This time it is not just about whether to hike or not to hike. There are quite a few indications that the glut of T-bills are also affecting the monetary policy stance.
As I write this the Federal Reserve (FED) has just hiked the Federal Funds Rate target range to 2 – 2.25%. Since the move was widely expected, most analysts got started parsing the statement and digesting FED chairman Powell’s every word to get some lead on how FED policies will be conducted over the coming year. Importantly, with the latest hike the FED has passed the lowest of the long-run estimates for the FFR (including the central tendency lower range) and is, therefore, in some type of neutral rate range. The FED admitted as much, removing the adjective ‘accommodative’ when describing the monetary policy stance.
Source: The Complete Works of Alexander Pelle
With nascent signs of (wage) inflation and still strong growth and labor markets this has implied some tensions, both within the FED and among financial market commentators. Financial market pricing, also noticeable from the OIS-pricing in the graph above, is that FED will hike to the long-run median target and pause indefinitely. However, in a speech by Deputy Governor Lael Brainard a couple of weeks ago, another approach was highlighted – that of separating between long run and short run neutral rates. The gist of the argument is that the FED is free to continue to hike past the long run neutral rate as the short run neutral rate is elevated by tax cuts and another stimulus. Many of the FED-speakers have, it seems, started to warm up to this idea. That said, at the presser following the decision, Governor Powell commented on these ideas with an honest, but less than constructive: “It’s very possible… It depends”. I believe it means that Governor Powell will endorse continued hikes for as long as economic outcomes stay benevolent. (An alternative take is that he will endorse hikes until we know the FED has made a policy mistake.)
In addition to these discussions, there are also market murmurs on the effects on excess reserves and the overall monetary policy stance from Trumpian fiscal policies – especially taking the FED’s balance sheet tightening into consideration.
Obviously, fiscal developments are creating tremors in the FED’s floor system as the higher T-bill rates soak up excess liquidity (at least as long as Interest On Excess Reserves, IOER, is lower than the T-bill rate). One way of illustrating these developments is when plotting the overnight treasury repo rate against the IOER (and the FFR Target rate bands).
As can be seen, while reserves in the system were still ample the IOER was identified as a ceiling but as Treasury issuance has increased in 2018 the IOER has become more of a floor. In the simplest possible terms: It seems that banks have found more profitable ways to put their reserves into good use (buying T-bills) than lending them back to the FED. If ‘excess’ liquidity was indeed excessive, this should not be happening, and the issuance should be dwarfed by the sheer volume of reserves.
Now, as indicated, maintaining the floor system, and keeping the FED’s desired amount of total reserves in the banking system requires that the IOER is set at a higher level than comparable market interest rates. If that doesn’t materialize, there is of course a chance of a swifter inflation process (as banks will prefer to lend out, increasing demand, raising inflation and so on and so forth). I believe, however, that this is more of a fiscally induced shift by banks. Banks are allocating from holding excess reserves into treasuries, due to the price (and risk) premia currently paid on T-bills. When this ‘arbitrage’ opportunity is exhausted, we will simply – and only – see a different composition of banks’ total reserves.
A compositional change could even have been one of the objectives with the relatively smaller (20bp) hike of IOER back in June (when the dark-blue line dips below the upper band in the graph above) since it makes it even more interesting to hold treasuries (or other assets) relative to reserves.
What will be interesting is the way the FED responds if there are not as many excess reserves as generally believed. If they do nothing the supply of liquid T-bills will continue to force (o/n) the federal funds rate upwards until it breaches the upper band of the target range. To be clear, that would constitute an autonomous tightening of monetary policy and serves to explain why *something* must be done.
From my viewpoint, there are two complementary ways of addressing this issue. The better and more sustainable approach is to institute a new monetary control system with, for example, a new repo facility complementing the current reversed repo facility (in the likes of, i.a., the Riksbank), Another, short-term and less controversial solution would probably be to stop – at least temporarily – shrinking the FED balance sheet. This would hopefully maintain enough excess reserves for banks to divert into treasuries and would also give the FED time to work on a longer-term solution.