In his testimony on Capitol Hill last week, Federal Reserve Chairman Jerome Powell responded to an unexpected question on the Federal Reserve’s balance sheet policy by affirming the Fed had no plans to stop or alter the pace of the current “normalization”and that the Federal Open Market Committee will take up the issues of the operating framework and the terminal size of the balance sheet “fairly soon.”
*** By “soon” Chairman Powell was referring to next week’s FOMC meeting in which, with no rate hike being considered, the balance sheet will be high on the agenda. But the meeting will mark only the beginning of what is likely to be a lengthy process with discussions and staff presentations stretching across several meetings, probably through the end of the year, if not longer. Indeed a complex mix of market, technical, governance and political issues will need to be resolved before the FOMC can move on to deciding on the final phase of the balance sheet normalization policy, including the optimal size of the balance sheet. ***
*** Likewise, while perhaps most FOMC members lean towards formally adopting a “large” balance sheet with ample reserves in the financial system and the current “floor” system using the Interest on Excess Reserves to manage the policy rate, there is no firm FOMC consensus yet. A not insignificant minority of Committee members remain unconvinced. Contrary to speculation over an early end to the balance sheet reduction, there is, for now — to borrow a phrase — considerable inertia within the Committee toward any near changes in the current pace of asset run-offs or using the balance sheet as a policy tool. ***
*** In addition, the balance sheet, not rates policy, is where many Fed officials see the greater vulnerability to political pressure, a point brought home by President Trump’s recent critical remarks. Some, for instance, fear a large “normalized” balance sheet could leave the Fed more exposed to political demands for renewed asset purchases to fund future fiscal policy. There are also lingering anxieties that unresolved internal governance issues could mean adoption of a new operating framework could leave interest rate policy solely in the hands of a politically-appointed Board of Governors rather than the full FOMC. ***
The Back End of QE
While managing the asset side of the balance sheet drove policy through the three phases of QE expansion, the policy focus is now on the liability side as the balance sheet is “normalized.” But when the FOMC agreed to begin shrinking the balance sheet in September 2016, it purposely set aside two of the more critical decisions in dealing with the “back end of QE:” which operating framework the Fed should formally adopt to implement monetary policy, and what the optimal size should be for a right-sized “normalized” balance sheet.
If the FOMC deems it better to return to the pre-crisis “corridor” system targeting a point fed funds rate to manage reserve demand with daily open market operations, the asset run-off will have to run much longer, until perhaps 2022, to get to a reserve-scarce “small” balance sheet. If, however, the Committee agrees to stick with the current “floor” system, in which the administered rate for the IOER is the primary policy tool, that would entail a “large” balance sheet of ample reserves and an earlier albeit undefined end to the asset run-off to reduce the size of the Fed’s securities portfolio.
Structural changes in the money markets, however, due to new regulatory and liquidity requirements, a high risk management appetite for safe assets, as well as greater swings in the Fed’s non-reserve liabilities — cash held by Treasury in its General Account at Fed, for instance, has swung from around $5 billion on any given day before the crisis to as much as $440 billion in recent years — made it near impossible to estimate reserve demand when the normalization got underway nearly two years ago.
So it was decided at the time, in a fairly remarkable achievement in Committee consensus building, to get the asset run-off underway on the announced pre-set schedule, with capped amounts allowed to run-off each month but scaling up each quarter through the first two years — the capped asset run-off will ratchet up to $50 billion a month this October — and to keep a close eye on the developments in the money markets as excess reserves were steadily extinguished.
In that way, the Open Market Desk in New York would get a better feel for where on the reserve demand curve the Fed could most “effectively and efficiently” execute monetary policy, as the FOMC laid out in its 2016 “Policy Normalization Principles and Plans.” The first “tell” for when reserves were becoming scarce would be a sustained upward pressures on overnight rates.
And that is probably the reason why the recent upward drift in the effective fed funds rate, from its mid-point in the fed funds policy target range towards the IOER, triggered so much speculation in the market the Fed may already be approaching its equilibrium balance sheet size and thus a much earlier end to the current pace of run-off of maturing assets.
Buying Time on Balance Sheet Decisions
But we don’t get any sense most FOMC members see it that way, and we suspect most of the Committee, perhaps taken a bit by surprise by the unexpected rise in the fed funds rate, feel no need to rush towards a change in the pace of balance sheet reduction.
Instead, if necessary to keep fed funds from again rising towards the IOER, the FOMC seems ready to authorize the Desk to make another technical adjustment as it did in June, when the IOER was increased by just 20 basis points within the 25 bp increase in the policy target range to 1.75% to 2%. If that is what it takes to buy more time in order to deal with the myriad and complex issues in this last phase of balance sheet normalization, so be it.
Many if not most of the FOMC members do seem to be leaning towards the merits of continuing with the current floor system in using the IOER and the overnight reverse repos to guide monetary policy, and maintaining a large balance sheet with a deep cushion of ample reserves to manage the demand for reserves andto offset the fluctuations in the central bank’s non-reserve liabilities.
The Desk has made the case for the “large/floor” system because it has worked well so far in lifting the policy rate, and it will entail far less volatility and extensive open market operations than compared to trying to target a point fed funds rate as the primary policy tool. The large balance sheet would also provide the banks with a low cost, efficient means to meet their liquidity management needs and thus provide a pre-emptive protection against against systemic risk.
The debate over the balance sheet will only begin in earnest next week, and there is no Committee consensus yet on how to get to the final phase of the balance sheet normalization policy. Indeed, there remains considerable hesitation, if not an outright resistance, among at least a minority of FOMC members, to adopting the proposals for a floor system and a large balance sheet.
Indeed, the recent rise in the effective fund funds rate goes to what many Fed officials believe should be the first order of the policy discussions starting next week. The debate over the optimal size of the balance sheet drawing so much of the market’s attention should more or less be at the end of the decision making process, not its beginning; instead the first question to be addressed is whether the fed funds rate can be credibly retained as the Fed’s primary policy instrument?
In that sense, rather than be alarmed by the steeper rise in the fed funds rate or to take it as an indication of an approach to the equilibrium level of reserves needed in the banking system, some FOMC members came to a different conclusion, namely that the recent rise in the effective fed funds rate implied a greater demand for fed funds and the start to a desired deeper trading in the fed funds market.
And indeed, in addition to the heavy Treasury bills issuance that has lifted the competing repo rates and pulled the fed funds rate higher, at least some Fed officials believe there has also been a real demand for fed funds from smaller and regional banks building larger loan books and deposits and needing reserves to meet their reserve requirements, thus bidding up the fed funds rate.
That the demand for reserves from a handful of smaller banks could move the fed funds rate amid some $1.9 trillion reserves still in the banking system would be hard to explain, save for that the fledgling fed funds market is highly bifurcated, with more than 90% of all the reserves in the system held by just the big five banks, all but one based in New York.
Those reserves are being held on the books of the big banks primarily to meet the requirements under the new Liquidity Coverage Ratio for High Quality Liquid Assets. But for those Fed officials still reluctant to embrace the large balance sheet arguments, they question whether it is properly the responsibility of the Fed (and taxpayers) to provide the banks with free assets in the form of the excess reserves to meet those liquidity needs, and to even pay them to keep the excess reserves on their books?
If not, the implication is that the big five banks are unnecessarily “hoarding” reserves to the detriment of a deeper and more actively traded fed funds market.
In that sense, a further rise in the effective fed funds rate to and above the IOER is not necessarily a bad thing. While it would invariably make the fed funds market more volatile by shifting reserve demand to a steeper part of the demand curve, it would also likely force the big banks to shed excess reverse for a more active trading in the fed funds market. The Fed would also have the option of paying a lower rate for excess reserves than the interest paid for required reserves to encourage more active two-way trading in the fed funds market.
There is also a political overlay to this debate since a deeper fed funds market could mean less reliance on the IOER to direct the policy interest rate and thus less cost to the Fed in paying interest on the excess reserves. The optics of paying the banks interest on their excess reserves over and above their required reserves has been politically sensitive for some time, and to the naked eye on Capitol Hill, it looks an awful lot like a free subsidy to the banks.
Congress has called out the Fed numerous times on this front, and as the cost of the IOER rises as rates are gradually increased under the current base case outlook — which will also reduce the Fed’s remittances to Treasury — that political sensitivity will only become more acute. Perhaps inevitably, there will be a presidential tweet about it before too long.
Those sort of non-technical considerations also play a role in what could perhaps be best described as ideological reasons to work towards the return to a smaller balance sheet in that a revived fed funds market would allow for a market-determined policy rate, with all the price signals it would afford the Fed as well as early warning indications for signs of systemic distress. The IOER sacrifices those signals in being an administered rate.
There is a similar themed argument that as a guiding principle, the Fed should seek to reduce its footprint in the market as much as possible — the flattening of the yield curve, for instance, is as much due to the distortions introduced by QE as anything else — and the goal should be, in effect, to avoid becoming the counter-party to the entire financial system as it would be implied in the floor system.
The Governance Challenge
And finally, there is a sensitive governance issue that will need to be resolved; that the Board of Governors sets the IOER, while the FOMC sets the fed funds rate. This issue was papered over during Ben Bernanke’s tenure as Fed Chairman with the commitment the Board would only set the IOER after a full debate and engagement of the entire FOMC. It was a compromise that mostly worked in the run up in the policy rate towards neutral, but it becomes a major issue from here.
The governance issue, incidentally, cuts both ways with either operating framework or balance sheet size, in that a return to a corridor system would invariably translate into such frequent and potentially large scale open market operations it may require new operations, namely a return of the Term Auction Facility — which is run through the discount window and also controlled by the Board, rather than the FOMC.
With such a long list of complex issues to resolve before ever getting to the decision on an optimal balance sheet size, we suspect the FOMC is likely to only get as far as laying out the broader agenda and staff research that will be needed at the two-day meeting next week.
With such a stiff resistance to alter much less stop the current pace of asset run-off any time soon, the balance sheet is likely to stay on course to shrink down to perhaps under $3.5 trillion by next spring. Money market developments could force the FOMC’s hand on its timing, but that could be how long it will be before the FOMC announces its intentions on the operating framework and the optimal size of the balance sheet.