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Normalizing Monetary Policy Simon Potter The University of Chicago Booth School of Business May 19, 2015 The views expressed in this presentation reflect the author’s and do not necessarily reflect that of the Federal Reserve Bank of New York or the Federal Reserve System. 1 Disclaimer The views expressed in this presentation are my own and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System. 2 Agenda Section 1: The Markets Group at the New York Fed Section 2: Unconventional Policy & the Fed’s Portfolio Section 3: Money Markets Section 4: Normalizing Monetary Policy 3 Section 1: The Markets Group at the New York Fed 4 Preamble to the Federal Reserve Act “Act to provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes” 5 Federal Reserve History The Federal Reserve was created to “solve a currency problem” The supply of currency did not expand and contract with the needs of the economy/financial system The Federal Reserve Act of 1913 12 Federal Reserve Banks created to manage money supply Banking Act of 1933 (revised 1935) formed the Federal Open Market Committee (FOMC) A new government agency to direct open market operations for the Federal Reserve system The 7 members of the Board of Governors The President of the FRBNY 4 of the remaining 11 reserve bank Presidents, on a rotating basis Bank Holding Company Act of 1956 named the Fed the regulator of bank holding companies owning more than one bank 6 Functions of the Federal Reserve System Monetary policy goals of price stability and maximum employment The longer-run inflation objective of 2 percent is deemed consistent with the Federal Reserve’s mandate Assessment of the maximum level of employment is based on a wide range of indicators Supervise and regulate banking institutions Provide financial services to depository institutions, the U.S. government, and foreign official institutions Payments systems – Fedwire More recently, a focus on maintaining stability in the financial system and containing systemic financial risks 7 Federal Reserve Organization President of FRBNY Member of Board of Governors Members of FOMC Markets Group/ SOMA Mgr. Discount Window and Collateral Valuation Gives direction to Markets Operations, Monitoring, and Analysis Members of Other Reserve Bank Presidents Central Bank & International Account Services 8 The Markets Group’s Mission Monetary policy implementation Manage Federal Reserve balance sheet and execute open market operations (OMO) consistent with FOMC directives Includes swap lines, exchange rate intervention, foreign reserves management Monitor and analyze financial market and financial stability developments Lender of last resort responsibilities Discount Window for the 2nd District Collateral valuation services for Federal Reserve Banks Fiscal agent support for the U.S. Treasury Provide debt issuance, debt management advisory, foreign exchange services and foreign reserves management Account services to foreign central banks, international agencies, and U.S. government agencies 9 Monetary Policy Implementation Implement policy through domestic open market operations (OMOs) FOMC votes on domestic monetary policy directive Directive establishes an operating objective for OMOs Desk designs and conducts OMOs to achieve the objective SOMA Manager accountable to the FOMC Market monitoring supports policy formulation and execution OMOs include Repurchase agreements (RPs): temporary loans to primary dealers using all eligible securities as collateral Reverse repurchase agreements (RRPs): temporary loans from primary dealers against general collateral Outright transactions: permanent purchases or sales of securities 10 How Do We Implement Monetary Policy? We have 22 trading counterparties used to conduct domestic open market operations, called “primary dealers” Includes banks and securities broker-dealers Required to participate consistently in open market operations and provide trading desk with market information Also participate in US Treasury auctions Currently running a pilot program that includes smaller firms Also have 141 “expanded counterparties” used only for RRP operations Includes banks, government-sponsored enterprises, and money market mutual funds 11 Section 2: Unconventional Policy & the Fed’s Portfolio 12 The Markets Group During the Financial Crisis Discount window lending to banks increased dramatically Designed and implemented variations on traditional “lender-oflast-resort” function Auction term funds to depository institutions (TAF) Lend Treasury securities from Fed’s portfolio on weekly basis (TSLF) Overnight collateralized loans to primary dealers (PDCF) Bilateral currency swaps with major foreign central banks Designed and implemented tools to support credit markets Provide liquidity to U.S. issuers of commercial paper (CPFF) Provide liquidity to U.S. money market investors (MMIFF) Boston Fed provided liquidity to U.S. banks to finance purchases of ABCP (ABCP MMMF LF) Lend to holders of consumer and small business ABS (TALF) 13 Large-Scale Asset Purchases as a Policy Tool Purchases put downward pressure on longer-term interest rates, eased financial conditions, and stimulated economic activity Purchases are understood to work through several channels Portfolio balance effect Reduce stock of securities held by private sector Remove duration risk and prepayment risk from market Drive risk premiums lower than they would otherwise be Market functioning/liquidity effect (LSAP1) Provide consistent and significant market presence Signaling effect May be perceived as signal of the FOMC’s intentions for the federal funds rate path 14 Timeline of Fed Securities Holdings & Asset Purchase Programs $ Billions 5,000 LSAP1 LSAP2 MEP LSAP3 4,500 Start of LSAP3 for agency MBS 4,000 3,500 3,000 2,500 2,000 1,500 Reinvest agency MBS/debt in MBS Reinvest agency 1,000 MBS/debt in Treasuries 500 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: FRBNY 15 Evolution of the Federal Reserve’s Balance Sheet Liabilities Assets Other Liabilities Reserve Balances F.R. Notes $ Billions 5,000 5,000 4,500 4,500 4,000 4,000 3,500 3,500 3,000 3,000 2,500 2,500 2,000 2,000 1,500 1,500 1,000 1,000 500 500 0 2005 2007 2009 2011 Other Assets* MBS Agencies Treasuries $ Billions 2013 Source: Federal Reserve Board of Governors 2015 0 2005 2007 2009 2011 2013 2015 *Includes crisis facilities. 16 Maturity Distribution of SOMA Treasury Holdings Percent December 2014 August 2007 80 70 60 50 40 30 20 10 0 Less than 3 years 3–6 years 6–10 years 10–30 years TIPS FRNs Source: Federal Reserve Bank of New York 17 SOMA Net Income and Fed Remittances to Treasury SOMA net income $ Billions Remittances 120 100 80 60 40 20 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: FRBNY 18 H4.1: Assets of All Federal Reserve Banks Source: Federal Reserve http://www.federalreserve.gov/releases/h41/Current/ 19 H4.1: Liabilities & Equity of All Federal Reserve Banks Source: Federal Reserve http://www.federalreserve.gov/releases/h41/Current/ 20 Implications for Open Market Operations LSAPs raised new operational challenges for the Desk New, more complex instruments (agency MBS) Increased frequency and size of operations However, the fundamental approach has remained the same Seek competitive pricing and cost efficiency Manage risks Be mindful of disruptions to financial markets Be consistent, predictable, and transparent Innovate and adjust operations as needed 21 Additional Operational Considerations Market functioning Monitor effects of purchases on market conditions, results Conduct securities lending and dollar rolls Transparency Release planned operation schedules in advance Release aggregate operational results and prices paid Release summary of individual transaction details monthly Release full transaction details with a 2-year lag Operational risk management and resiliency Ensure robust controls Provide end-to-end resiliency for mission-critical operations 22 SOMA Holdings as a Share of Outstanding Supply Percent SOMA Treasury Holdings as Share of Outstanding Supply December 2014 SOMA Agency MBS Holdings as Share of Purchasable Universe December 2014 Percent 60 60 50 50 40 40 30 30 20 20 10 10 0 0 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 Coupon (percent) Remaining Maturity (years) Source: Federal Reserve Bank of New York 23 Global Asset Purchases Bank of Japan Expanding the monetary base by ¥80 trillion rate per year since October 2014 Purchases include JGBs, commercial paper, corporate bonds, ETFs and JREITs “Will continue with the QQE, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner” Balance sheet is currently about 62% of GDP while securities holdings were about 41% of GDP at end-2014 European Central Bank Purchase €60 billion per month beginning in March 2015 Purchases will include euro-denominated sovereign bonds, ABS, and covered bonds Intend to continue purchases “until end-September 2016” or in any case until “a sustained adjustment in the path of inflation” is achieved Balance sheet is currently about 22% of GDP while securities holdings were only about 2% of GDP at end-2014 24 Section 3: Money Markets 25 Money Markets Wholesale market for low-risk, highly liquid, short term loans Banks and other participants trade in excess of a trillion dollars daily Money market rates influence other interest rates: U.S. government funding costs Corporate funding costs Interest rate on retail deposits Monetary policy is largely transmitted through money markets The Federal Reserve directly changes the supply of reserves\sets administered rates to impact money market rates, thereby changing financial conditions in the real economy Administered rates are expected to be used during policy normalization given the size of the Fed’s balance sheet 26 Money Markets Short-term wholesale funding markets provide financial intermediaries with funds that supplement retail deposits and long-term debt issuance. Motivations to borrow in funding markets: To finance assets To meet liquidity needs Earn a spread by lending borrowed funds at a higher rate (e.g. fed funds “IOER arbitrage” trades) Who lends in funding markets? Institutions seeking returns on their cash positions (e.g. banks, GSEs, MMMFs, Securities Lenders, corporates etc.) Transactions can be secured or unsecured Money market rates reflect short-term marginal borrowing costs, influence yields on longer-term assets (e.g. Treasury yields) 27 Types of Money Market Transactions Unsecured – no collateral pledged by the borrower to obtain the loan Federal funds Eurodollars Commercial paper Negotiable certificates of deposit Secured – collateral is pledged by the borrower to obtain the loan Repurchase agreements (Repo markets) 28 Unsecured: Federal Funds What are Federal Funds? Unsecured loans of reserve balances at Federal Reserve Banks of eligible institutions Governed by the Board of Governors of the Federal Reserve System’s Regulation D (imposes reserve requirements on depository institutions) Most borrow funds to leave balances at the Fed for liquidity buffers and IOER The Fed does not transact directly in the federal funds market Brokered Federal Funds Volume and Reserves Index* $ Billions 3,000 300 Trading Volume (RHS) Total Reserves (LHS) 2,500 250 2,000 200 1,500 150 1,000 100 500 0 2006 50 0 2008 2010 2012 2014 *Indexed to 1/2/2009 Source: Federal Reserve H.4.1, FRBNY Market Participants Depository Institutions, Banks, Thrifts eligible to Lend, Borrow, and receive IOER Agencies & U.S. branches of FBOs eligible to Lend, Borrow, and receive IOER Federal Agencies (GSEs) eligible to Lend Government Security Dealers eligible to Lend http://libertystreeteconomics.newyorkfed.org/2013/12/whos-lending-in-the-fed-funds-market.html 29 Unsecured: Other U.S. Dollar Funding Markets Eurodollar deposits: unsecured U.S. dollar deposits in a bank or bank branch outside the U.S. – frequently Cayman Islands Eurodollar deposits are used to finance U.S. dollar assets held “outside” of the U.S. Commercial paper: short-term debt (<9 months) issued by both financial and non financial institutions Certificates of deposit: term deposits placed with a depository institution with maturity profiles ranging from 7 days to 5 years 30 Collection of Money Market Rates The FRBNY collects brokered overnight federal funds transactions to calculate and publish the federal funds effective rate Data collected from brokers that represent a subset of the federal funds market FRBNY and FR Board finalized new data collection requirements during 4Q 2013 (FR 2420) Since April 2014, daily transaction is collected on federal funds, Eurodollar time deposits, and certificates of deposit (CDs) of all tenors1 Data collection covers insured depository institutions with total assets of $26 billion or more, and U.S. branches and agencies of foreign banks with third party assets of $900 million or more Data collected accounts for approximately 80 percent of total fed funds outstanding 1) CD Data is expected to be reported with a 2-day lag; Fed funds and Eurodollar time deposits are reported with a 1-day lag. 31 FR 2420 Data Collection FR 2420 data can improve the process for producing the federal funds effective rate and be a more representative benchmark rate Higher transactions volumes Transaction level detail for better data monitoring FR 2420 and brokered FFER levels largely similar Source: http://libertystreeteconomics.newyorkfed.org/2015/04/the-fr-2420-data-collection-a-new-base-for-the-fed-funds-rate.html 32 FR 2420 Data Collection The overall distribution of rates is also quite similar The majority of transactions occur close to the brokered FFER Transactions occurring substantially away from FFER account for smaller percentage of overall volume 33 Secured: Repurchase Agreement (Repo) What is repo? Economically similar to a collateralized loan Sale of securities together with an agreement to buy back at a later date Securities dealers finance positions, intermediate cash and securities flows (matchedbook) Tri-party & delivery vs. payment (DVP) Tri-party: settle through clearing banks DVP: settle bilaterally 34 Secured: Repurchase Agreement (Repo) Primary mechanism for temporarily adding or draining reserves – indirectly affect fed funds rates Repo – dealer borrows funds and pledges collateral to lender Reverse Repo – dealer lends funds and receives collateral from borrower Rate on Fed RRP an important component of the Federal Reserve’s normalization strategy New York Fed has long offered foreign official accounts repo against SOMA collateral, known as the foreign RP pool 35 Section 4: Normalizing Monetary Policy 36 Reserve Balances and the Fed Funds Rate (pre-crisis) 37 Interest Rate Control: Pre-Crisis Federal Funds Target Rate Federal Funds Effective Rate Percent 8 7 6 5 4 3 2 1 0 2000 2001 2002 2003 2004 2005 2006 2007 Source: Federal Reserve Board of Governors, Federal Reserve Bank of New York 38 Difficulties of Large Reserve Balances Reserve Balances $ Billions 3000 2500 2000 1500 1000 500 0 2005 2007 2009 2011 2013 2015 Source: Federal Reserve Board of Governors 39 New Tools in Large Excess Reserve Environment Interest on Excess Reserves (IOER) Original authorization granted in 2006 to be applicable on reserve balances starting Oct 2011, accelerated to Oct 2008 IOER is paid to depository institutions on reserve balances in excess of the reserve requirement Initially Only rate 0.75%, 0.25% since Dec 2008 available to depository institutions Theoretically, if all money market participants had access to deposits earning this risk-free rate, this would serve as a floor on rates. However, non-banks are large participants in the federal funds market. These include: money market mutual funds (MMMFs), Government Sponsored Enterprises (GSEs), and Federal Home Loan Banks (FHLBs) 40 Overnight Interest Rates Treasuries – DTCC GCF Repo Index® Federal Funds Effective Rate Interest on Excess Reserves Percent 0.5 0.4 0.3 0.2 0.1 0.0 01/01/10 01/01/11 01/01/12 01/01/13 01/01/14 01/01/15 Source: Federal Reserve Bank of New York, The Depository Trust & Clearing Corporation 41 New Tools Focused on Draining Reserves Term Deposit Facility (TDF) Offers fixed quantities of term deposits through competitive auctions Only available to depository institutions Does not change the size of the balance sheet, but alters the composition of liabilities by substituting reserves for TDFs Term and overnight fixed-quantity Reverse Repos (RRPs) Allows the withdrawal of reserves by temporarily selling securities from the SOMA portfolio under an agreement to repurchase the securities in the future Economically equivalent to a collateralized loan made to the Fed by a financial institution Historically infrequently used with primary dealers. In Oct 2009, Fed announced offering RRPs to an expanded set of counterparties. Small scale operational exercises of fixed quantity since 2009 Each dollar of RRPs held by counterparties reduces one-for-one reserves held by financial institutions 42 Overnight Reverse Repurchase Agreement Exercises In September 2013, the FOMC authorized a series of daily ON RRPs at a fixed rate with a capped allotment to explore whether an ON RRP facility could provide greater control over short-term interest rates by setting a floor on money market rates Testing currently authorized by FOMC through January 2016 There are 163 eligible counterparties, including the traditional 22 primary dealers, banks, GSEs and MMMFs More usage by MMMFs (cash to invest, no access to IOER) Increased take-up around reporting (e.g. quarter- and yearend) dates Evidence of increased usage when spread to market rates narrowed 43 Percent 0.3 Treasuries - DTCC GCF Repo Index® Fed funds effective rate Rate of interest on excess reserves ON RRP offering rate 0.25 0.2 0.15 0.1 0.05 0 2013 2014 2015 Five-day moving averages except for ON RRP offering rate. Sources: Federal Reserve, The Depository Trust & Clearing Corporation. 44 Cumulative Distribution of ON Fed Funds Volumes during Rate Test, by Rate ON RRP offering rate = 5 bps (pre-test) ON RRP offering rate = 7 bps (test period) Percent of Volumes ON RRP offering rate = 10 bps (test period) 100 80 60 40 20 0 0.00 0.02 0.04 0.06 0.08 Rate (%) 0.10 0.12 0.14 Pre-test period captures rate distributions in October 2014. Test period for an ON RRP offering rate of 7 basis points was November 17 to November 28, 2014, and for a rate of 10 basis points was December 1 to December 12, 2014. Source: Federal Reserve (FR 2420). 45 Term RRP Testing October 2014: FOMC instructed the Desk to examine how term RRP operations might work as a supplementary tool Could help control the federal funds rate and reduce potential volatility in money market rates, particularly around quarter- and year-end Conducted 4 operations over the December 2014 year-end, with a maximum total size of $300 billion Conducted 3 operations over the March 2015 quarter-end, with a maximum total size of $200 billion January 2015: FOMC instructed the Desk to conduct operations that do not cover quarter-end, to enhance operational readiness and increase understanding of the tool 46 Reverse Repos Outstanding USD, billions ON RRPs Term RRPs 400 350 300 250 200 150 100 50 0 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Temporary open market operations only. Source: FRBNY. 47 Normalization Strategy FOMC participants agreed on the following elements of the approach to normalization Will raise target 25 bps range for fed funds rate when conditions warrant Intends to control fed funds rate primarily using IOER at top of range Intends to use ON RRP facility and other supplementary tools as necessary, offer rate at bottom of range - Elevates capacity of ON RRP facility at liftoff - Will phase out ON RRP facility when no longer needed Reduce securities holdings in a gradual and predictable manner Expects to cease or commence phasing out reinvestments after first increase in target range Does not anticipate selling MBS Will hold no more securities than necessary in the longer run; those securities will primarily be Treasuries Prepared to adjust details to normalization as necessary 48