Fedspeak: Roadmap for the Exit

October 28, 2009 By Richard Berner New York & David Greenlaw San Paulo The FOMC next meets on November 3-4. In anticipation, market attention is riveted on every nuance of Fed language and actions. That's hardly surprising, as the case for today's ‘sweet spot' in risky assets rests on short rates staying anchored, liquidity remaining abundant and prospects improving for growth, however modest. Fed officials won't change policy any time soon. But they know that effective communication is more critical than ever as they craft the exit strategy from an ultra-accommodative stance. Market participants want the Fed to clarify its views about the outlook and about the circumstances in which the Fed will unwind its stance. That will help to reduce uncertainty about the implications of the exit process for financial markets. By reducing uncertainty, Fed officials can actually improve the effectiveness of monetary policy. Three areas are critical: First, officials can update the baseline outlook and risks to it, and how they will react to changes. Second, they can map out their exit game plan, continuing to identify the tools they will use and the sequence for deploying them. Third, they can say what they do and do not know about the exit process, given that the Fed and market participants are in uncharted waters. Outlook risks. As noted in the minutes from the September FOMC meeting, the Fed's baseline outlook has probably improved since late June, when the central tendency for growth over the four quarters of 2010 was a range of 2.1-3.3%, and the Fed projected core inflation to run about 1.5%. The revisions will probably reflect generally improving incoming data and a further easing in financial conditions. Despite our conviction that the recovery will be sufficiently strong as well as sustainable, we'd be the first to admit that both are uncertain. Underlying vehicle and housing demand remains unclear following the expiration of ‘cash-for-clunkers' and the first-time homebuyer tax credit. With payrolls still declining and income growth weak, consumer spending strength is in doubt. And contributions to growth from capex, net exports and the government are uncertain. There is even more dispersion around the inflation outlook: Economic slack is unprecedented, while monetary stimulus, rising commodity prices and a weaker dollar might boost inflation expectations and inflation. Even the extent to which inflation has fallen is unclear: The Fed's preferred inflation gauge - the core PCE price index - rose only 1.3% in the year ended in August, but removing a sharp decline in the so-called non=market component of PCE prices yields a rate of 1.7%. Clarifying the reaction function. Given that uncertainty, clarity on how officials will react to changes in the outlook will help market participants understand the roadmap for policy. Many will expect the Fed to tighten sooner if it boosts its growth outlook. However, even if its revised outlook for growth improves to match ours, with ‘core' inflation low and declining, we think that officials will keep policy accommodative through mid-2010. An ongoing improvement in financial conditions may promote a gradual unwinding of the quantitative/credit easing that the Fed implemented to offset the credit crunch. Nonetheless, the current circumstances suggest that the existing guidance on interest rates - "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period" - is probably due for a change. A softening of the language at either the November or December FOMC meetings would be entirely consistent with our expectation that the first phase of the exit strategy (whether you call it reining in excess reserves, shrinking the balance sheet, or unwinding QE) will commence in 1H10 and that rate hikes will follow in 2H. Unlike in 2004, this language is highly conditional on economic conditions. By spelling out how much economic conditions have changed and what will be the response, the officials can help market participants understand the Fed's preferences and reactions. The "exceptionally low" language describes the stance of policy rather than its direction, so it is conceivable that it could still be applied to a 1% or even 2% funds rate target - especially with some small tweaks to the wording. Tools to use. While there appears to be some disagreement regarding the timing and the triggers for exit, all Fed officials seem to agree that the exit strategy has two basic components: 1) shrinking the volume of excess reserves and 2) raising the policy rate. Reverse repurchase agreements (RRPs) will be used to address the former. But there are several unanswered questions: How and when will the Fed use reverse RPs to drain excess reserves, given the massive size of the job? Will it need other tools such as accepting term deposits or selling assets? Will paying interest on reserves give it control over the funds rate? Here is some background. Thanks to aggressive expansion by the Fed, excess reserves - the surplus held by banks at the Fed over required reserves - currently total US$987 billion. We estimate that the excess will grow to about US$1.2 trillion by early 2010. The expected increase reflects three factors: 1) the ongoing impact of the large-scale asset purchases (LSAPs); 2) a looming slowdown in the pace of unwinding other Fed liquidity support facilities (the unwinding has provided significant offset to the LSAPs to this point but simply does not have much more room to go); and 3) the winding down of the Treasury's Supplementary Financing Program (SFP). Thus, far from exiting any time soon, the Fed will actually be adding more quantitative easing unless it takes offsetting action. This means that an important near-term issue is whether the Fed passively accepts more QE or attempts to offset the growth that should soon appear in the balance sheet and bank reserve data reports. The hawks on the FOMC would appear to have a powerful argument if they want to push the issue: "OK, we understand the rest of you don't want to exit yet, but if the recession is over, why are we doing the opposite of exiting?" The counter argument from the doves will be that draining operations might send a confusing signal to financial markets, and as long as the reserves are merely being stockpiled in cash accounts at the banks, what does it matter if more are added? Indeed, this seemed to be the prevailing sentiment at the September FOMC meeting, according to the recently released minutes. Thus, while it will be interesting to watch this debate play out in coming weeks as excess reserve balances soar to new highs, we don't sense that the Fed is about to start draining reserves. At this point, our best guess is that draining operations won't commence until early 2010. Whenever it does decide to start draining, the Fed will quickly enter uncharted territory. Although officials point out that reverse RPs are a standard component of the Fed's toolkit, the largest previous operations ever conducted with primary dealers were on the order of US$25 billion - and that was only for a relatively brief interval last autumn when the Fed was still attempting to sterilize the impact of all the new liquidity support facilities. Communications are critical here too: For example, the Fed has been conducting test reverse RPs, and to insure that investors understand the difference between policy and operational testing, the New York Fed issued a clarifying press release. Fed officials have actually outlined three approaches to draining reserves: reverse RPs, term deposit accounts and asset sales. We doubt that the Fed intends to sell assets any time soon, since such action would probably be quite disruptive to markets - this is more of a long-run option. Moreover, while offering term deposits would appear to be a useful means of draining significant volumes of reserves, this is an untested innovation that carries some legal and technical complexities. The Fed seems to be moving forward most aggressively with the reverse RP option. Initially, there was some concern that dealer capacity for large tri-party reverse RPs was quite limited due to balance sheet constraints, so the Fed signaled that it might have to conduct operations directly with large investors, such as money market funds. However, it now appears that dealers may be able to absorb a much larger volume of operations than previously believed, which would avoid the need for the Fed to deal with a new set of counterparties. Since this matter is expected to be a topic of discussion at the upcoming FOMC meeting, we are likely to get additional clarity on the technical aspects of how reverse RP operations fit into the overall exit strategy following that session. Finally, looking further ahead, the Fed has another tool - interest on excess reserves (IOER) - that, if effective, would enable officials to raise the policy rate without significant reserve draining. If the Fed hikes that rate, it raises the cost of borrowing; when banks can hold excess reserves on deposit with the Fed, they won't lend at rates below the IOER. Yet there are some institutions (in particular, the GSEs) that are not authorized to receive IOER, so there are leakages in the system. And at very low rates, IOER may not function properly. Therefore, the open market desk at the NY Fed may have to use the other tools noted above to execute the tightening as instructed by the FOMC. Uncertain impact of exit on markets. Beyond when exit will start and how it will work, there are several questions about the impact of such policies on financial markets. Will banks deploy their cash assets into securities or loans, reducing market rates and expanding credit supply? Will the interest rate on excess reserves become the policy rate, at least for a while? What will be the impact on market funding rates of conducting large reverse RP operations? The September FOMC minutes note that the Fed staff has examined the impact of very high reserve balances for bank balance sheet management and the economy. In tandem with the substantial volume of excess reserves, large banks that report weekly hold nearly US$1.2 trillion in cash assets on their balance sheets, or more than double the year-ago level. The staff believes that as banks grow more comfortable with the economic outlook, those now holding these balances for liquidity-management purposes could redeploy them into securities or loans. That shift in the asset mix would narrow spreads or increase credit availability; instead of boosting bank liabilities and the ‘money' multiplier, this would increase monetary stimulus through the asset side of banks' balance sheets. Finally, we suspect that large reverse RP operations could put upward pressure on financing rates - with general collateral RP rates possibly trading well above fed funds. We will be exploring this issue in greater detail over the course of coming days because it opens the door to the possibility that the fed funds rate might lose its status as the main barometer of monetary policy. Political constraints? Effective Fed communications will also help the FOMC navigate the current political environment. There is a deeply held concern that the Fed will be unable to execute an exit strategy due to political constraints. That's not surprising, given that criticism of the Fed is at its highest level in 70 years, according to some historians. And there will always be some politicians who criticize the Fed when it embarks on a tightening campaign. Nonetheless, we believe that such concerns are overblown. Since the days of Arthur Burns, the Fed has largely managed to run policy independently, and there is a new and very powerful argument in favor of independence. Since many place the blame for the financial and economic crisis of recent years squarely on an overly lax monetary policy coming out of the last recession, it's going to be especially difficult to criticize the Fed for exiting this time around. In addition, Chairman Bernanke's campaign to communicate directly with the public at large has strengthened the Fed's hand and probably contributed to President Obama's decision to nominate him for a second term. In the end, it's certainly conceivable that the Fed could delay exit longer than it should (just as it is possible that it moves too soon). But we are convinced that if the Fed was to wait too long, it would be because it misread the economy, not because of political influences.