Amid the continued dysfunction on Capitol Hill in passing a fiscal package, dueling town hall meetings, or the debate over rising probabilities of a Biden presidency, it might have been easy to miss what we think were some pretty important comments this week by Federal Reserve Board Vice Chairman Randall Quarles.
The Vice Chairman for Banking Supervision offered rare and insightful glimpses – albeit with a healthy dose of reading between the lines – into what we believe are critical “twin tracks” of Fed deliberations driving the next phase of the new policy framework: the concerns over market function and financial stability in a prolonged period of low rates and a low short run r*, and the Fed’s monetary policy options in the face of ongoing uncertainty over when, by how much, or even whether there will be another major fiscal policy support to bolster a clearly ebbing recovery.
Admittedly, Quarles did not directly address the latter fiscal issue in the way that every other Fed official has from Chairman Jerome Powell on down (sans one lonely Committee member). But the challenges for the Fed in ever larger Treasury debt issuance was a constant thread weaving throughout his remarks all week.
*** As much as the forward rates guidance and balance sheet policy questions dominate the market debate over the Fed’s new framework, we believe the Fed reviews currently underway regarding the linkages between monetary policy and broader financial stability and market function will make regulatory reforms an equally critical “third leg” to the still evolving policy framework. If anything else, the lessons being drawn from the March market stresses are imposing an imperative need to better understand unforeseen transmission channels of further easing through balance sheet policy, and to find the means to significantly expand the balance sheet capacity of the broker-dealer banks. ***
*** When the FOMC formally adopted the “ample reserves” policy in January 2019, it was in a period of a shrinking balance sheet and, frankly, we doubt it was ever imagined the balance sheet could mushroom north of $7 trillion at last count, or that it would still be rising by more than $1 trillion a year – and that even before weighing whether a policy easing through additional asset purchases will be needed. The harsh reality is that those assets have to be funded with excess reserves that could soon, without regulatory reforms, threaten to “crowd out” other low yielding assets on bank balance sheets and, in turn, limit the Fed’s balance sheet policy options going forward. ***
*** We are fairly confident the Fed’s reviews into the market dislocations of March, and September last year, will start a process towards several key market structural reforms. Perhaps the most significant will be the movement towards a central clearing system for treasuries, which has drawn considerable interest from Fed officials. That will take time, so as a likely “bridge” to bolster dealer balance sheet capacity, we suspect an extension of the relaxation to the Supplemental Leverage Ratio seems likely. It will be politically charged, and Fed officials insist it will not be permanent, or at least we suspect, not without trade-offs on dividends and share buybacks. ***
*** The internal work led by the Board’s financial stability division, as well as the review by the Basel Financial Stability Board, which Quarles chairs this year, will be both unveiled in mid-November; the former in the release of the next bi-annual Financial Stability Report, and the latter to be presented to the G20. Both will likewise be on the agenda for discussion at the FOMC’s November meeting, and their conclusions, we think, will go a long way to shaping the next stage of the Fed’s balance sheet policy deliberations at the December meeting. ***
*** Indeed, we think the decision on the next stage in the promised pivot from stabilization to monetary policy, and how to inject a greater accommodation into the real economy through balance sheet policy, be it QE or yield curve caps — which we believe is still very much on the policy table at some point – will only come into place once the linkages and safeguards between a highly accommodative monetary policy and financial stability are addressed, and there is far greater clarity on the scale and scope of fiscal policy. Absent the latter, the efficacy of the former will be limited, and its costs may come to quickly outweigh intended benefits. ***
Assessing the March Market Dislocations
The Quarles remark that grabbed the most headline attention – and which he quickly tried to roll back — was his suggestion there may be a “lasting need” for Fed support to market function, in that “the volume of Treasury securities has gotten so large the financial market infrastructure as currently set up, can’t handle much stress.”
We think, though, the key phrase there was “as currently set up;” that is to say, that somber scenario for strained market structures underscores the urgent need to further strengthen the banks and their balance sheet capacity to absorb a future enormous spike in treasury volumes, not to mention a more muscular oversight of the non-bank financial institutions.
Although a fair amount of the Fed’s initial assessment of what happened in March was focused on the role of highly leveraged hedge funds forced to unwind massive basis and relative value trades, it is interesting that Quarles since acknowledged that the hedge funds played more of a secondary role in the March market dislocations
Instead, while hardly downplaying the vulnerabilities in the scale of leverage that had to be unwound so rapidly, the trigger to the March market dislocations in a such a massive “dash for cash” was initially and primarily driven by foreign sellers and foreign central banks in particular.
In fact, in no small degree of irony, the surge in US Treasury debt issuance to finance the 2017 tax cuts was more or less financed by hedge funds that swooped in to capture an unusually persistent spread between cash treasuries and futures when the buy and hold pensions funds and other more traditional investors shied away from the low yielding paper.
Those basis trades, however, came back to bite when the liquidity of the deepest fixed income market in the world began to disappear once the cascade of sell orders began to swamp the treasury market, then quickly ripped across the markets for spread products and down-drafted equity markets worldwide into ferocious freefalls.
Yet, “the system worked,” Quarles affirmed in a burst of seeming pride. Quarles, in fact, was downright complimentary of the performance of the US banks that, despite the enormous strains, were “a source of strength to the financial system and the economy.”
The banks were able to meet the massive cash demands of corporate clients that were quickly activating hundreds of billions of dollars in standby lines of credit, all the while pulling in nearly $2.5 trillion of core deposits from investors seeking the safe haven of the dollar and insured bank accounts and absorbing more than $1.2 trillion of central bank reserves in the period; the banks even adhered to regulatory pressures for Covid-driven debt forbearance.
But before the bank lobbyists submit their invoices, Quarles also barely missed a beat in noting the resilience of the banks in coping with this crisis was primarily “due to the much stronger balance sheets with more and higher-quality capital, more liquid assets” — a testimony in fact to the Dodd Frank reforms implemented by the Fed and other agencies in the aftermath of the GFC to bolster the bank capital ratios.
And in a less enthused tone, Quarles also noted earlier in the week that while the banks performed well under extraordinary circumstances, “the same cannot be said for important parts of the system of nonbank financial intermediation.”
Quarles thus strongly pointed the FSB, which he chairs, towards an overall, “comprehensive framework,” rather than new or high regulatory capital charges, for regulating “non-’traditional lenders” – the shadow banking system – to ensure plentiful liquidity in periods of market stress.
The Long Road to Market Reforms
Quarles in fact repeatedly echoed a theme we have previously written about (see SGH 9/21/20, “Fed: Ok, So Now What” and SGH, 9/3/20, “Fed: On September’s Guidance and QE”), namely, that while the FOMC was relieved by how successful its rapid interventions were in March in easing the unprecedented strains in the global markets, they were at the same time positively taken aback that it took more than $2 trillion in asset purchases in less than two months to stabilize the US markets
There was likewise an impressively quick roll out of a half dozen or so “exceptional and exigent circumstances” 13-3 facilities, armed with up to $452 billion of Treasury credit courtesy a rightfully frightened Congress, as a backstop to market function. The Fed “engineers” even took to structuring new even more direct credit facilities; the well tapped Paycheck Protection Program with the Small Business Administration, the little tapped Municipal Lending Facility, and barely touched, more complex Main Street Lending Facility.
The latter two have drawn their share of criticism for how little cash they have pushed out the door, but as Fed officials will tell anyone willing to listen, all of the 13-3 facilities were meant as backstops to keep the markets functioning and were “lending not spending,” as Chairman Powell put it a hundred times.
Left unsaid, however, is what happens if the economy takes another turn south, and to say that the Fed never wants to be forced into that again would be an immense understatement.
In hindsight, perhaps the most critical success in stabilizing the markets came in the decision to activate existing dollar swap lines with a handful of foreign central banks, to then widen the access to the Fed’s swap facilities to even more foreign central banks with big dollar-based markets, and perhaps most of all, to then give key foreign central banks access to the Fed balance sheet to repo their treasuries holdings for cash as needed rather than selling into the market.
That success, at minimum, will probably mean expanded and perhaps in time, permanent swap lines and repo arrangements with a range of the most important dollar denominated offshore markets, subject naturally enough to annual reviews and possible, if not probable, Congressional oversight.
A Centralized Treasury Clearing System
But our sense is of a gathering momentum also inside the Fed to begin a regulatory push in coordination with the necessary other federal agencies, and with private market associations to create a centralized clearing system for treasuries. It is a proposal best argued by Stanford University’s Darrell Duffie, which seems to be garnering considerable support from within the Fed and in think tank circles in Washington.
Its structure and purpose would not be all that complicated, though its politics might be; for one, the banks won’t necessarily like it because they will have to stump up the capital as a first recourse to a systemic settlement failure rather than relying on taxpayers to step in to cover a settlement failure. And a centralized clearing house to settle the treasury trades in a $5 trillion plus market would entail the very definition of a too big to fail institution, thus ensuring mountains of disclosure and regulatory oversight.
But the benefit would be enormous: a net settlement of the trades would literally free hundreds of billions of dollars of capacity on bank and broker-dealer balance sheets that, in turn, could and should mean a market system capacity to absorb the scale of treasury debt issuance that is all but certain to be rising even higher in the coming months and years.
Greater capacity in treasury volumes will likewise spill over in addressing any potential liquidity challenges in the investment grade corporate bond market, which saw similar, unexpected turns into illiquidity in March.
The benefits of a clearing system, however, are somewhat tempered by the reality it will take a year if not years to pull together the necessary buy-in across the regulatory and market to put into place. In the meantime, short term band-aids to boost dealer balance sheet capacity came in April, when the Fed was granted the regulatory interpretative room to “temporarily” exempt reserves and Treasury securities from the Supplementary Leverage Ratio for the big banks.
Needless to say, the banks are arguing that relaxation needs to be made permanent to have any of its intended lasting impact, but Quarles — with an eye no doubt on the November elections – was quick to say there is no intention on that front. That, however, we think will change, even under a Biden Treasury, in exchange, for instance, for even tougher guidelines on limits to dividends and especially share buybacks to safeguard the preservation of capital among large banks
Fiscal’s Whiskey Tango Foxtrot
And finally, there is easily no policy or economic turn of events more concerning and unsettling to Fed officials than the dysfunction and failure to date of Congress and the Trump Administration to finalize and to pass a fiscal support package.
At the same time, the level of treasury issuance, and the likelihood of Fed expanded asset purchases to create the accommodative financial conditions to help underpin a sustained recovery, will entail some very tricky and high stakes understandings going forward on the role and relationship between fiscal and monetary policies.
Chairman Powell went about as far as he dared to go in laying out the case for the benefits of a big fiscal package versus the “tragedy” of one that is too small, much less none at all. And after he joined in on a long call to Treasury Secretary Steven Mnuchin and House Speaker Nancy Pelosi the week before last, presumably to lay out the critical underpinning to a recovery in a fiscal income support, we doubt he or any of the Fed officials will wade in too directly from here.
But it is worth noting why the Fed officials have been so increasingly shrill in their pleas for fiscal policy and how it will shape their monetary policy options going forward.
For one, if Congress does abdicate on fiscal policy or punts a fiscal injection into early next year, it will also mean a growth downgrade across most of the December round of Summary of Economic Projections. Almost all the September projections had at least another $1 trillion penciled in by now, so an extended delay or nothing at all will certainly darken the outlook, and ultimately raise the cost both in fiscal policy and the monetary policy trade-offs.
But not to put too fine a point on it, the truly stark underlying anxieties of Fed officials is the unspoken reality that it is unlikely the Fed will be able to even come close to achieving either of its twin mandates any time soon without a strong and tailored fiscal policy to lead the way in boosting demand and inflation expectations: there is simply little monetary policy can do when rates are already so low, and yes, while the FOMC will have options, none of them are attractive and all will entail high costs relative to whatever benefits they may bring.
Even with asset purchases termed out to longer tenor treasuries, for instance, one of the staff memos to the new framework released in August concluded, the important “duration channel” of the easing would be very limited in its intended transmission into real economy activity. Instead its main impact may simply come in stoking further asset price inflation and bringing the focus back to financial stability anxieties.
An alternative Fed response to the absence of a scaled up fiscal boost could also come in an equally unattractive ramping up of direct credit policies through the 13-3 facilities. Their terms could invariably be eased, changing them from backstops to outright credit policies to push cash to where it is needed the most, especially in a greater reliance on the Main Street Lending Facility, the PPP with the Small Business Administration, or the Municipal Lending Facility.
In effect, though, the Fed would be funding its expanded credit policies by pushing more excess reserves on the balance sheets of the commercial banks, making them the lenders to the Fed as their counterparty rather than lending directly to private sector borrowers. It is hardly an optimal scenario for any central bank and the politics of exiting from it would keep most everyone up at night.
A Secondary Monetary Role to Fiscal’s Lead
The clearly more attractive scenario, albeit with its share of complications, is a sustained fiscal expansion that drives aggregate demand and consumer spending high enough to lift business confidence and investment spending towards that elusive virtuous cycle of above trend growth.
The Fed’s role in this optimal world would then come into play by holding rates near zero as promised under the new framework until measured inflation hits the 2% mark, and to use its balance sheet to extend a period of accommodation with further asset purchases to dampen down a “premature” steepening in yields or an excessive jump inflation expectations.
In effect, monetary policy would play a secondary, supporting role to the lead set by fiscal policy, with all that this will imply on the working relationship between the Fed and Treasury.
And those future further asset purchases will require the creation of still more excess reserves. But without at least a clear and consensus movement in the direction of the regulatory fixes we think Vice Chairman Quarles is hinting at, the reserves could literally swamp the commercial bank balance sheets, potentially beginning to crowd out lower yielding assets, starting with repo. And that could put the Fed, and markets, right back to March, sorting out self-ignited fires.