FINANCIAL TIMES → An exit strategy for the Fed

Posted by John McDermott on Apr 01 21:15.

We have all the tools we need to achieve a smooth and effective exit at the appropriate time.

Ben Bernanke, Semiannual Monetary Policy Report to the Congress, March 1, 2011

Friday’s decent jobs report and accompanying hawkish cacophony have encouraged further talk about when the Fed will raise rates and revert to a place called normalcy.

But what of the how?

In a research note out Thursday, Credit Suisse’s Neal Soss and Dana Saporta look at the tools the Fed can use as it totters along “a long and winding road” back to “normalisation”. (If anyone remembers what that looks like, please let us know.)

First, cast your mind back to February 2010, when QE1 was nearing its end. The Fed raised the discount rate 25bps to 0.75 per cent, increasing the spread over the fed funds target rate to 50bps. It floated further increases but was soon overwhelmed by the eurozone crisis and, then, QE2.

Last year’s false start reminds us that the Fed’s exit attempt, like that of the Bronx Zoo snake, will be non-linear and could come to an abrupt halt should conditions change.

Nevertheless, here’s what Credit Suisse surmise as the main weapons available to Bernanke et al:

1. rhetoric / altered policy language

2. bank reserve neutralization (reverse repos; term deposits)

3. reserve draining / balance sheet shrinkage (suspension of MBS reinvestments; suspension of maturing debt rollovers; outright asset sales)

4. interest rate hikes (raising the interest rate paid on reserves and hoping the fed funds rate follows IOR higher)

And here is an exit chronology the authors tentatively propose:

Q2-2011 – Fed completes $600bn large-scale asset purchase program (QE2)

Q4-2011/Q1-2012 – Fed suspends reinvestments of MBS and Agency debt proceeds, allowing for passive balance sheet shrinkage; FOMC alters “extended period” language

Q1-2012/Q2-2012–- Fed neutralizes significant fractions of excess reserves via large term reverse RPs and term deposit accounts

Q3-2012/Q4-2012 – Fed initiates hikes in IOR and in its target range for the fed funds rate

Q1-2013 – Fed begins selling MBS and perhaps Agency debt securities

Late 2013 – Fed considers selling Treasuries

Note that in this scenario interest rate rises aren’t scheduled until late 2012. The authors say this is because of a couple of important constraints built into the any exit chronology.

Firstly, the slippage between the IOR and the effective fed funds rate:

We’ve looked at the odd goings on with federal funds rate before. Credit Suisse write that the Fed is convinced the problem could be tackled with fewer excess reserves in the banking system. “For this reason, we anticipate the Fed will begin draining and neutralizing bank reserves before it hikes interest rates,” predicts the report.

Secondly, semantics. The authors point out that the FOMC has said conditions warrant “exceptionally low levels for the federal funds rate for an extended period” since March 2009. And then make the reasonable point that:

Surely, the Committee would need to alter its forward-looking wording in some way before committing to the pursuit of higher short-term rates. The risk is that this language change will precede active normalization moves by a much shorter period than the words “extended period” would imply – maybe by only a month or two.

We’re not convinced this would override a decision to raise rates should the fundamentals dictate it — but it’s an interesting insight nonetheless.

And to put it mildly, there are also exogenous factors that could complicate further the endogenous constraints described here.

Full note in the usual place.

Related links:The fight over interest on reserves – FT Alphaville
Being Ben Bernanke – FT Alphaville
QE2 coverage – FT Alphaville

This entry was posted by John McDermott on Friday, April 1st, 2011 at 21:15 and is filed under Capital markets, People. Tagged with ben bernanke, Fed, federal funds rate, federal reserve, FOMC, interest rates, qe2, QE3.