What Will The Fed Do Next Week? JP Morgan Answers
The question of what the Fed will do next week in response to what effectively amounts to quantiative easing by the SNB, the BOJ and, as of today, the SNB, is preoccupying everything with a passing interest in finance. Here is the answer of JPM's Michael Feroli, who has recently surged to the league tables of least worst Wall Street economist (even if, for whatever reason, his Goldman competition still sets policy with merely one recommendation).
From Michael Feroli -FOMC Preview
Next week's FOMC meeting will be more about policy actions rather than statement language. It seems fairly obvious that the growth description will be downgraded quite a bit. Regarding policy actions, we think there is almost no chance that the Fed initiates another round of large-scale asset purchases. However, we do believe the Fed will change communications to indicate that the current policy of reinvesting principal payments will be maintained for an extended period. In addition, we also feel, though with less conviction, that the reinvestment policy will be altered to extend the average maturity of the Fed's securities portfolio. Finally, we don't see them lowering the interest on excess reserve rate, though we would not be shocked if they did this as well. Below we discuss the pluses and minuses of each of these policy options, though we should warn up front, Bernanke never promised us a rose garden: none of these options is likely to provide a powerful kick to the economy. Here it may be helpful to recall Bernanke's own assessment of Japanese monetary policy in the lost decade: "Why isn't more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn't absolutely guaranteed to work." With that, here are the possible experiments, no guarantees:
Changing statement language on reinvestment policy: Bernanke has emphasized that the first step in the multi-step Fed exit strategy is to halt reinvestments of principal payments of securities on the Fed balance sheet. If this first step doesn't begin until after an extended period, then the timing of the whole sequence of steps leading up to a rate hike should get pushed back. One commonly-heard objection to this is that the market already has priced in very little Fed tightening. While that is true now, in the event that we actually do get some better data, as sure as the sun rises the market will price in more Fed hikes, thereby tightening financial conditions and slowing the pace of the recovery. By emphasizing just how extended the extended period language really is, this policy option would avert any potential tightening due to a misperception of the Fed's reaction function. Arguably a potential cost of this option would be a loss of flexibility of the Fed to respond to changing economic conditions. We don't see this as a strong criticism; as is the case with the extended period language regarding fed funds rate policy, the conditionality on economic conditions gives the Fed an out to quickly change policy. Indeed, in the Q&A after the last FOMC meeting the Chairman seemed to agree with the logic for communicating with regard to the prospects for the Fed balance sheet and we don't see the hurdle for taking this action as particularly high.
Extending the maturity of reinvestments: The weighted average maturity of the Fed's holdings of Treasury securities is currently around 6.1 years. In the second half of this year the Fed will be probably be reinvesting close to $20 billion per month in principal payments. If one believes the logic of the portfolio balance effect, then increasing the average maturity of reinvestments could remove more duration from the market, thereby exerting more downward influence on longer-term borrowing rates. Consistent with this, our rates strategists estimate that if the Fed increased the average maturity of their reinvestments out to 15 years, this could lower fixed-rate mortgage rates by around 5 to 10 basis points. As alluded to above, this is probably not a big shot in the arm for the housing market, but better than nothing. The argument against this policy option is that it will make the eventual exit from accommodative policy a little bumpier: after the reinvestment policy is halted, with less short-dated securities rolling off the Fed balance sheet, it will take longer for the Fed balance sheet to passively contract, implying eventually more active selling of securities. We think this counter-argument may have appeal to more than just the hawks on the Committee, and so we don't think this option is a slam-dunk. Nonetheless, we do think it probably has better than even odds of being enacted.
Lowering IOER: Before looking at the benefits of lowering IOER, we should ask what are the perceived costs that led the Fed to choose this rate in December, 2008 rather than something lower. At that time, there had been little experience with ultra-low interest rates in the US and there was concern that if the money fund business model suddenly became unprofitable there could be a rapid and disorderly deleveraging in short-term fixed income markets. Since that time, the institution of the FDIC assessment fee, in conjunction with particularities relating to the fed funds market and IOER has meant that short term interest rates available to non-depository institutions such as money funds -- which don't have access to reserves -- has already moved quite low. Arguably, this could mean that the cost of lowering IOER is less, as the money funds are already having to deal with very low interest rates. In terms of the positives of lowering IOER, one might be that it is a signalling device, reinforcing the view that the Fed will be accommodative for a very long time. In addition, the perception that some banks may be sitting on reserves to earn the arbitrage returns from funding for less in capital markets might reinforce the case for cutting IOER. Even so, we think the odds are probably tilted away from this action being taken, as there are still some residual risks to market functioning that may not be worth the modest benefit from an IOER cut.
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