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United States Fed Exit Strategy Still Far Off Global Growing Pains View GEF Archive

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No action likely on LSAPs or on an offset to SFP wind-down.  Nonetheless, the Fed has several decisions to make prior to implementing an exit strategy.  The main focus at this meeting will probably be on whether the FOMC will contemplate changes in their agency and MBS securities purchase programs.  Officials have begun to taper their Treasury purchase program, but two factors suggest it is premature to indicate a similar winding down for the other ‘large scale asset purchase' (LSAP) programs.  Officials believe that the current announced scope and pace of these programs is built into market pricing and expectations, so to even hint at a dialing back would alter market pricing and thus tighten financial conditions.  Given their caution, officials are not ready to signal any changes.  In addition, officials have made it clear that these two programs have had a significant beneficial impact on the level of mortgage rates and spreads of mortgage over Treasury yields, and thus on housing and refinancing activity.  In contrast, in their judgment, the stimulative effects of the Treasury purchase program on markets and the economy have been less clear, so the decision to wind down that program was straightforward.  Thus, while adjustments to the non-Treasury LSAPs will certainly be a discussion item, it's more likely that officials will wait for the November meeting before announcing that they will spread out the final tranche of purchases for an extra month or so - as they did with the Treasury program. 

Action to absorb excess reserves created by the wind-down of the SFP program is also unlikely.  Some background on this point might be helpful.  The Treasury has announced that they will wind down their Supplemental Financing Program (SFP) over the coming weeks.  The shrinkage of the SFP is occurring because the Treasury faces a debt ceiling constraint.  Under the SFP, instituted in September 2008, the Treasury sold bills to help the Fed sterilize the impact on the Federal funds rate of the liquidity support programs that were ballooning the asset side of their balance sheet.  The Treasury parked proceeds from selling SFP bills in their account at the Fed.  Since the Treasury account is on the liability side of the Fed's balance sheet, these funds offset (or sterilize) the growth on the asset side of the Fed's balance sheet.  At one point late last year, the size of the SFP peaked at $560 billion. 

Soon after the introduction of the SFP, however, the Fed gave up trying to sterilize the impact of their asset expansion as they began quantitative easing (QE), which continues to this day.  QE mooted the whole point of the SFP, but Treasury left the program in place.  There are currently $200 billion of SFP bills outstanding, and the Treasury has indicated that the balance will fall to $15 billion (they apparently want to keep the program in place at a much reduced volume so it can be rejuvenated if necessary at some point down the road).  The maturity schedule of SFP bills is as follows:

Sept 24)  $35 billion

Oct 1)     $35 billion

Oct 8)     $30 billion

Oct 15)   $35 billion

Oct 22)   $35 billion

Oct 29)   $30 billion

The prospective decline in Treasury bill supply has triggered a rally in the bill market.  Also, it will add to the excess reserve position in the banking system - absent offsetting action by the Fed.  So, an important question at this point is whether the Fed will decide to take action to drain reserves and offset the wind-down of the SFP.  In our view, the Fed is probably willing to just pile on more reserves for now because trying to offset the SFP runoff via reverse RPs or some other mechanism might prove too disruptive to markets.  Instead, they will merely accept that they will have a larger exit job to do once they begin to move in that direction.

The current excess reserves position is a little more than $800 billion.  We estimate that this will grow to nearly $1.4 trillion by year-end because of the wind-down of SFP and the ongoing impact of the Fed's LSAPs (as New York Fed President Dudley pointed out in a recent CNBC interview, there won't be as much offset going forward from shrinkage in the Fed's other liquidity support facilities because those programs simply don't have that much more room to shrink.)

In a conference call with dealers last week, NY Fed officials discussed the mechanics of doing reverse tri-party repos and getting all the documentation in place to do so.  The Fed indicated that they will probably conduct a test of these operations.  However, we suspect this is just contingency planning - i.e., a test of their ability to conduct reverses of any magnitude given the limited balance sheet capacity of the primary dealer community.  We doubt the Fed wants to start actively draining reserves just yet.

What about the debt ceiling?  The current limit is $12.104 trillion.  As of the end of last week, the outstanding debt subject to limit was $11.752 trillion.  Last month, Treasury Secretary Geithner sent a letter to Congress indicating that the debt ceiling could be reached as early as mid-October.  Our own estimates suggest that this is too pessimistic.  Even without the room provided by the shrinkage of the SFP, the Treasury probably wouldn't have reached the debt ceiling until December.  And the extra $200 billion will probably provide an extra couple of months of breathing room.  Clearly, the Treasury is being overly cautious because they want to avoid any possibility that a debt ceiling vote will be needed before the health care reform issue is resolved, since all indications are that the vote to hike the debt ceiling vote will be highly contentious.  Republicans have indicated that no one from their side will support a debt ceiling hike, and for those Democrats facing a reelection battle it will be a very tough vote in an environment in which polls show the public becoming increasingly concerned about big budget deficits.  There have been six occasions since 1995 in which the Treasury has been forced to utilize unconventional measures to maneuver around the debt ceiling.  Such measures include: withholding interest payments to government employee trust funds, disinvesting a portion of Social Security and Medicare, and shutting down some nonessential elements of the government.  In some cases, Treasury auctions had to be cancelled.  Although the possibility of an outright default by Treasury is virtually nonexistent, we believe there is some chance that auction schedules will be disrupted before the current debt ceiling battle is resolved.  However, such a showdown is still a long way off - perhaps February or March of 2010.

Healing in the economy and markets.  Incoming data used by the National Bureau of Economic Research to decide when business cycles begin and end do not completely support the Fed Chairman's contention that the recession is probably over.  Manufacturing production has advanced by 2% in the past two months; apart from the bounce following Hurricane Katrina, that's the biggest two-month rise in a decade.  However, payroll employment is still declining.  And based on data through July, real incomes have not yet increased, nor do available data (through June) suggest that real manufacturing and trade sales have increased. 

Chairman Bernanke's contention is reasonable, however, because on balance, data on retailing and housing activity through August, on manufacturing and trade orders, shipments and inventories, and private construction through July, and on exports through July, all seem to be moving in the right direction.  And both business surveys and higher frequency data such as those on jobless claims appear to support the contention that recovery has begun.  Moreover, the healing in financial markets that began in March has advanced significantly since the August FOMC meeting, contributing to easier financial conditions and thus to recovery.  Mortgage rates have declined, credit spreads have narrowed, and equity prices have risen.

But the Fed likely believes, as we do, that the recovery will be bumpy, given the expiration of the ‘cash for clunkers' vehicle sales incentives and the upcoming expiration of the first-time homebuyer tax credit (see Recovery Arrives - But Not a ‘V', September 8, 2009).  Against that backdrop, they see no immediate need to become less accommodative and every reason to wait until recovery moves to firmer ground before doing so. 

Even if recovery was more certain, officials also believe that "substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time."  We agree.  Slack is still ample: While operating rates appear to have bottomed, they are still close to record lows.  With the unemployment rate at 9.7% and likely rising, downward wage pressures still dominate (apart from the influence of the final installment of the hike in the minimum wage).  Slack in housing markets has promoted decelerating rents, and weakness in demand has pressured prices for many goods and services.  Incoming inflation data also remain tame, with the rate excluding food and energy (measured both by the CPI and by the personal consumption price index) declining under 1½%.  The Fed does not have an explicit inflation target, but most officials presume that market participants understand that the implied numerical objective for inflation is around 2% (measured by the core CPI in the short run and by headline inflation over the medium term).  With inflation below the Fed's implicit objective and still falling, the burden of proof is on those who want to tighten to avoid a future inflation upswing.

Do Taylor rules help calibrate policy?  Given those considerations - low and declining inflation and substantial slack in the economy - many turn to so-called Taylor rules to determine the appropriate setting for monetary policy.  Taylor rules, developed by Stanford economist John Taylor, prescribe how the central bank should set its policy interest rate in response to inflation and economic activity.  Following such a rule, officials can communicate policy intent and actions easily and credibly, and understanding the Fed's ‘reaction function' reduces uncertainty and helps the public hold officials accountable for their actions.  

The simplest policy rules prescribe that the central bank adjust interest rates relative to a baseline or equilibrium level in response to deviations of inflation from a desired rate and output from its potential path.  Taylor's original formulation was:

(1)  r = r* + p + (p - p*)/2 + (y-y*)/2,

Where r is the policy rate, r* is the real equilibrium or neutral interest rate, p is the inflation rate, p* is the Fed's desired inflation rate, y is real output or GDP and y* is potential output.  The rule thus states that the Fed should adjust rates up or down when inflation rises above or falls below the desired rate and/or when the output gap is positive or negative.  Taylor showed that such a simple rule helped to describe what the Fed actually did in the past, and that has held true through 2008. 

With inflation falling below target and most measures of the output gap falling to -6% to -8% of GDP, if the real neutral rate is around 2%, the Taylor rule suggests that the funds rate should be roughly minus 75bp.  That is somewhat consistent with the notion that, once interest rates hit the zero bound, policy should focus on quantitative easing and other measures effectively to accomplish the easing in financial conditions implied by the prescription of a negative nominal interest rate.  Indeed, some factors in the Taylor rule would push the prescribed nominal rate significantly negative, calling for more aggressive use of unconventional tools.  Our colleagues Joachim Fels and Manoj Pradhan estimate that the real neutral funds rate is not constant, but instead has recently declined to around 1%.  Using a small model of the economy and a statistical procedure called the Kalman filter, they estimate the time-varying neutral rate.  Others maintain that the credit crunch warrants moving the neutral rate temporarily to zero, to offset the tightening of financial conditions.  Still others have estimated new parameters for the Taylor rule that would put more weight on the output gap and would substitute their forecasts for inflation for the current spot inflation rate in the traditional formula.  Using such adjustments, their rules currently prescribe a nominal funds rate of -4% or -5%, and the prescribed funds rate does not turn positive for at least two years.

While we are sympathetic to the motives for such tweaks to policy rules, we are suspicious of the results thus obtained.  Even in their original simple form, in our view, such rules are only a guide that can help calibrate monetary policy.  Uncertainty about the tightness of financial conditions, the appropriate neutral rate, the magnitude of the output gap, the flatness of the Phillips curve (the relationship between slack in the economy and inflation), and whether current data accurately reflect economic conditions all suggest that to use such rules even under ‘normal' circumstances requires a high degree of judgment.  Moreover, as interest rates fall to zero, it is far from clear that the level of interest rates adequately describes the stance of monetary policy.  Nor is it clear what the relationship is between, say, a prescribed rate of -4% and the appropriate scope and mix of unconventional tools. 

This discussion does lead us to a couple of conclusions.  First, remember the rationale for such simple rules: They are useful for communicating the Fed's reaction function.  If so, policymakers shouldn't tweak them in midstream; rather, they should acknowledge their shortcomings and retain the simple formulation that enables them to describe how they will react to changing circumstances.  Second, if the credit crunch warranted reducing r* in order to promote policies to offset tighter financial conditions, then symmetry suggests that healing financial markets warrant raising r* at least back to a time-varying estimate of neutrality.  In that context, one very simple way to think about our forecast for monetary policy is to compare the time-varying real rate with our forecast for the real funds rate.  By the end of 2011, we expect core inflation will move back to slightly over 2%, and thus that the real funds rate will still be below the 1% level that such estimates imply. 

Weak private credit demands hold down real rates, supporting housing.  Our view that real rates will rise significantly in recovery is still intact.  We strongly believe that recovery will lift private credit demands, and when combined with heavy Treasury issuance, will push up real interest rates.  But for now, household and business credit demands are contracting, helping to hold down real rates, sustain easy financial conditions and support a revival in housing demand.  Private credit outstanding was flat over the past year for the first time since 1952; households' credit-market liabilities shrank by 1.2% and nonfinancial businesses' liabilities barely rose.  More delevering is likely in store, as households pay down debt and as write-offs reduce it.  Businesses are still liquidating inventories and cutting back capex even as corporate cash flow begins to improve.  So, corporate external financing needs as a share of corporate GDP have shrunk to a record-low of -2.5%.  Together with the Fed's LSAPs, such weakness in private credit demands seems likely to hold real longer-term rates well below 2% for now, facilitating a revival in housing demand and helping stressed mortgage borrowers by keeping open a much-needed mortgage refinancing window.  But, in our view, eventual movement toward a normalization of private credit demands, together with sustained massive public sector borrowing, implies much higher real rates down the road.

Global
Growing Pains
September 24, 2009

By Manoj Pradhan | London

Risky asset markets are booming, US growth is set to resume with a bang in 3Q09 and the ISM has bounced solidly off its lows. Yet central bank officials have remained active in warding off attempts by markets to price in early hikes in policy rates. Experience from the previous three recessions in the US suggests that the Fed is likely to look through improvements in GDP and the ISM. Instead, its rate hikes have coincided strikingly with an upturn in inflation expectations. In our view, the biggest risk to medium-term growth is a policy mistake. Stronger-than-expected growth over the next few quarters may lead to a rise in inflation expectations, which may in turn prompt a premature start to the tightening cycle, as it seems to have done in the past.

‘Stylised facts': Using the previous three US recessions as a guide to possible exit policies, a few important ‘stylised facts' assert themselves:

•           A resumption of growth and an upturn in business sentiment predate even the end of easing, and lead the beginning of rate hikes by long intervals;

•           The end of easing and the trough in policy rates occur about a year before the Fed starts hiking rates again;

•           Rate hikes by the Fed occur around the same time as the upturn in inflation expectations with striking regularity.

A revival of growth has not triggered rate hikes in the past... GDP and ISM turnarounds on all three occasions preceded even the end of the policy rate cuts. Rate hikes were, on average, about a year further away. The fact that the Fed waited for a significant period of time beyond the trough in growth and business sentiment provides a gauge of how long it takes to ensure that recovery is entrenched and able to withstand a withdrawal of stimulus. One reason for this is that the early part of the recovery is usually based on this policy stimulus. A further reason is that disinflation usually continues well into the early recovery phase. Policymakers ideally start withdrawing stimulus only when growth is self-sustaining and inflation looks poised to increase. This time is no different in that regard.

Our US economics team expects growth to resume with a strong start in 3Q09 but still see a policy exit a long way away (see Fed Exit Strategy Still Far Off, Richard Berner and Dave Greenlaw, September 21, 2009), with the first rate hikes coming in 3Q10. The rate hikes will arrive about 11 quarters after the start of the recession - bang in line with past experience. The upturn in GDP and ISM, however, has taken longer to materialise, which means that the interval between a turnaround in output and sentiment and the first rate hike is shorter in this recession than it has been on average in the past three cycles. Why? The massive monetary and fiscal stimulus provided to the global economy has led to a resumption of growth sooner than would have otherwise been possible. This time around, central banks are likely trying to find a balance between waiting for a self-sustained recovery and not waiting too long and risk stoking an asset price bubble. Unless, that is, the stylised relationship between inflation expectations and policy rate hikes reasserts itself and forces their hand.

...but rising inflation expectations seem to have been a trigger: While the trough in output and business sentiment led rate hikes and even the end of rate cuts, the trough in inflation expectations has coincided with the beginning of policy tightening on every occasion in the previous three recoveries. There is reason to believe that policy rates were reacting to the rise in inflation expectations. On each occasion in the past, the increase in the fed funds rate has at least been equal to the rise in inflation expectations, and rates have risen at a faster rate in the last two episodes in order to raise the ex-ante real interest rate. It is still possible that this survey measure of inflation expectations was reacting to the same strengthening fundamentals that drove policy rates higher (i.e., we could be mistaking correlation for causation), but the consistency in each recession of the timing and the speed with which policy rates were raised makes such a caveat less likely to be true, in our view.

Comparisons with the past are not easy... It is difficult to compare monetary policy in this cycle with the past because the monetary stimulus has been markedly different. Policy rates of all major central banks are very close to zero while monetary easing is still being delivered by central banks via their ongoing QE programmes. The end of rate cuts as they approached zero cannot therefore be considered the end of easing. The time between the end of easing and beginning of tightening is therefore even smaller this time around. On the way up, raising rates is going to be that much trickier thanks to the need to unwind active QE. Looking at the policy rate profile of central banks who have adopted QE measures will therefore provide only part of the story because those hikes will be influenced to a great deal by how successfully central banks are able to negotiate unwinding their QE purchases.

...but while history may not repeat itself, it may rhyme: On the evidence, it is difficult to rule out the possibility that a premature start to the hiking cycle could be precipitated by an earlier-than-expected rise in inflation expectations. The base case from our US team is for headline CPI inflation and core inflation to breach 2.5% and 2%, respectively in 2011 but remain stable and benign. However, given the rapid growth of narrow money in the economies where QE has been adopted and the difficulties surrounding policy tightening (see "QExit", The Global Monetary Analyst, May 20, 2009), the risks to inflation are likely biased to the upside.

In a recent note, we pointed out that the biggest risk to medium-term growth was from a policy mistake, most likely through an aggressive response to stronger-than-expected growth in the near term (see "‘Up' with ‘Swing'?" The Global Monetary Analyst, September 16, 2009). Such a ‘blow-out' scenario is not our base case, but the policy stimulus has produced upside surprises so far and there is no obvious reason to think that it will find less traction going forward. If growth were to surprise to the upside, rising inflation expectations would be a natural response. Rising inflation expectations seem to have triggered rate hikes in the past. They might well do so again.

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