New Nuances - Fed Summer Reading

Includes: GLD, SPY
by: Edward Hoofnagle, CFA


QE is nearing the end, its time to learn about IOER and RRP rates.

These rates are untested, Forward Guidance will take a larger role.

As Policy Normalization happens, the markets will likely be tested.

Despite the financial media's focus on the termination of QE efforts at the Fed, the balance sheet continues to grow into uncharted territory. The following graph illustrates the trend in the assets held by the Fed over the past few years. Note that the rate of increase is slowing, but the slope is still steep…


And while the Fed is decreasing the rate of purchase of assets, the nation's banks now have almost 3T of "excess" reserves on deposit at Fed to support these asset balances.


This month's minutes of the Federal Reserve meeting contain a summary of deliberations about changing the current approach of flooding the market with dollars. And while none of the above is new news, the Fed has publicly acknowledged that its former tool for raising rates, the Federal Funds Rate ("FFR") is now largely irrelevant. In a world flush with QE liquidity, banks aren't borrowing at the FFR. Net result, changes in FFR will have no effect on the cost of funds, except as a token gesture. In other words, if you raise a rate that no-one borrows at, it's a non-event.

The Fed has now become a net-borrower - they borrow excess reserves from the nation's depository institutions or from their nascent repurchase program. In short, the Fed has lost control of its historical interest rate setting tool - it now relies on QE and Forward Guidance.

The Rise of Uncertainty

So, the fed is trying to figure out how to raise rates, and there is a lot of discussion about new terms including the interest on excess reserves (IOER), the repurchase rate (RRP), and propaganda (forward guidance). But deep down, there seems to be a growing confusion within the board of governors.

"…one participant preferred to use the range for the federal funds rate as a communication tool rather than as a hard target, and another preferred that policy communications during the normalization period focus on the rate of interest on excess reserves (IOER) and the ON RRP rate in addition to the federal funds rate. Participants agreed that adjustments in the IOER rate would be the primary tool used to move the federal funds rate into its target range and influence other money market rates. In addition, most thought that temporary use of a limited-scale ON RRP facility would help set a firmer floor under money market interest rates during normalization. Most participants anticipated that, at least initially, the IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range. Alternatively, some participants suggested the ON RRP rate could be set below the bottom of the federal funds target range, judging that it might be possible to begin the normalization process with minimal or no reliance on an ON RRP facility and increase its role only if necessary. However, many other participants thought that such a strategy might result in insufficient control of money market rates at liftoff, which could cause confusion about the likely path of monetary policy or raise questions about the Committee's ability to implement policy effectively."


Fortunately, there is a generally accepted path of declining QE from now until October, so the Board of Governors has some time to get it together. But while the Fed continues to figure out what to do in October, look for lots of "uncertainty" and "nuances"…

"As the recovery progresses, assessments of the degree of remaining slack in the labor market need to become more nuanced because of considerable uncertainty about the level of employment consistent with the Federal Reserve's dual mandate"


"…although participants generally saw the drop in real GDP in the first quarter as transitory, some noted that it increased uncertainty about the outlook, and they were looking to additional data on production, spending, and labor market developments to shed light on the underlying pace of economic growth.


A Summary of the New Paradigm

In the old days, the Federal Reserve was considered the "lender of last resort". The Central Bank regulated the depository institutions and provided end-liquidity for firms who could not make ends meet in the Interbank Market. It used to be considered "bad" when a bank had to borrow from the Fed. There were questions raised - "What was wrong? Who screwed up?"

Source: Author's Illustration

Today, the banks are so overloaded with excess reserves that the tables have turned. And, because of this dramatic shift in the money markets, the old tools no longer apply. Or, at least they will not apply until the above model comes back into existence (and that might be several years from now).

Source: Author's Illustration

As illustrated above, in this new money markets environment, the Fed Funds rate doesn't really come into play. As a result, once the Fed gets beyond discussions of buying the government's debt, you will start to see a lot of guidance about the IOER and RRP. But before we get there, get ready for a debate on reinvestment policy.


The Fed's balance sheet has gotten so large that decisions to reinvest maturing bonds will have an impact on money supply. In 2013, the reinvestment amounted to almost $300bn.


Under the post QE regime, the Fed's desire to be seen as accommodative will imply that it should keep rolling over bond maturities, and a desire to withdraw liquidity might be implemented by simply letting the bonds mature and taking possession of the principal proceeds. Indeed, a worthwhile research path would be to examine the impact of the Fed's rolling MBS maturities into Long-Dated treasuries on the yield curve. Is it a significant driver that has been flattening the yield curve? Going forward, look for "reinvestment policy" debates - here's a window from the recent minutes of July 2014:

Most participants supported reducing or ending reinvestment sometime after the first increase in the target range for the federal funds rate. A few, however, believed that ceasing reinvestment before liftoff was a better approach because it would lead to an earlier reduction in the size of the portfolio


Making the IOER and RRP Rates Matter

The Fed would like to be able to control the progression of interest rates, and, in my opinion, it must fear losing control of the rate-setting mechanism as a result of QE. The new tools such as IOER and RRP rates will become commonplace indications of rates movements in the near future. And for the Fed to be able to make these rates matter, they would like as many market participants as possible to feel the impact of changes in these rates. So far, the results have been promising:

Since late 2009, the FRBNY has taken steps to expand the types of counterparties for reverse repos to include entities other than primary dealers. This initiative is intended to enhance the Federal Reserve's capacity to conduct large-scale reverse repo operations to drain reserves beyond what could likely be conducted through primary dealers.


In other words, the Fed will have to get deeper into the money markets for its new rate setting regime to be meaningful - especially the Reverse Repo Rates (RRP). So, don't confuse the end of QE with the beginning of the Fed normalizing the money markets. Rather, the Fed will be digging in deeper.

Reflexivity of IOER

While the IOER seems like a fine tool for controlling rates, there are limits to its effectiveness. First of all, the rate will most likely not go negative. In the late Spring 2014, the ECB began charging its banks to retain excess reserves on deposit at the Central Bank. The logic was that they felt the funds should be put to work by the banks into the economy, and therefore, this "penalty" would force the banks to lend more. In my opinion, the Fed could not implement this approach because the Fed is a huge borrower thanks to years of QE. Make no mistake, if the IOER becomes negative, it might cause the nation's banks to fully lend as per their current capital base, and this would remove trillions in excess reserves which are currently deposited at the Fed. The effect would be highly stimulative, and the money supply would skyrocket. Given the low rate environment, the elasticity for such a shift could be very small (it might even be considered a binary choice - "on" or "off"). If the elasticity is binary, even a tiny negative IOER rate could have widespread effects. More importantly, chairperson Yellen would have a true dilemma on her hands. The board would either have to sell bonds in the SOMA account, increase bills in circulation, or borrow funds to carry its bond inventory.

  • Increasing bills in circulation would flood the money supply even further, so the act of changing IOER could have add-on effects far greater than the nominal change in rates.
  • If the Fed borrows funds to cover its loss of reserves, it would mean that the implementation of Negative Reserve Deposit rates would require that other rates raise further - risking an out of control spiral in the cost of funds.

Let's look at the other side. What would happen if the Fed raises the IOER too high? Banks would be discouraged from lending to home buyers and businesses because banks would be doing just fine by milking the Fed. In other words, the act of raising IOER could not only cause higher rates, but it might also cause lending to contract, thereby magnifying the initial effect of the rate increase beyond the nominal change in the IOER. Normally we think of increasing rates as changing the demand for loans, but in the case of IOER, the act of increasing rates might simultaneously affect the supply and demand for credit. Given the uncertainty of IOER impact on the supply of credit, the Fed's decision to move that rate around will be deeply debated and constantly second-guessed. In other words, more uncertainty, more nuances.

Role of Forward Guidance

The Fed will have its hands full over the next year as policy accommodation moves towards normalization. I have attempted to illustrate some of the challenges that the Fed may encounter as they make this shift from QE communication towards rates communication. And I'm hoping that the reader is aware that this process will be messy. Given the new set of tools (IOER, RRP), the Fed will be at great pains to be very precise on the guidance it provides. Regrettably, Forward Guidance is also an untested tool, and the Fed will always run the risk of having to explain too much, or too little, and then do verbal acrobatics to justify any changes in forward guidance. For example, consider the hand-wringing that took place when the unemployment rate fell below that stated in the forward guidance statement.

"…FOMC explicitly recognized that factors determining maximum employment "may change over time and may not be directly measurable," and that assessments of the level of maximum employment "are necessarily uncertain and subject to revision."4 Accordingly, the reformulated forward guidance reaffirms the FOMC's view that policy decisions will not be based on any single indicator, but will instead take into account a wide range of information on the labor market, as well as inflation and financial developments."


That seems like a lot of explaining to do just because the unemployment rate fell below 6 ½ %. But it matters, because the Fed said rates wouldn't increase until unemployment fell. So, when it fell below their line in the sand, the Fed had to create a new line, a blurry line, a nuanced line…

Investment Implications

The new Fed chairperson has been extremely fortunate to date. She has not really been tested by a financial calamity, and the performance of the economy and stock market have been supportive towards the Fed's goals. Ms. Yellen has been able to philosophize about Labor Market slack while she and the Board try to figure out how to shut off the QE spigot. But, to be clear, the end of QE is coming. In a few short weeks we will be into October, and the markets will have to contemplate matters other than the end of QE. So far, the economic indicators are leaning positively, and this is friendly to the Fed and to equity prices. If the economy starts to slip before policy normalization has occurred, look out! That's why the 1Q negative GDP must have caused many at the Fed to bite their bottom lip.

Years of deficit consumption and bad fiscal management have left the country with a debt level that few Americans can even contemplate - our brains can't handle it. At the same time, our monetary policy accommodation has been unprecedented. Today, being stretched fiscally and monetarily seems not to matter, but it might matter one day - it usually does. And if it begins to matter, the time-tested progression from financial crisis to sovereign debt crisis will begin to unfold. We read about these events in history, and it seems like it was obvious. But it isn't, it happens gradually, and then there's a jump or shock which exacerbates the decline. I believe that the undefined and reflexive impacts of rate changes such as IOER and RRP could provide the financial shocks. And, it must be said, the geopolitical situation is not pretty. There's no shortage of candidates to be the geopolitical shock - Russia, Iran, Syria, Hamas, fanatical Islamic Terrorists, border chaos, racial unrest and wealth disparity…the list goes on.

I will reiterate that investing is a marathon, not a sprint. Returns over the past several years from the equity markets have been great! There's little risk in taking some money off the table and letting events play out over a few months. One might let a few % go by, and one might also save a few % in losses. That's a decision which should be based on risk tolerance and time horizon. My position has been clear for a few months. I trade opportunistically [see Kforce Inc. (KFRC) and Tesla (TSLA)], but I am keeping a neutral or short stance on the equity markets (NYSEARCA:SPY), and a small allocation into precious metals (NYSEARCA:GLD). Most is sitting in very short fixed income (MUTF:FSTIX), and I've been trying to build a real estate portfolio - but that's a different story.

Disclosure: The author is long GLD. Short SPY, Long FSTIX. This article is not a recommendation to sell or buy securities. It is intended for educational and discussion purposes.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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