Fed Balance Sheet Expands, Reward-Risk Clarity Fades
T. Rowe Price
By Alan Levenson
November 16, 012
• While the minutes of the October 23-24 FOMC indicated a lack of consensus regarding whether to initiate a new asset purchase program to replace the Maturity Extension Program (MEP) upon its year-end conclusion, we believe that the Committee will announce at the conclusion of its December 11-12 meeting that the Fed will begin open-ended purchases of Treasury securities at a pace close to the $45 billion per month in the MEP.
• We appreciate the likely limited benefits and rising future risks in additional securities purchases. Market distortions are already evident, as in the persistence of negative real long-term interest rates. Moreover, we think that there is a direct relationship between the size of the Fed’s balance sheet – specifically, the stock of reserve deposit liabilities – and the degree to which short term market interest rates will rise relative to the fed funds rate in order to achieve the desired degree of policy tightening.
Replace the MEP, or not? Zero is not the answer
Minutes of the October 23-24 FOMC meeting suggest that there is not a clear consensus to replace the $45 billion per month Maturity Extension Program (MEP) with an open-ended program of Treasury securities purchases. On one side of the debate, “a number of [meeting] participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the Maturity Extension Program in order to achieve a substantial improvement in the labor market.”1 Indeed, FOMC communications currently peg total asset purchases at $85 billion per month, putting the balance sheet-neutral purchases of long-term Treasury securities ($45b/mo.) in the Maturity Extension Program on equal footing with the balance sheet-expanding purchases of agency mortgage-backed securities (MBS, $40b/mo.). From this vantage point, in our view, consistency of message – and of thought process – calls for maintaining total asset purchases into 2013 at something close to this prevailing $85 billion monthly pace.
Yet “several” meeting participants pushed back, questioning “the effectiveness of the current purchases or whether a continuation of them would be warranted,” and expressing concerns “that sizable asset purchases might eventually have adverse consequences for the functioning of asset markets or that they might complicate the Committee’s ability to remove policy accommodation at the appropriate time and normalize the size and composition of the Federal Reserve’s balance sheet.”2
Deteriorating risk-reward trade-off
We, too, are skeptical of the incremental impact of additional asset purchases on the pace of recovery; the level of interest rates and cost of equity capital are not the primary barriers to stronger housing demand or capital spending, in our view. Moreover, hints of impact on the functioning of asset markets – or at least on the quality of price signals – are already apparent. For example, real interest rates have become increasingly negative over the past year, despite positive real growth (Figure 1). The jump start to this anomalous concurrence came in a late July-early August 2011 “risk off” trade in response to the U.S. debt ceiling scare and subsequent rating downgrade, as well as to the broadening of the euro area debt crisis to engulf Spain and Italy. The real 10-year TIPS yield fell from 0.62% in the second week of July to 0.02% a month later. Yet the slide continued, spurred by the late-September, 2011 introduction of the Fed’s Maturity Extension Program, which has absorbed virtually all of the net new supply of Treasury securities with maturities of five years or more. The more entrenched economic recovery becomes the more offside will negative real interest rates be relative to positive real growth.
The bigger it gets…
We concur in the view that the ability to remove policy accommodation becomes more complicated as the balance sheet grows. The Fed has indicated on numerous occasions that, as in past cycles, raising the fed funds target rate will be the main instrument for reducing the degree of policy accommodation. To be able to do so in the presence of an enlarged balance sheet, the Fed gained authority to pay interest on excess reserves, and will raise that rate to support the effective funds rate when the time comes to tighten policy. To further enhance control of the fed funds rate in the presence of liquidity flows from outside of the banking system, the Fed has established the capacity to issue term deposits (TD) and reverse repurchase agreements (RRP), which will replace excess bank reserves on the liability side of the Fed’s balance sheet.
We think it is reasonable to assume that the larger the stock of excess reserves, the greater the quantity of TD and RRP the Fed has to issue, and that the greater the supply of these instruments, the higher will be the interest rates required to place them. Simply put, a larger balance sheet now means higher short-term interest rates and a steeper short-maturity yield curve relative to the fed funds rate when the time comes to tighten policy.
Finally, concern that the Fed will incur losses on its asset sales seems to grow with the size of its balance sheet. Long-term assets purchased after the mid-2011 interest rate plunge seem particularly vulnerable. The Fed has roughly $80 billion of interest income with which to absorb losses (Figure 2). Congress would not be pleased with the resulting reduction in the Fed’s annual remittance to the Treasury, but fears that capital support for the central bank would be required seem over done.
1 “Minutes of the Federal Open Market Committee, October 23-24, 2012,” Federal Reserve.
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