From HSBC comes an interesting discussion about how the FOMC might go about raising interest rate sand shrinking its balance sheet.
Tools for normalization
The minutes of the June FOMC meeting may provide some clues as to how Fed policymakers will manage the transition to policy “normalization” in the months ahead. Normalization has two major components; first, how to gain control over short-term interest rates once the decision is made to “lift-off” from the current 0.0% – 0.25% range for the Fed funds rate; second, how to manage the Fed’s balance sheet once the move toward a less accommodative policy stance begins.The Fed’s various QE programs have ballooned the central bank’s balance sheet from about USD850bn at the start of 2008 to USD4,326bn this past June. Bank reserves have shot up from USD96bn in early 2008 to nearly USD2,700bn. With that many reserves in the banking system, the FOMC will not be able to control the Fed funds rate as it did in the past with modest additions or subtractions of reserves on the order of one to two billion dollars a day. The Committee is currently experimenting with other tools to control short-term interest rates. These include the interest rate paid on excess bank reserves (IOER), the overnight reverse repo facility (RRP) and term repo deposits with a broad range of counterparties, and term deposits for bank reserves (TDF).
Both the overnight RRP facility and the TDF are currently in trial runs to see how the markets will react to different sizes and offering rates for the facilities. The IOER has been set at 0.25% since January 2009. It is possible that the IOER could become the primary “official” policy rate once the FOMC does begin the lift-off from its ultra-easy policy stance. Alternatively, the Committee could choose to emphasize the joint use of the IOER and the overnight RRP rate.
Meanwhile, QE and the expansion of the balance sheet were aimed at easing financial conditions by putting downward pressure on longer-term interest rates. Moving to a less accommodative policy at some point in 2015 could involve shrinking the balance sheet, thereby reversing some of that downward pressure. How to shrink the balance sheet when the time comes is already under discussion at the FOMC. It appears that outright sales from the Fed’s portfolio of Agency and Treasury securities are not being considered, at least not in the near- to medium-term. Instead, the discussion is focused on when and how the Committee might decide to stop reinvesting the principal proceeds of its MBS and Treasury holdings.
Ceasing reinvestment is not a simple matter. If it were done prior to hiking short-term rates, it might cause some market turmoil since the effects of shrinking the balance sheet by ceasing reinvestment would be hard to judge in advance. For this reason, some members of the Committee have expressed a preference for hiking rates first and then ceasing reinvestment in the portfolio at a later date. Others have suggested that ceasing all reinvestment might be too abrupt, especially now that the balance sheet has gotten so large. A gradual and partial reduction in reinvestment might be more appropriate. Still others on the Committee would like to reduce the holdings of MBS as quickly as possible. This raises the possibility of letting the MBS portfolio run off and then reinvesting the proceeds in Treasury securities.
This would limit the shrinkage of the balance sheet, but would put some upward pressure on mortgage rates relative to Treasury yields.
In the end, the Committee may eventually decide on a range of options that will allow it the flexibility to adjust the mix of policy tools for both the balance sheet and short-term interest rates as it tries to “normalize” policy. In any case, it is not likely that the FOMC reached any definitive conclusions about these issues at the June policy meeting. There are too many diverse opinions about how to proceed and the trial runs for the RRP and TDF facilities have not been completed. In her press conference, Fed Chair Yellen indicated that the Committee is still “working through the many issues related to normalization and will continue its discussions in upcoming meetings…” Nevertheless, we believe the discussion in the minutes about these issues could provide some clues as to which approach is finding favor with a majority of the policymakers on the Committee.
