What the Fed Did NOT do

Fed maturity

We will not spend much time discussing what the FOMC did as tons of ink have been spilled on that already. We will rather spend more time on what the FOMC did not do.

A short recap will suffice; the FOMC did raise the interest rate band by 25 basis points to 0.25 – 0.5 per cent from the seven yearlong band of 0 – 0.25 per cent. No surprise there as this move was well communicated weeks in advance. As discussed in Unintended Consequences of Liftoff the recent move to secure a floor in the new interest rate band requires changing the rate on O/N RRP as well, which the Federal Reserve did (from 5 basis points to 25 basis points). As of December 17th the IOER provides a ceiling (currently 0.5 per cent), while the O/N RRP the floor (0.25 per cent) in a band where the actual Federal Funds rate for unsecured overnight bank lending will settle, or at least that’s the plan. This is the scheme opted for to be able to lift rates in an environment with $2.5 trillion excess reserves. As the O/N RRP can meet up to $2 trillion in demand, and possible more at auctioned rates, the Federal Reserve “is confident that the normalization process will proceed smoothly” without addressing the real possibility of flows within the financial system being heavily disrupted. As the $300bn cap on O/N RRP is essentially removed, banks can no longer arbitrage money funds excess cash with its exclusive access to the IOER. Expect to see deposit flows out of the banking system and into the O/N RRP by way of money funds. How this will affect collateral chains is unknown, but could potentially be worrisome as O/N RRP cannot be used for re-hypothecation.

As can be seen from the following chart, money funds have been desperate to use the O/N RRP at quarter end in order to park cash from banks cleaning up their balance sheet for regulatory window dressing. We should expect take-up to increase and stay elevated on a more permanent basis from now on.RRP Take Up

Source: Federal Reserve Bank of New York, Bawerk.net

However, the most important thing in the FOMC press release, which got scant attention, is something we raised back in May; namely the need to change the overall exit strategy. In a press release dated September 17th 2014 the Federal Reserve says it will “reduce the Federal Reserve’s securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA… ….[and will] commence phasing out reinvestments after it begins increasing the target range for the federal funds rate”. At the time of the press release it was widely assumed the Fed would cease reinvesting existing bonds few months after lift-off. If that was the case we would see almost an additional trillion worth of treasuries on the market place over the next three years. Needless to say, this act alone (which presumably would be anticipated and traded on by speculators) would raise rates far more than a meagerly 25 basis points. In other words, if investors were told today that the Fed would dump treasuries from early 2016 they would obviously sell existing holdings today and by extension lift the whole curve until recession and/or QE4 got under way.Fed maturity

Source: Federal Reserve Bank of New York, Bawerk.net

With that in mind, 25 basis points is not much to worry about. So it was probably with great relief that speculators and investors were told the Fed “is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.”

The rumor mill has it that this means mid-2017 and thus of no immediate concern. What it really means is never as the only way the Fed can get rid of this problem is through inflation of nominal GDP until the relationship between the Fed’s balance sheet and the overall financialised economy doesn’t look so out of whack. In today’s deflationary environment that will take much longer than most people expect. Treasury monetization, or helicopter money, has already been with us for quite some time.