Colleagues,
This is a bit of a dog’s breakfast, but I have some observations to share on three different topics: next week’s FOMC communications, a standing repo facility, and reduced transparency. Sorry about the length.
FOMC communications
Even though the message the FOMC will convey next week with the statement and the press conference will largely be one of an unchanged stance – steady as she goes, patient, observe incoming data – I expect them to shade the language in order to increase a bit, but not too much, the odds that the market puts on further tightening this year.
To me, the significant dovish shift by the Committee in December and January only makes sense as largely a response to increased downside risks, particularly from abroad. But in recent weeks, those risks appear to have declined somewhat. The Chinese economy looks stronger, Europe a bit less scary, and the soft patch in U.S. growth appears to be behind us.
Under those circumstances, the Committee may be concerned that the market now puts only about 15 percent odds on an additional tightening this year (and the mean outlook is for an easing). As I’ve noted before, while the Committee is thrilled to deliver an easing surprise, it is never willing deliver a tightening surprise because of concerns that the increase will cause financial turmoil. As a consequence, if the market does not price in sufficient odds of a tightening, the Committee is boxed in. Of course, they also don’t want the odds to be too high, in large part because they don’t see a tightening as imminent or inevitable. The sweet spot to keep the Committee’s options open seems to be about 30 percent odds of a tightening (that probability is then managed higher in advance of any actual tightening to prevent a surprise).
More broadly, the Committee is probably, at least I hope, thinking about the fact that they need two to three tightenings just to get back to neutral, the unemployment rate is a percentage point below the NAIRU, and the Phillips curve appears to be very flat. If inflation were to start edging up, the Committee could find itself needing to tighten both quickly and considerably to keep inflation from ending up well above the Committee’s target of 2 percent.
The job of Chairman Powell to convey this subtle shift may have been made more challenging by the Committee having put limits on what he can say in press conferences following meetings without a new set of FOMC forecasts (known as “the Summary of Economic Projections” or “SEP”). January was the first such press conference that did not coincide with an SEP. Adding non-SEP press conference not only doubled the number of press conferences, it added ones with less Committee-agreed material to discuss.
Post-meeting press conferences shift power to the Chairman at the expense of the Committee because, while the Committee votes on the post-meeting statement and the minutes, the Chairman controls the press conference. It would be natural, therefore, if the Chairman and the Committee discussed the bounds of his non-SEP press conferences. Chairman Powell appears to have agreed with the Committee that he would discuss (quoting from the January press conference)
“…decisions we made today, as well as our ongoing discussions of matters on which we expect to make decisions in coming meetings.”
I suspect that it was important to the Committee that the Chairman not speculate about the likely outcome of decisions that had not yet been made because doing so could lock the Committee in. Indeed, when Steve Leisman asked if the Committee had discussed any specific possible change in balance sheet policy, the Chairman repeated
“Okay. So, today I’m here to talk about decisions and also discussions about decisions that haven’t been made. So we’re talking about the latter thing, which is discussions and so I can’t get ahead of where decisions are.”
Turning to the balance sheet, it seems inevitable that the Committee will provide more details on how, exactly, it will have stopped rolling off securities as they mature by September (as they said they intend to do).
We may also learn more about the prospects for a standing repo facility next week. The minutes of the March FOMC meeting stated that “Some participants suggested that, at future meetings, the Committee should discuss the potential benefits and costs of tools that might reduce reserve demand or support interest rate control.” If April/May is the “future meeting” then Chairman Powell may give a readout of the discussion and any decisions at the post-meeting press conference.
Standing reverse repo facility
In two recent blog posts (here and here), two Fed economists, David Andolfatto (St. Louis Fed) and Jane Ihrig (Board) argue that the Fed should have a standing repo facility as part of its new monetary policy implementation framework to both reduce reserve demand and increase interest rate control. The facility would allow commercial banks to conduct Treasury repos with the Fed at a known price. The Federal Open Market Committee has stated in minutes to the December, January, and March meetings that it is considering additional tools along the lines of a standing repo facility.
I emailed last month about the first blog post. The second post provides additional information on how they judge a standing repo facility could reduce the demand for excess reserves. In particular, Ihrig and Andolfatto argue that if the facility existed, banks should be able to anticipate using it in resolution, so supervisors should be comfortable if banks held Treasuries rather than reserves to meet resolution liquidity requirements.
While I agree that that would help, the facility would also have to reduce the stigma associated with borrowing from the Fed. At a BPI symposium in January, several bank participants indicated that their demand for excess reserves was determined by a determination to never again borrow from the discount window, and a standing repo facility is just another way to borrow. For a variety of reasons, there has always been a stigma associated with borrowing from the discount window, and that stigma intensified sharply following the financial crisis because of public vilifications of institutions that borrowed. A recent study by the New York Fed concluded that if banks are unwilling to borrow from the discount window they need up to $934 billion in excess reserve balances to cover potential day 1 stress outflows.
I discussed in my previous email reasons why a standing repo facility could be subject to less stigma than the discount window, although, as I explain a bit more below, stigma is a tough nut to crack.
Ihrig and Andolfatto also provided their views on how the facility should be designed. They state that the facility should be available to the large banks that file living wills (although note that other counterparties could also be included), should accept on Treasury securities, and should charge a rate only a few basis points above market repo rates (to discourage everyday usage).
Based on my experience with the 2003 revamp of the discount window, the Fed may find it challenging to find an acceptable joint solution for the design parameters. First, it would be politically impossible to offer the facility only to large banks—all banks will have to have access. If all banks have access, then the interest rate will have to be more than a few basis points above market rates to avoid community banks seeing the facility as an attractive source of ongoing funding. There are thousands of small banks, the vast majority of which own Treasury securities but don’t have access to repo markets. Moreover, if the facility is available for banks in resolution, then it can’t have a financial soundness requirement (Ihrig and Andolfatto’s earlier post said the facility would be for banks in “good standing”).
For small or weak banks, the spread needed to deter frequent borrowing will have to be high. In 2003, even with a financial soundness requirement, we concluded that a spread of 100 basis points was needed. (The spread for a Treasury repo facility could be a lower than for the discount window which accepts all bankable assets as collateral.) The alternative to a high rate would be rules governing use. But a high rate and rules about use contribute to stigma. It’s a very tough problem to solve.
Reduced transparency
Last week, the New York Fed released its annual report on open market operations in 2018. What’s striking about the report is what’s missing. The previous four reports all included forecasts of the Fed’s balance sheet and net income under different assumptions about the operating framework and the path for interest rates. Those projections were not included in the 2018 report. Instead, there is a note (page 3) stating that the projections would be provided later in the year when the Fed’s balance sheet plans were finalized.
The delay is an unfortunate reduction in transparency at a time when the Fed is actively seeking public input on its implementation framework. Indeed, the minutes from the December FOMC state:
Participants considered it important to present information on the Federal Reserve’s balance sheet to the public in ways that communicated these facts. In discussing the long-run level of reserve liabilities, participants noted that it might be useful to explore ways to encourage banks to reduce their demand for reserves and to provide information to banks and the public about the likely long-run level of reserves.
One of the most problematic things about implementing policy using a floor system, as the FOMC intends to do, is the optics of the enormous interest payments to banks the Fed will have to make. (In a floor system, the Fed holds such a large portfolio of securities that the correspondingly large supply of excess reserves pins market rates to the “floor” set by the interest rate the Fed pays on those reserves (the IOER rate) A primer on the Fed policy implementation can be found here.). Over the past year, as some tightness in the market for reserves has materialized sooner than expected, estimates of the minimum level of excess reserves needed to operate a floor system have jumped from about $500 billion to about $1 trillion, so the projected interest payments should also have doubled.
Moreover, it seems possible that current projections for net income could be negative under some scenarios now. Last year’s projections showed a sharp drop in remittances to Treasury under a “higher rates” scenario. The current report indicates that the Fed’s domestic portfolio has already shifted from having unrealized net gains to having unrealized net losses. The combination of higher reserves and more embedded losses could combine to a unflattering projection for future earnings.
If the Fed decided to hold off on providing the projections in part because the numbers were uncomfortable, they should be thinking twice about implementing policy with a floor system.
A similar apparent regression in transparency has occurred in the Fed’s communications about financial stability and the implications for its setting of the countercyclical capital buffer (CCyB), an additional 2½ percentage points that the Fed can add to capital requirements. In the regulation implementing the CCyB, the Fed describes in only general terms the complex and judgmental method it intends to follow to determine if conditions required for raising the CCyB have been met – if “systemic vulnerabilities are meaningfully above normal.” The Fed indicates that the public could determine the Fed’s conclusion by reading its twice-yearly “Monetary Policy Report” (MPR) to Congress, which includes a section on financial stability.
In addition, the Board’s biannual Monetary Policy Report to Congress, usually published in February and July, will continue to contain a section that reports on developments pertaining to the stability of the U.S. financial system. That portion of the report will be an important vehicle for updating the public on how the Board’s current assessment of financial system vulnerabilities bears on the setting of the CCyB.
When the Fed adopted the regulation, and through February 2018, the financial stability assessment in the MPR began with a sentence summarizing the overall state of financial stability risks. For example, the July 2016 report states “Financial vulnerabilities in the United States overall remain at a moderate level.”
The staff also provides the Board and then FOMC a quarterly briefing on financial stability, and the minutes to those FOMC meetings included a short summary of the assessment beginning with a judgement about overall conditions. For example, the minutes to the November 2018 FOMC indicated “The staff provided its latest report on potential risks to financial stability; the report again characterized the financial vulnerabilities of the U.S. financial system as moderate on balance.”
Unfortunately, the financial stability section of the July 2018 MPR did not include an overall assessment of systemic vulnerabilities, nor did the Board’s Financial Stability Report in November. In the remarks quoted above, Chairman Powell finessed that absence by describing his own overall assessment based on the report and pointing to the staff judgement in the November 2018 FOMC minutes. However, despite significant developments bearing on financial stability at the end of 2018 including an easing of some asset price pressures but also increased volatility, the financial stability section of the minutes of the January 2019 FOMC omitted an overall assessment.
It seems likely that the Board and the FOMC have stopped providing an overall assessment of systemic vulnerabilities because of difficulties agreeing. In April 2018 and again in December 2018, Governor Lael Brainard gave a speech calling for CCyB to be increased and in March 2019 she voted against the Board’s decision to keep the CCyB at zero.
For the public to understand the Board’s evolving thinking on the level of financial stability risks and therefore the prospects that the CCyB be raised or lowered, it is necessary that the Board provides an overall assessment of those risks. A simple numeration of the current risks and strengths of the financial system is insufficient.
Again, sorry for such a long, rambling email. Comments and questions welcome (or just a simple “unsubscribe”!)
Bill
