Fed Guy

personal views of a former fed trader

Come Hell or High Water

Governor Waller suggests two significant changes to the Fed’s QT framework that effectively removes all obstacles to an extended QT. First, Waller suggests that the $2t in RRP balances should be consolidated with bank reserves when thinking of bank liquidity levels. This indicates that the Fed would be comfortable with bank reserve levels dropping below the roughly estimated $2.5t minimum level. Second, Waller appears to be open to maintaining QT even if policy rates are cut. This would reverse longstanding Fed dogma where both the policy rate and balance sheet must express the same stance of monetary policy. This post reviews these two developments and suggests that they represent an effort to re-tighten financial conditions by steepening the curve.

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Credit Boom

A tremendous credit boom took place in 2022 and it may not even be over. The combination of healthy banks, financially strong households, and attractive rates appears to have to led to a surge in bank lending. Banks and credit unions together created $1.5t in cash last year that likely has not yet fully filtered into economic activity. Recall, bank lending creates money out of thin air. Interestingly, higher interest rates have so far only shown very tentative signs of moderating the boom. This post reviews the credit boom of 2022, suggests it was due to the strong financial position of banks and households, and notes that it will be supportive of demand throughout the year.

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Trapped Liquidity

A change in the underlying plumbing of the financial system is making it unlikely that QT can run its expected 2+ year course. An ideal QT would drain liquidity in the overall financial system while keeping liquidity in the banking sector above a minimum threshold. That is only possible if the bulk of the liquidity drained is sourced from the $2t RRP, which holds funds owned by money market funds. MMFs could facilitate QT by withdrawing funds from the RRP to invest in the growing supply of Treasury bills, but recent data suggests they have lost interest in bills. Households appear to have replaced MMFs as the marginal buyer of bills and are funding their purchases out of funds held in the banking sector. This suggests QT may lower banking sector liquidity below the Fed’s comfort level much earlier than anticipated. This post illustrates the emergence of households as the marginal investor in bills, suggests the change is due to high MMF fees, and discusses its implications on the path of QT.

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Stock and Flow

The stock effects of monetary tightening are clearly disinflationary, but the flow effects are less clear. The Fed’s rapid tightening markedly reduced the level of household wealth and thus potential demand, but the bulk of asset repricing seems to be behind us. The impact of tighter policy going forward is less certain because higher rates restrain some sectors but subsidize others. Interest income from reserves, RRP, and newly issued Treasuries rise along with rate hikes and can potentially increase demand. In addition, households and corporations borrowed at historically low rates and have been largely insulated from recent hikes. This post walks through the cross currents of higher interest rates and suggests the relative ineffectiveness of the Fed’s policy tools may lead to a more aggressive policy response.

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Quantitative Buybacks

A Treasury buyback program today would be mechanically equivalent to quantitative easing and a tailwind for risk assets. Buybacks funded by bill issuance would move cash out of the RRP and into the broader financial system. The end result would be an increase in cash held by banks and non-banks, both whom may rebalance their portfolios into other assets. In addition, the reappearance of a steady bid for coupon Treasuries would put downward pressure on yields and boost market liquidity. This post shows why buybacks would be mechanically equivalent to QE, reviews two channels QE operates to boost risk assets and suggests a potential shift in the conduct of monetary policy.

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Solvency Constraints

The dollar rally may be set to continue as limits on quantitative tightening bind other central banks before it binds the Fed. The tail risks of QT have first appeared in the gilt market, where significant price volatility prompted official intervention. What appears to be a liquidity issue will ultimately become a financial stability issue as investors discover their “safe assets” are not safe. These concerns may prompt a policy response similar to that seen in Japan, where the price of sovereign debt is explicitly supported. Just as yield curve control led to significant Yen weakness, so a similar move by other central banks would also severely weaken their currencies. This post describes the link between bonds and financial stability, notes the existence of a central bank “put” on bonds, and suggests other central banks would likely cave first.

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The Reserve Gap

A rapid decline in the level of bank reserves would be an obstacle to QT that may prompt action from the authorities. An aggressive QT was premised on first draining the large RRP balances, but the monetary plumbing suggested that was never likely. Banks can easily maintain their own reserve levels, but their own target levels are significantly below those of the Fed. This implies that bank reserve levels will likely fall below the Fed’s comfort level far before QT is slated to end. In this post we sketch out the Fed’s dilemma, show why its options are limited, and suggest that Treasury buybacks or SLR adjustments would likely be used to boost bank reserve levels.

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Fed Balance Sheet FAQs

This post answers four frequently asked questions on the Fed’s balance sheet. The answers to the first two questions will affirm that the Fed is executing QT exactly as promised, even if it may not appear that way. The apparent discrepancy is due to TIPS appreciation and details in MBS settlement mechanics. The answers to the second two questions will show how the Fed balance sheet behaves when the Fed has and negative net interest income or capital losses. The Fed has special accounting rules where losses appear as “deferred assets” that will be repaid out of future earnings.

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The Marginal Buyer

Treasury buybacks would be a powerful tool that could ease potential disruptions arising from quantitative tightening. The Treasury hinted in their latest refunding minutes of potential buybacks, which is when Treasury issues new debt to repurchase old debt. Buybacks can be used to boost Treasury market liquidity, but more importantly also allow Treasury to rapidly modify its debt profile. By issuing bills to purchase coupons, Treasury could strengthen the market in the face of rising issuance and potentially structural inflation. An increase in bill issuance would also facilitate a smooth QT by moving liquidity out of the RRP and into the banking sector. This post reviews the basics of Treasury buybacks and explains how it could be an important tool in managing Treasury market stability and Fed liquidity flows.

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The Money Still Flows

The market appears to misunderstand the Fed’s reaction function and is pricing a path of policy that is not consistent with a return to 2% inflation. Inflation moderates through demand destruction when households can no longer afford the price increases. But the sources of household purchasing power – credit, wages, and wealth – all appear to easily support elevated inflation. These metrics may not indicate that a 9% inflation rate is sustainable, but they are much too high for a 2% target inflation rate. The market’s eagerness to price in a dovish Fed pivot early next year is worsening the situation by effectively easing financial conditions before inflation has even peaked. This post reviews the strength of household purchasing power along the three sources and suggests a dovish Fed pivot is far away.

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