I have said it before, and I will say it again: one of the most important reasons I write these articles is to test my ideas on paper, and put them in front of other minds who comment (sometimes derisively, but that goes with the territory) and help me find things I would not otherwise have found – flaws in my thinking, other applications of the thought process, additional facts outside of my own fact-gathering sieve, and the like. It is a lot of work to produce these articles, but it is generally worth it.
Here are three examples, all of which flow from comments received on yesterday's article about the implications of the size of the Fed's balance sheet and the likelihood that the market may make it difficult, if not impossible, to drain all of the excess reserves in a timely fashion so that traditional tools of monetary policy are once again efficacious.
One: Reader "Cyniconomics" pointed out, regarding my blithe dismissal of the convexity of the Fed's portfolio, that the negative convexity of the MBS portfolio is likely small, since these are short-dated MBS, and probably fades back into positive convexity quickly after a large move (since the negative convexity of a mortgage-backed security is due to the fact that higher interest rates cause borrowers to stop pre-paying; but once pre-pays have gone to zero you're done with that effect).
As a result, I went back and estimated the convexity of the SOMA portfolio. And it is, in fact, reasonably large – large enough that for the Fed to exhaust its portfolio before Excess Reserves were drained, interest rates would have to rise more like 500bps, rather than the 313bps I originally estimated. Now, I still question whether the Fed could unwind in practice a $2 trillion portfolio with only that amount of impact: in the early 2000s, the bond market saw several 125bp sell-offs on mortgage extensions of a mere 200bln. But it's at least more likely than I originally thought.
Two: In responding to reader "bbro," it occurred to me that there is another possibility for soaking up Excess Reserves that I hadn't previously considered (and would not have, but for the discussion): the Fed could, in principle, raise the reserve requirement. It hasn't changed since 1992 (read a history of it here), but that doesn't mean it cannot change. And the more I think about it, the more crazy sense this makes.
One reason the Fed never changes reserve ratios is that it uses up a lot of reserves very quickly, and creates volatility where none was previously. But in this case, those reserves are already in place, and it could potentially reduce volatility. It would be, as this article points out, a tax on financial institutions and would damage banking shares by making permanent the decrease in leverage that is already de facto. And doing this would also reduce the risk attendant on moving the Interest On Excess Reserves and trying to guess what effect that would have. The more I think about it, the more I think this might well be at least a part of the right strategy, although I think it's also quite unlikely to be implemented by the FRB.
Three: Finally, reader "Jim H." brought to my attention a very recent working paper by researchers at the Fed, entitled "The Federal Reserve's Balance Sheet and Earnings: A primer and projections." What is really fascinating about this article is how devoid it is of rational connection to the markets.
The authors examine the effect on the portfolio of interest rates rising in line with the Blue Chip consensus forecast of economists, which bravely forecasts 10-year yields to rise to near 5% by 2017 (and never exceed 5%, even though presumably there would be a tightening cycle in there somewhere). And it assumes that the Fed can sell its agency securities over three to five years and normalize the balance sheet over two to three years, without pushing market rates higher than the levels implied by the Blue Chip consensus forecast. In other words, either the Blue Chip economists were forecasting a sub-5% 10-year Treasury rate despite expecting the Fed to completely flush the SOMA, or the forecast is based on the evolution of interest rates that would occur without any adjustments to SOMA. The latter is more likely, since something slightly below 5% is close to the "neutral" Treasury rate if the economy is growing at potential with contained inflation.
But they consider an alternative scenario where interest rates follow a path 100bps higher than the Blue Chip consensus. Be still my heart! Can such a calamity actually come to pass? Well, the authors specifically state "although this shock – particularly the parallel shift – is an unlikely outcome, we present it to show the interest rate sensitivity of the portfolio…Of course, to the extent that inflation expectations have become better anchored over time, this increase in interest rates may be even less probable than the historical record may suggest." Apparently 100bps lower is equally likely in their minds, as they also consider that scenario.
I suppose it is unreasonable to expect a public working paper to include a scenario where the Fed breaks the buck, but it is almost laughable to assume no impact, or only 100bps of impact. Frankly, I think you get 100bps in the month or two after the Fed says they're done buying, long before they begin to sell.
(I confess that I don't fully understand how they get their numbers. According to one of their charts, SOMA Treasury holdings, which were in the ~$700bln range prior to the crisis, would fall until 2019, getting down to $1.2T or so, then rise back to $2.5T by 2027. I'm not sure what assumption is being made that requires the Fed's balance sheet to remain permanently a multiple of its pre-crisis level. I believe it may be based on the assumption that Federal Reserve capital grows at 15% per year.)
The article does discuss the impact of higher interest rates…on Federal Reserve net income, not on the market value of the SOMA. Essentially, the Fed ends up booking large capital losses, which live on its balance sheet in the form of future earnings they will not be remitting to Congress. It actually becomes an asset. Brilliant. Their calculation has the "deferred asset" getting as high as $125bln in the "high interest rate" scenario, which is actually plausibly close to the estimate of DV01 I made yesterday.
I personally don't care whether the Fed has a net loss or a net gain. What I'm interested in is whether there are plausible scenarios under which the Fed would be unable to normalize policy using the method of shrinking SOMA. I believe there are – but this article is a fun read anyway.
Again, all three of these points represent good feedback and have richened my thought process about the possible routes the Federal Reserve may take to exit the extraordinary policies implemented over the last several years. I conclude that there are more tools available than I'd believed, but that (while it's theoretically possible that the Fed could normalize policy by actually selling securities) outright sales of securities are likely to be insufficient of themselves. Moreover, it remains the case that politically, it will be much harder to be seen as pushing rates higher with asset sales, raising IOER, or increasing reserve ratios. Unless the Federal Reserve Board is made of much sterner stuff than the authors of this last Fed paper are – and there's not much evidence of that, although I'll pin my hopes on Esther George and Richard Fisher – it is still far more likely that they move too little and too late than too much and too soon.