The minutes of the most recent FOMC meeting, released last week, have gotten much attention. This is in part because of details the Committee provided regarding its discussions about framing the processes and procedures for returning interest rates to a level consistent with its statutory mandate of stable inflation and maximum employment.
The minutes reveal the Committee’s desire to employ, as its primary policy instruments, interest on reserves, the federal funds rate, and of course the discount rate, in a corridor structure. However, the much-discussed experimental reverse repo rate is seen as playing a supportive role rather than a principal one. This reduced emphasis on the overnight reverse repo rate (ON RRP rate), a policy tool promoted by the Federal Reserve Bank of New York staff and the Open Market Desk, reflects a subdued struggle within the system over the Desk’s policy instruments and procedures. The minutes detail some of the Committee’s concerns about the ON RRP policy tool, including possible unintended market effects. For example, there is concern that, during times of stress, funding would shift from other markets to the ON RRP market, thereby further disrupting those other markets. There is also concern that the facility would be so large as to expand the Fed’s role in intermediation and to reshape financial markets in ways that are not fully predictable.
But that is only part of the import of the minutes, which also touch on the conditional, data-dependent nature of the economic developments required to signal that it is time to start returning policy to normal and on how the Committee hopes to proceed. In particular, the Committee favors a simple, gradual approach accompanied by clear communications. But this may be easier said than done.
Subsequent to the meeting, FOMC participants have begun to elaborate more specifically on what they personally will be looking for as the economy evolves and how that evolution will affect their views on the appropriate time to begin changing policy. Briefly, once the economy appears to be on a sustainable growth path with reduced slack in labor markets and inflation within a tolerable margin around the Fed’s 2% goal, the Committee would consider moving its 0-25 basis-point target for the funds rate up. Some FOMC participants as well as outside observers have suggested that the first move might be to keep a target range and simply move it up to 25-50 basis points and then gradually move the funds rate up to a level consistent with the Committee’s view of what the longer-run equilibrium rate should be. In the most recent summary of economic projections released after the June meeting, that rate was in the vicinity of 3.75% and the unemployment rate was about 5.2%.
This hoped-for strategy will obviously be data-driven; and as President Evans suggested in his presentation at the Rocky Mountain Economic Summit in Jackson Hole last week, there are several possible combinations of growth and inflation that would be acceptable courses to equilibrium.
The first step, however, is to complete the tapering process as the asset purchase program is phased out of existence. The minutes indicate that tapering is now planned to be completed in October if the economy grows as forecast. Missing from the public discussion of the minutes, however, are the differing views within the Committee as to when it should stop reinvesting maturing issues of securities in its portfolio and simply allow those securities to run off. Four options are being discussed. One is to stop reinvesting when tapering ends in October. A second is to stop after tapering ends but before the Committee begins to move the federal funds rate. A third is to stop reinvesting when it moves the funds rate for the first time, and the fourth is to stop sometime after the Committee has begun to move the funds rate.
If the Committee chooses the first option, then the Fed’s portfolio will remain at its then-current level; and policy accommodation, at least as measured in terms of the amount of reserves and liquidity it has injected into the system, will still be in effect. If the Committee chooses to let maturing issues run off, then reserves will begin to contract at pace; and policy accommodation and liquidity will be gradually reduced, reflecting a policy tightening – even without a corresponding increase in the federal funds rate. As such, this may delay the actual increases in interest rates, since a de facto modest policy tightening will already have begun.
How will markets react to the different ways that the FOMC may choose to combine, or not to combine, the end of its tapering with the decision about whether to reinvest maturing securities in its portfolio? If the FOMC chooses to reinvest when tapering is concluded, then markets will fixate on when reinvestment will stop and whether or not its end will be accompanied by a rate hike. If a rate hike occurs before reinvestment stops, then markets will focus on the timing of future rate hikes and the timing and incidence of the reinvestment decision will be of minimal importance since the policy tightening will have already begun in earnest. What is clear is that considerable uncertainty will be associated with whatever decision is made regarding reinvestment, and there is a risk that markets will react significantly to that decision and to rate hikes.
For example, if reinvestment stops with the end of tapering, then markets may interpret that as signaling future rate hikes are near, and react accordingly. Specifically, holders of large portfolios of low-yielding securities are likely to attempt to liquidate those portfolios, as they will be unwilling to see a serial decline in portfolio values while the Fed tries to figure out what to do next. In this case, the advantage of being out first dominates the marginal benefit of waiting. This outcome would likely imply a huge spike in market rates, much larger than is currently envisioned by the FOMC. But there will be essentially the same reaction to the first movement in the policy rate, regardless of whether it is accompanied by a cessation of reinvestment, because bond holders will extrapolate subsequent rate movements and act preemptively, especially if the FOMC lays out its preferred gradualist approach as part of its communications strategy.
Despite the Committee’s wishes or hopes, it is not logical to think that rates will move up only incrementally in lockstep with the FOMC’s planned gradual elevation of the federal funds rate. This is because bond managers know exactly what is going to happen to their portfolios. Consequently, they will attempt to sell as quickly as possible, knowing, as they will, based upon the FOMC’s SEP, where the Committee anticipates the funds rate will be by the time it has completed its tightening process. A likely outcome is an abrupt spike in the funds rate near the 3.75% rate the Committee has embedded in the SEP. Such a large and abrupt rate shock has significant implications for both the real economy and for financial stability. Moreover, rapidly rising rates in the US will set off a carry trade by foreign banks and investors, who will be able to borrow at low rates in their home countries and from their central banks in order to deploy funds in the US. This predictable maneuver may tend to dampen the expected movement in the term structure, but it will also lead to an increase in the dollar exchange rate, which will weaken US exports, worsen the US balance of trade, and have a depressing effect on the US real economy.
It is important to emphasize that the sequence of financial and real-economy effects outlined above are possible reactions whenever the FOMC begins it tightening process, irrespective of what that very first step is. The only difference will be the triggering event. What this means is that the planned-for exit is just a hope and may or may not be a viable strategy.