Why the Fed will change its exit strategy…again


In a press release dated September 17, 2014 the Federal Reserve updated their “policy normalization principles”  that was laid out in 2011 when our monetary masters first flirted with the idea of “green shoots” turning into “escape velocity.” As mission got closer to completion eternal bliss for all subjects lucky enough to be under the reign of enlightened central planners was clearly within reach. Without the steady guidance and micromanagement of the Politburo we would all be jumping off the nearest high-rise as approximately 37 per cent of the US population apparently did in the 1930s.

Now, it did not quite work out that way and the normalization plan has been just as dormant as the economic promised land. Maybe, just maybe hope is not a viable long term plan after all. If household spending behaviour is really caused by perceptions about the future,  neatly discounted into a surging Russell 2000, then, and only then, would our Ivory Tower economists be right. However, if that was the case there would be no need for scarcity in this world and we could essentially return to the Garden of Eden and live happily ever after.

The real world is unfortunately more complex and as shown by Ludwig von Mises, in his article of 1920 called “Economic Calculation in the Socialist Commonwealth,” there cannot be a pricing mechanism in a centralised society without a free market and if there is no mechanism for honest pricing there cannot be rational economic calculation.

In this light, isn’t the whole purpose of Federal Reserve, and their brethren’s, market interventions attempts, so far successfully, to impose upon free society a pricing structure that differs from the free market outcome?

Prices are like traffic signals, guiding resource flows, but if for some reason resources starts to flow in a direction that does not fit with some grand master plan our self-proclaimed money masters have laid out, they find it fitting to change its direction at their own discretion.

Who, in their right mind, would suggest  that in a free market the most insolvent government on the planet, Japan, can fund itself for mere basis points when they have an explicit strategy to debase their currency by two per cent annually?

Have we not taken a a giant step towards the society Mises suggest cannot  perform rational economic calculation? And if we have, does this not mean vast amounts of resources are routinely being misallocated?

If resource flows have become distorted from all the monetary shenanigans witnessed over the last years it is a safe bet to assume it will resume its original, or intended rather, flow as central bank excesses are reversed.

And this brings us back to the press release which clearly states that the “…committee expects to cease or commence phasing out reinvestments” of securities holdings currently on the Federal Reserve balance sheet after it raises interest rates.

Now, we assume that the first 25 basis points to the Federal Fund Target Rate will come in September, the Fed should stop their reinvestments shortly after. By looking through the Federal Reserve balance sheet by CUSIP we can calculate the current maturity profile of both TSYs, TIPS, Agencies and MBSs which is provided in the chart below.








While there is no problem for 2015, by 2018 over 30 per cent of TSYs will have disappeared from the Federal Reserve’s balance sheet assuming no reinvestments. Since the US government is running a deficit, this means the reduction in Federal Reserve TSY holdings can be considered net supply of TSYs because the US Treasury will have to issue bonds to repay the Fed, and these bonds must be absorbed by the private sector.

With good collateral being in short supply these days added bonds will probably get bid within a reasonable, but presumably lower, price than today, but funding for extra TSY flow will come by through reallocation of existing private portfolios.

From the chart we see there will be a spike in H1 2016 and then the run-rate drops to around USD50bn per quarter until another spike in 2018.

With expected return on risk being what it is, one should not be surprised to see increasing market volatility as the Fed withdraws and the private sector tries to take up the slack.

Unless the economy tanks completely (more on this in a upcoming post) and added QE is felt necessary the Fed will be forced to continue to roll-over TSYs in perpetuity with the odd attempt to scale down the reinvestments to, say, 90 per cent of par, then 80 and so on.



    1. I had to stop blogging for reasons I cannot disclose here, but I am glad to be back. Thank you.

  1. The exact mechanism for the Treasury “repaying the fed” is confusing. Do you mean that when the bond matures the Treasury must pay the Fed the face value on the bonds? Why must the Treasury pay the Fed anything? Please explain.

    1. Ryan,

      If the Fed decide not to reinvest the bonds in their portfolio the Treasury must issue bonds to private investors when they roll over their debt outstanding. In theory the Treasury could get a free pass from the Fed, but then the Fed balance sheet would consist of liabilities and no assets which would be 100% monetisation of treasury debt. The idea is that the current treasury holdings in the Fed balance sheet will eventually be shifted to private investors.

      Not sure if that will work out though and a more likely scenario is for the Fed to maintain its balance for years and years until its is inflated away, that is when the Fed balance sheet to NGDP falls back to historic levels, not through sales, but trough inflation of GDP.

      Hope this answers your question.


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