On Thursday, 31 May, the Clearing House hosted a pop-up symposium on the forces shaping money market conditions, the outlook for deposits, and the implications of and for Fed normalization and longer-run monetary policy implementation framework. The symposium was attended by leading market participants on the buy and sell sides, academics, and representatives from the Fed, Treasury, and IMF. Key takeaways were
- Frictions in money markets owing in part to the regulatory environment were slowing adjustment to an increased supply of Treasury bills and heavy repatriation flows.
- Limited data for LIBOR-fixings could be contributing to less accurate and more inertial LIBOR rates.
- If bank asset growth accelerates, LCR and resolution liquidity requirements could lead large banks to bid more aggressively for deposits, narrowing deposit spreads and tilting deposit market share toward larger banks.
- As the Fed’s balance sheet shrinks, initial signs of reserve scarcity owing to LCR-related demands were likely to show up as wider term spreads and a larger discount on liquid assets.
- Because of those demands, the Fed’s balance sheet could remain larger than the market expects, with roll off ending as soon as next year.
- Weaker arbitrage across markets resulting from regulatory changes may require the Fed to adopt a policy implementation framework that involves a larger set of counterparties and more direct control of repo rates.
Some further details from the panel moderators:
Panel 1: Forces Shaping Money Market Conditions
A number of factors contributed to the widening in the LIBOR/OIS spread that has been evident in recent months. However, the spike in T-bill issuance following resolution of the debt ceiling situation was clearly a key catalyst. The money markets are adjusting to higher bill supply but pricing going forward will depend on the volume of repatriation flows, CP issuance, dealer balance sheet dynamics, foreign bank funding behavior, and money fund inflows. The impact of shrinking reserve balances is not yet clear, but it would not be too surprising to see fed funds trade above IOER as the Fed’s balance sheet continues to normalize.
Panel 2: Deposits and FHLB loans
The panelists considered the outlook for the pricing and distribution of bank deposits. The cyclical backdrop for bank deposits and pricing is currently quite different from that prevailing in the last rate cycle, 15 years ago – loan and deposit growth are more subdued, and rates are likely to peak at much lower levels. If bank lending accelerates, LCR and resolution liquidity requirements could eventually lead large banks to bid more aggressively for deposits, thus narrowing deposit spreads and tilting deposit market share toward larger banks.
Panel 3: Fed normalization and longer-run implementation framework
The final session of the symposium focused on Fed normalization and the long-run operational framework for monetary policy. After this long period of an excess supply of central bank liquidity, a common theme among the panelists was the “great unknown”: what the demand for reserves actually looks like in light of the sizable market and regulatory changes in recent years. The panelists agreed that at the margin, new liquidity regulations, particularly the LCR, were likely the “binding” constraint in determining bank demand for reserves in the long run, but the dynamics of reserve demand were particularly uncertain because reserves are one of a number of ways that banks can satisfy liquidity regulation, particularly the HQLA requirements of the LCR. There was somewhat less agreement on what this implied for the monetary policy framework. Several panelists argued that a large Fed balance sheet and a floor system where the policy rate is same as the IOER would allow for the best combination of flexibility and control of the policy rates. In essence it would be a system where Fed would not need to respond with OMOS to fluctuations in reserve demand. While a corridor system with reserves scarcity (i.e. one with policy rate set between the IOER and discount window rates) might work, the uncertainty around reserves demand – and its potential volatility – might make Fed operations substantially more complicated and much larger in the past.
Relatedly, this same uncertainty about the demand for reserves means that the appropriate “stopping rule” for the size of the Fed’s balance sheet is highly uncertain. Several panelists suggested that stopping with very large reserves – most likely next year – would be preferable, but the consensus was that the FOMC would likely continue to reduce the size of the balance sheet until there was evidence in money market rates that reserve demand and supply were close to each other. Several suggestions were provided for future operating procedures, including use of broader liquidity provision, for example the Term Auction Facility, or a broad repo facility (at a penalty rate) and made available to counterparties beyond the primary dealers.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.
