in the next cycle when the economy weakens. I don t suspect Chairperson Yellen will speak openly about this motivation, but it remains an important reality for policymakers. The tightening later arguments remind me of the adage that you can drown in an average of six inches of water. Averages or broad measures can at times paint a misleading picture. Yes, the broad measures tell us that we have been in a continuous expansion for five years. Yes, the broad measures tell us that the size of the economy, the size of the employment base, and the size of household wealth have all now exceeded prior peaks, so this must be a prosperous period for America, right? For some yes, but for many no. These broad measures are masking a large swath of America that has yet to join the recovery. This fact came home to me recently in a series of very powerful charts published in the New York Times which compared/contrasted a series of metrics before and after the financial crisis/recession. The one that stood out to me was the number of Americans receiving assistance through food stamps. About 26 million Americans received food stamp assistance before the recession, and that number has continued to rise ever since, reaching 48 million more recently. We also know from the employment data that there are large numbers of discouraged workers who have technically exited the labor force, but who would seek employment if opportunities improved. This pool of labor in waiting continues to exert downward pressure on employment costs, and by extension, on inflation. Alarming Number of Americans On Food Stamps Million Data reported as of year-end Sources: United States Department of Agriculture Food and Nutrition Service and BBH Analysis Tighter fiscal policy (e.g. higher tax rates) and a tighter financial sector regulatory environment (e.g., higher capital requirements) may delay any Fed action. But, surely the most powerful argument for tightening later is the absence of meaningful inflation pressure. No matter what measure is used CPI, Core CPI, the Core Personal Consumption Expenditure Deflator (Yellen s favorite), Average Hourly Earnings, the Employment Cost Index there are no inflation measures that suggest the Fed needs to be concerned that its hyper-aggressive monetary policy is setting in motion an upward inflationary spiral. In fact, policy makers around the world are probably still more worried about falling prices than rising prices as was evidenced by the ECB s recent, mind-twisting step of instituting negative short-term interest rates on reserve balances. This is perhaps the most experimental of all policy moves around the world instituted since the financial crisis. How European banks respond to this new penalty rate for holding reserves is far from clear, and it may be just as likely that is leads to a shrinking banking system a bad thing than to an expanding banking system the ECB s desired goal. Time will tell. 2

3 Now to the how question of Fed tightening. Up until the crisis, the Fed achieved its short-term interest rate target by adjusting the supply and cost of borrowing bank reserves. Their policy focus, the Federal Funds rate, is the rate at which banks borrow/lend excess reserves to each other in order to satisfy their reserve requirements at the Fed. Reserves are deposits at the Fed, and they are broken into two categories. Required reserves must be held at the Fed based on the size of a bank s deposit base. The larger the bank, the higher are required reserves. Excess reserves are deposits at the Fed in excess of required reserves. They are the raw material available for banks to expand their balance sheets (by increasing lending or investing) at which point excess reserves are converted to required reserves. The Fed turns up the supply of reserves and lowers the cost when they want the banks to expand their lending/investing, or turns down the supply and raises the costs when they want the banks to rein in their lending. That system worked pretty well in a bygone era, but the advent of Quantitative Easing (QE) greatly changes the conduct of monetary policy ahead for which there is no precedent. $ Billion Massive Excess Reserve Balances Will Change the Conduct of Monetary Policy Ahead Excess Reserves (right hand scale) Data from January 2 May 214 Sources: Federal Reserve and BBH Analysis Required Reserves (left hand scale) $ Trllion Pre-crisis, banks needed about $41 billion of reserves to satisfy Fed requirements, and excess reserves totaled just $1.9 billion. Today, banks need about $134 billion of reserves to satisfy Fed requirements, but after three rounds of QE, excess reserves have soared to $2.5 trillion. Pre-crisis, the Fed was not allowed to pay interest on excess reserve balances held by banks. But among the dramatically widened powers they achieved during the crisis, the Fed received authorization to pay interest on reserves, a tool they suggested would be vital to their exit strategy. Their thinking went as follows. Once the banking system returned to health, banks would naturally have an incentive to use the massive amount of excess reserves to expand (or over-expand) their balance sheets, ballooning the money supply and ultimately fueling higher inflation. The Fed would not be able to shrink the amount of excess reserves without pushing the economy back into recession, so they somehow needed a mechanism to jail the excess reserves and create an incentive for banks to moderate the expansion of their balance sheets. The Fed hypothesized that by paying interest on reserves, they would be able to set the interest rate at a level which would prevent undesired bank behavior. Well, like many things in this cycle, that hypothetical thinking ran into reality. The Fed did not contemplate that some of the excess reserves would end up belonging to the GSEs (Ginnie Mae, Fannie Mae, and Freddie Mac) who are not allowed by law to be receive interest from the Fed. Since the GSEs are a major supplier of excess reserves they can lend their excess reserves to other financial institutions, but just not receive interest from the Fed then the Fed s new-found ability to pay interest on reserves will not be as effective in jailing the excess reserves and achieving a targeted Fed Funds level. So the Fed needed to devise an entirely new strategy to lift the Fed Funds rate in the future when they determine that the time is right. Get used to new terminology Term Deposit Facility (TDF), Large-Scale Reverse Repos, and Overnight Repos which will be the mechanical means by which the Fed implements its tighter monetary policy. 3

4 The TDF is a partial, but incomplete, tool. The Fed will set a rate of interest to attract long-term deposits from banks whose reserve accounts will then be debited. This will jail these excess bank reserves, prevent excessive lending/investing, and allow the Fed to (partially) lift short-term rates by reducing the supply of excess reserves. There are two problems with this tool, however. First, it does nothing to address the fact that the GSEs cannot be paid interest and will persistently be large sellers of excess reserves. Second, it will dramatically change the liquidity profile of a bank (vs. overnight investments) at a time when Basel III capital guidelines are focused on enhancing bank liquidity and quality. So the Fed needs other tools, and they will be relying on Large-Scale Term Repos as well as Overnight Repos to mop up the excess reserves and effectively target a higher Fed Funds rate. Money Market Funds have recently been allowed to be counterparties for the Fed s repos in addition to banks. Since Money Market Funds do not have accounts at the Fed, in such a transaction, the Fed will deduct reserves from the Money Market Fund s clearing bank, and by doing so, the Fed reduces the amount of excess reserves in the banking system. Sound complicated? That s because it is. We are heading into a much more complicated Fed operating environment, where the mechanisms, the communication language, and the results are all unorthodox. On the one hand, we believe that the Fed probably has enough tools in its arsenal to effectively raise rates when it determines that the time is right. On the other hand, they may need to pull many levers at the same time, and experimentally, to get the job done. The changes in behavior on the part of individuals and institutions are not yet clear, and there will undoubtedly be surprises along the march to higher short-term rates. Here are a few unresolved questions: Will Money Market Fund yields rise sufficiently such that they begin to siphon away traditional (and importantly sticky) retail deposits from commercial banks? Will this potentially attractive new investment choice for Money Market Funds lead to new growth at a time when public policy is seeking to diminish the size and importance of unregulated or under-regulated parts of the so-called shadow banking system? With retail investors (via Money Market Funds) now able to run to the Fed in times of panic, will this further exaggerate price movements of Treasury and Non-Treasury assets (in opposite directions) in these environments, and further impair market liquidity for Non-Treasury assets? Finally, it is unclear how the Fed will communicate policy changes in the future. Will their minutes express a shortterm rate target and contain details of authorized program sizes for the TDF, Large-Scale Reverse Repos, and Overnight Repos? We don t know. We expect plenty of experimentation between now and an ultimate policy change so that the Fed convinces itself, and investors, that they have the right levers to pull, and they know how to pull them effectively when the time comes. Welcome to the new, more complicated, Fed policy world. Undoubtedly, there will be interesting investment opportunities that emerge through the confusion and complexity. Jeffrey A. Schoenfeld Partner 4

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