Fed-Issued Floating Rate Notes - Another Arrow In The Quiver

by: UNC-CH Fed Challenge

It didn't have to end this way. The Fed just announced that it will end Operation Twist. The program, formally known as the Maturity Extension Program, buys long term Treasuries, and sterilizes the balance sheet impact by selling equivalent amounts of short term Treasuries. Long term rates fall; short term rates rise (kind of); and the yield curve twists.

The program is slated to expire at the end of this year. Something had to be done. Regardless of whether or not you agree with should the Fed have extended Twist, we know the Fed could not have extended Twist not in its current form anyway.

According to the NY Fed, nearly all-available Treasury securities with maturities of 3 years or less will be sold by year's end at the current run rate. This means that the Fed is losing its financing tool for buying the long end of the curve. The Fed's decision: undertake $45bln a month of unsterilized purchases (i.e. "print" the money to finance the operation). What else could they have done, you might ask? Certainly, they couldn't have moved their sales up the maturity curve, since this would have diminished significantly the program's impact, as less net duration would have been taken out of the market. And despite the calls from the inflation hawks regarding the possible inflationary consequences, they had no choice. ... Not so fast.

There is a third option that gets very little attention: The Fed could have issued its own debt to sterilize the purchases. The Fed actually has some experience issuing debt through its Term Deposit Facility, an exit strategy tool that will enable the Fed to drain reserve balances from the banking system if there were a sudden increase in inflation or inflation expectations.

Questions abound. First, would these Fed notes have a "money-ness" similar to cash, and if so, would their printing cause unwanted inflation? Second, would Fed notes be attractive to investors? Maybe not. Since the beginning of this year, every other month the Fed has auctioned $3 billion in 28-day term deposits to allow the banking system to become familiar with this operation. However, the bid-to-cover ratio of the auctions has fallen from 4.52 in January to 1.39 last month, which may be a signal of weak investor demand.

So how could the Fed make its debt attractive? The US Treasury has the answer: auction Floating Rate Notes (FRNs), which the Treasury is tentatively planning on issuing sometime next year.

How would Fed-issued FRNs work? Perhaps the coupon rate could be linked to a market rate, such as the DTCC GCF Repo Index- which represents the par-weighted average of Agency, MBS, and Treasury securities. Or perhaps the coupon rate could be tied to economic metrics, which would fit nicely with the FOMC's new strategy of linking monetary policy to the economy. Or perhaps the rate could simply be set by discretion.

How could the Fed use these tools for policy? The opportunities are endless, and need to be explored, but here are some ideas. If Fed-issued FRNs were a sizable market with similar risk characteristics to Treasuries, then a simple arbitrage condition could link them together. Say for instance the Fed wants to lower interest rates in a particular maturity range. Typically, it would purchase those assets, increasing their price and lowering their yield, with the possible negative externality of increasing the monetary base. But what if they simply lowered the coupon rate on their FRNs by discretion? The FRNs are less attractive, making similar maturity Treasuries more attractive on the margin, prices rise, and yields fall. And the kicker: the money supply could fall (not rise) since coupon payments from the Fed's vault are falling.

Notice that the Fed doesn't take ownership of new assets, like it does in QE. This tool allows policy to focus on the liability side of its balance sheet, not the asset side. Doing so might mitigate distortionary effects (e.g. Is the Fed's 20% ownership of the MBS market exerting undue influence?). Also, attempt to normalize the composition of the balance sheet might de-linked from the total size of the balance sheet. For instance, what if the Fed wants to exit the MBS or LT Treasury market, but feels like the economy is not ready for a drain in the money supply (and doesn't want a fire sale on their hands)? They could raise the coupon rate and/or purchase outstanding FRNs.

Of course, the market for Fed-issued FRNs must be sizable enough for any policy option to be effective. Witness the high liquidity premium for Treasury Inflation-Protected securities (OTC:TIPS). Fed notes might have a similar characteristic, and thus might need to be substantially larger than the $819Bn TIPS market. Perhaps the Fed could get creative and negotiate a debt swap: Fed issued FRNs for equivalent maturity Treasury securities in the secondary market. This way the Fed could effectively create a large market, without soaking up liquidity through debt issuances.

For fixed income investors, the introduction of such a tool could provide them with another "risk free" asset. Imagine the debate in the ratings agencies: Who is safer, the US Treasury or the Fed? A substitution effect away from TIPS might occur as investors have someplace else to displace their high liquidity premium, thereby allowing TIPS to get back to being a pure inflation play. And munis may no longer be the sole safe-play alternative to Treasuries.

If we learned anything from the Great Recession, it is that the Fed can be very creative when it needs/wants to be. Issuing its own debt might have been a credible option to extending Twist. And with a liquid enough secondary market, the Fed could have had a flexible new tool at its disposal (Maybe they are already considering this for future policy?). Questions remain, but it's worth considering.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. UNC-CH Fed Challenge is a team of students and alumni from UNC-CH (The University of North Carolina at Chapel Hill). We are linked together through our involvement in the Fed Challenge, which is a collegiate competition sponsored by the U.S. Federal Reserve to test participants' knowledge of macroeconomics and finance. This article was written by Prof. Mike Aguilar, Gabriel Tan, and Sam Grote.The content of this article reflects the opinions of the authors, and not of UNC-CH nor the US Federal Reserve.