Risks to Balance Sheet Normalization Plans

The recent upward drift in the effective fed funds rate (EFFR) toward the upper bound of its target range occurred earlier than the Fed likely expected and prompted the interest rate on excess reserves (IOER rate)  adjustment.  

The June 2018 Implementation Note that accompanied the FOMC statement said that the adjustment is  “intended to foster trading in the federal funds market at rates well within the FOMC’s target range.” 

Perhaps to avoid the perception that this adjustment signals an imminent change to balance sheet  normalization plans, Powell suggested that the FOMC saw higher Treasury bill supply (as opposed to reserves  scarcity) as the predominant cause of a higher effective funds rate: “there’s a lot of probability on the idea  of high bill supply leads to higher repo costs, higher money market rates generally, and the arbitrage pulls up  federal funds rate towards IOER.”1If the level of reserves is not a major factor affecting these recent developments, then the FOMC is less likely to adjust plans for balance sheet normalization in response.  

Powell said that while at this time they don’t expect another adjustment to the IOER rate, a further change could be made in the future if necessary. 

New York Fed surveys last month revealed that both the sell-side and buy-side expect changes in the level of reserves and Treasury supply to be the most important factors in determining the IOER-EFFR spread through  2019.

1 Of course, bill supply and the level of reserves can be related: An increase in bill issuance results in lower reserves to the extent that the funds raised are kept in the Treasury’s General Account, not spent and returned into the private market. This has occurred to some extent, reflected in a higher balance in the Treasury’s General Account in recent months and a lower level of reserves than otherwise. 

This measure could be effective in bringing EFFR closer to mid-range, although the Fed is unable to address other key factors (T-bill supply, regulations). 

The Fed doesn’t have a precise estimate of the demand curve for reserves. It must infer the likely level of the  EFFR for a given quantity of reserves from (1) observing how EFFR changes with the balance sheet and (2)  surveying market participants. 

(1) A simple linear regression of the IOER rate-EFFR spread and reserves suggests the spread would compress to zero (EFFR trades at upper bound) once reserves shrink to $1-$1.5 trillion (Figures 3 and 4). But the Fed has revealed its unease with a spread as narrow as five basis points, which would correspond to reserves above $1.5 trillion–or only $500 billion less than the current level. We estimate a linear relationship for simplicity, but nonlinearities likely exist in this relationship, and would likely mean that the spread could compress to zero at an even higher level of reserves. 

(2) Buy-side and sell-side market participants also think that the level of reserves should not fall below $1.5  trillion for the funds rate to safely trade below the IOER rate (Figures 5 and 6). 

A higher neutral level of reserve balances–that is, the minimum quantity of reserves necessary to keep rates near the floor created by IOER– implies an earlier end to runoff. Governor Quarles recently warned of this:  “Greater longer-run demand for currency, reserve balances, or other liabilities implies an earlier timing of balance sheet normalization and a higher longer-run size of the balance sheet” (May 4). The current level of reserves is $2 trillion so could be only $500 billion away from that threshold. (As assets shrink, on the  liabilities side the decline will be in reserves and not currency, which grows exogenously.) The balance sheet will likely shrink by $400-$500 billion over the next year, which suggests that the FOMC could terminate or reduce runoff earlier than initially anticipated, likely in 2019. This would bring the balance sheet policy back into the foreground despite repeated assertions that it would be in the background. But the hit to credibility if  EFFR trades too high is even more serious.  

All else being equal, reduced or earlier cessation of balance sheet normalization could put some downward pressure on the long end of the curve and exacerbate any perceived flattening/inversion issue (to the extent that it is relevant for policy). And that’s assuming no contemporaneous changes in funds rate policy. For a  given amount of the desired tightening, using less of one policy lever to tighten (runoff) would normally imply using more of the other policy lever (rate hikes). But there is likely a fairly high bar for speeding the pace of rate hikes on this account, especially past neutral. Accelerating rate hikes would flatten or invert the curve more and also increase the risk of policy being seen as excessively tight, which might prompt further downward pressure on the long end. Indeed, at least for those FOMC participants who are most intent on limiting the flattening of the curve, more downward pressure on the long end might make a slower pace of rate hikes more appealing, at least in the short run. If you want a steeper curve and you can’t raise the long end, then limit the updraft in the short end. But that option brings additional overheating risk. 

One way to maintain a higher level of reserves but still remove duration from the balance sheet, thereby continuing to normalize that aspect of the balance sheet, would be to replace the agency MBS and Treasury notes/bonds running off with Treasury bills. It would be an elegant means of conveying the distinction  between a secular, trend-driven expansion of the balance sheet (bills) and a cyclically-driven asset-purchase program (coupons).

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