Tuesday, January 8, 2019

"Fed's Portfolio Manager Says Not to Worry"

No need to panic. this is actually from last August, not another "ample liquidity." Mnuchin moment.
We'll have more on the Fed's balance sheet reduction next week.

From New Monetarist Economics, August 7, 2018:
I ran across an interesting talk by Simon Potter, who is responsible for the System Open Market Account at the New York Fed. Potter is a powerful person in the Fed system, as he looks after the specifics of monetary policy implementation. His talk addresses issues that I discussed in this previous blog post.

The first order of business in the talk is the phasing out of the Fed's reinvestment policy. Recall that, after the buildup in the Fed's balance sheet that occurred from 2009-2014, the size of the Fed's asset portfolio, in nominal terms, was held constant by purchasing new assets as the existing assets matured. In fall 2017, the FOMC began a phaseout of the reinvestment program which will be completed this fall. After that, the size of the balance sheet will continue to fall until the Fed either decides reduction should cease, or it resumes asset purchases. There have been no public statements about whether the Fed might choose to maintain a significant stock of excess reserve balances in the financial system (retain the current floor system) or revert to the system in place before the financial crisis, perhaps modified in some fashion.

Potter provides a useful figure that shows what happens as reinvestment is phased out, and after:
That's interesting, as it shows us how the caps on balance sheet reduction work. When the FOMC set up the phaseout in its reinvestment program, it included specific caps (increasing over time as shown in the figure) for Treasuries and for MBS. The caps limit the quantity of assets that can mature without triggering some reinvestment. Ultimately, these caps won't bind in the near term for MBS, but you can see that they matter for Treasury securities. Intuitively, caps might seem reasonable. You can see in the figure that Treasury securities on the Fed's balance sheet mature in a rather lumpy fashion, so smoothing might appear to be an OK idea. Indeed, as Potter says:
The cap-based program to normalize the balance sheet...is the mechanism by which the decline in the balance sheet is kept to a gradual and predictable pace.
But I'm wondering why this matters. The concern seems to be that if reserves fell by a large amount in a given month, this could be disruptive. Consider this though. Here's the Treasury's general account with the Fed:

Every time the balance in the Treasury's general account increases, reserves held in the private sector decrease by the same amount, everything else held constant. So, apparently reserves can move by two or three hundred billion dollars over a short time, and the Fed does not consider that disruptive, at the current time. So why do we need a cap on balance sheet reduction to prevent $20 or $30 billion of assets from running off? I think you could make a case that the caps are disruptive, as that means the Fed is engaging in on-again off-again purchases of on-the-run Treasury securities.

Next, there's an issue concerning the recent reconfiguration in overnight interest rates that I discussed in my previous post. Basically, the FOMC set up a system of monetary policy implementation with a target range of 25 basis points for the fed funds rate, bounded by the interest rate on reserves (IOER) on the high side and the interest rate on reverse repurchase agreements issued by the Fed (the ON-RRP rate), on the low side. But recently, the fed funds rate has moved up very close to IOER, and overnight repo rates have moved up close to IOER as well. Further, other than at quarter-end, there is essentially no takeup for the Fed's ON-RRPs, so the ON-RRP facility has become irrelevant - basically that "lower bound" on the fed funds rate isn't bounding anything....MORE