The New Economic Normal and the Impact on the Federal Reserve

A recent speech by Eric Rosengren, President of the Federal Reserve Bank of Boston, gives us a glimpse of what may lie ahead in the world that is the Federal Reserve.  In his speech, he outlines why it will be necessary for the Fed to implement one aspect of its new monetary policy ammunition and why this will be necessary.

As we all know, the Fed and its most influential peers have kept interest rates at historically low levels for the longest period in history as shown here:

Obviously, when the next recession hits, the Federal Reserve will have very little room to drop nominal interest rates, particularly when looking at how much rates dropped in the past as shown on this table:

In real terms (i.e corrected for inflation), the Federal Funds Effective Rate has been in negative territory for the longest duration since the 1960s as shown here:

Mr. Rosengren notes the following:

1.) with today's ultra-low short-term interest rates, there will be a limited buffer for monetary policy to respond to economic slowdowns (i.e. central banks have not got sufficient room to lower interest rates as they have in the past). 

2.) real short-term federal funds rates are likely to be negative more frequently.

3.) nominal federal funds rates are likely to reach zero more often (and in my opinion, may become negative).

The economic problem that the Fed has faced since 2008 is structural rather than cyclic in nature, that is, the functioning of the economy has transformed in a manner that is permanent.  In other words, very little of what the Fed has done since the Great Recession has been effective because the Fed's policies are designed to deal with cyclic (temporary) changes in the economy.

Here are two examples showing how the economy has undergone structural changes:

1.) Productivity Growth - Change in non-farm real output per hour:

2.) Civilian labor force growth rate (i.e demographic changes):

So, what's a central banker to do when the next recession arrives?   Here's a hint:

The world's three most influential central banks have massively increased the nominal size of their balance sheets because they discovered that, in the wake of the Great Recession and the nature of the post-recession economy, simply lowering interest rates were "...insufficient to rekindle economic growth..."

Here's the same data as a percentage of GDP showing how desperate the situation is for Japan, a nation that has undergone the most profound demographic changes:

Mr. Rosegren states that "...structural changes in the macroeconomy may necessitate more frequent use of large scale asset purchases during recessions.  This latter view hinges on the argument that the combination of low inflation, low rates of productivity growth and slow population growth may imply an economy where normal or equilibrium short-term interest rates remain relatively low by historical standards, even once the economy has fully normalized."

As I've noted in the past, central banks have painted themselves into a policy corner from which there is no easy extrication.  Never before in modern history have central banks acquired such a massive inventory of assets and never before have they faced divesting themselves of these assets.  No one understands the market implications of unloading and offloading trillions of dollars worth of bonds, and yet, Mr. Rosengren suggests that expanding central bank balance sheets is the only way to stimulate a contracting economy in a low interest rate environment.  Keeping in mind that the world's central bankers didn't see the looming Great Recession until it was on the doorstep, we should be concerned that the repercussions of their remaining monetary policy tool is unproven.

Let's close this posting with Mr. Rosengren's concluding remarks:

"While the extensive use of central bank balance sheets has been a distinguishing feature of the most recent downturn and slow recovery, I see it as quite likely that this tool will be necessary in future economic downturns. Unless productivity growth and demographic trends change, or monetary policymakers set a higher inflation target, the feasible reductions in short- term rates to combat recessions will not be sufficient. Thus, monetary policymakers are likely to need to use balance-sheet tools.

If monetary policy is to rely primarily on short-term interest rates to normalize policy, as seems prudent given the historical experience, in my view the Federal Reserve should adopt balance sheet exit strategies that reinforce the primacy of interest rate policy. Starting to shrink the balance sheet earlier – and doing so in a very gradual fashion – implies very little reduction in the degree of monetary stimulus coming from the U.S. central bank’s balance sheet. This, in turn, will allow policymakers to focus on gradual increases in the federal funds rate target as the primary mechanism for normalizing monetary policy and calibrating the economy." (my bold)

Good luck with that, Mr. Rosegren. 

The Federal Reserve's Treasury Dilemma

Updated March 2016

While everyone focuses on whether the Federal Reserve will raise interest rates again in 2016, one aspect of the Fed's actions are being pretty much ignored as you will see in this posting.

Let's look at what has happened to the Federal Reserve's balance sheet since it took unprecedented actions to rescue the U.S. economy back in September 2008:

The Fed's balance sheet grew from around $900 billion in August 2008 to its current level of $4.535 trillion on January 14, 2016, an increase of $3.635 trillion or roughly 400 percent.

Let's look at the latest statistical release from the Federal Reserve dated March 10, 2016 which shows us the assets held by the Fed:

As of March 2016, the Federal Reserve held $2.461 trillion worth of U.S. Treasuries which was composed of $2.346 trillion worth of Treasury notes and bonds and $98.5 billion worth of inflation-indexed Treasury notes and bonds.  Thanks to its long-term monetary policy experiment, the Federal Reserve is now the largest holder of government debt, owning 21.7 percent of the total $11.348 trillion in outstanding Treasury notes, bonds and TIPS. 

Now, let's look at a table that shows us the maturity distribution of the Federal Reserve's massive inventory of U.S. Treasuries:

In case you are interested or curious, here is a complete listing of all of the Treasury notes and bonds held by the Federal Reserve.  One problem that has occurred because of the Fed's massive holdings is that there are less Treasuries for sale on the open market, meaning that certain Treasuries either command a premium (i.e. higher price and lower yield because supply is lower than demand) or trades simple fail because there is a shortage of certain Treasuries as shown on this graphic which shows the growing daily Treasury settlement delivery fails in billions of dollars for the last year:

Over the next year, the Federal Reserve has a total of $216.11 billion worth of Treasuries that are maturing, a far larger volume than in any other year since QE1 began.  If we look further down the line, over the next five years, the Fed will hold $1.334 trillion worth of maturing Treasuries.  Here is a table showing a more detailed view of the Fed's maturing inventory of Treasuries:

The Federal Reserve has already announced that it will not be selling its massive inventory of Treasuries to normalize its monetary policy, rather, it will raise interest rates by increasing the interest rate that it pays banks on the reserves deposited at the Fed, which it did on December 17, 2015 (up to 0.50 percent from 0.25 percent) and continuing its experiment with reverse repurchase agreements. In other words, as shown here, the Fed will roll over its maturing Treasury securities into new Treasury securities:

"As directed by the FOMC, the Desk is rolling over maturing Treasury securities at auction. However, for operational efficiency, when the proceeds received by the SOMA from Treasury securities that mature on a given day total less than $2 million, the Desk will allow those securities to mature without reinvestment.

For example, if on a given date the SOMA holds two Treasury coupon securities maturing with balances of $0.5 million and $1.1 million, the full $1.6 million would be allowed to mature without reinvestment. However, if the balances of the maturing securities on that date were instead $0.5 million and $1.6 million, the full $2.1 million would be reinvested into newly issued Treasury coupon securities at auction."

At its December 16, 2015 meeting, the FOMC reaffirmed its commitment to rolling over its maturing Treasuries.  Additionally, a recent speech by William C. Dudley, President of the Federal Reserve Bank of New York and Vice Chairman of the Federal Open Market Committee stated that:

"Let me close with some observations about my current thinking concerning our reinvestment of maturing Treasury securities and paydowns in our agency MBS holdings. As we noted in the December FOMC statement, we anticipate that we will continue reinvestment “until normalization of the federal funds rate is well underway.” I think this policy makes sense not only because the decision to end reinvestment will represent a further tightening of monetary policy, but also because it is difficult to assess ahead of time the impact of such a decision on financial market conditions given the lack of historical experience.

I also believe that continuing reinvestment until the federal funds rate reaches a higher level makes sense. We want to ensure that we have the ability to respond to adverse shocks by easing monetary policy by lowering the policy rate. Having more “dry powder” in the form of higher short-term interest rates seems more desirable than less dry powder and a smaller balance sheet." (my bold)

By signalling that it will continue to reinvest its massive portfolio of Treasuries, the speech by William Dudley shows that the Fed is concerned about two things:

1.) What will happen to the Treasury market when the Fed ends its unprecedented monetary policy since there is no historical precedent?  As well, since Treasury prices behave inversely to yield, as yields rise, prices will drop, leaving the Fed with a capital loss on the value of their portfolio that could prove to be very significant.

2.) Ending the reinvestment program will represent a further tightening of monetary policy because it means that the Treasury will have to make up the lost funding by selling additional debt which will push interest rates higher whether the Fed likes it or not.  

As the Fed rolls maturing issues into new debt, the amount that comes due later in this decade and into the 2020's rises, kicking any potential problems further down the road and through the next recession.  A 2010 study by Stefania D'Amico and Thomas King at the Federal Reserve Board's Division of Monetary Affairs suggests that the Fed's large-scale asset purchases of $300 billion during 2009 resulted in a persistent downward shift of the yield curve by as much as 50 basis points (one-half percent) with the largest impact being on the 10 to 15 year sector.  It is this sector that largely dictates the interest rates on mortgages and other loans.  This research suggests that we could see substantial increases in interest rates once the Fed starts to divest.   

As I have explained in many postings, no one really knows the long-term ramifications of the Federal Reserve's 7 year program of monetary policy experimentation.  As this posting shows us, the Fed's massive Treasury inventory is likely to prove problematic, particularly if they continue to rollover the hundreds of billions of dollars worth of government debt into the distant future.  The acquisition of trillions of dollars worth of Treasuries could have a detrimental impact on the Fed's ability to move interest rates in the future, particularly since reducing the inventory will put significant upward pressure on yields at a time when the global economy is looking particularly fragile.

Treasury Yields and the Federal Reserve's Dilemma

Let's open this posting by looking at the latest data on the Federal Reserve's balance sheet.  Since the Federal Reserve began its unprecedented involvement in the United States bond market, its balance sheet has ballooned as shown on this graph:

In the latest Federal Reserve Statistical Release, on November 12, 2014, the Fed held $2.451 trillion in U.S. Treasuries, mainly nominal notes and bonds, up $329.9 billion from the previous year.  As an aside and just in case you were curious, the Fed now provides those of us that are interested with a transaction level database so we can see when the Fed bought and sold Treasuries, who the counterparty was and a description of the security bought or sold.  Unfortunately, the database is two years behind (I have no idea why there is such a long delay) but in the latest report which reflects the activity in the quarter ending September 30, 2012, there were nearly 8050 transactions with Morgan Stanley and Co. being the counterparty (seller or buyer) in nearly 2500 of those transactions, by far the largest beneficiary of the Fed's activities in the bond market during that quarter.

According to SIFMA, at the end of October 2014, there were $8.1997 trillion in Treasury notes and $1.5471 in Treasury bonds outstanding.  This means that the Federal Reserve holds 25.35 percent of all outstanding Treasury notes and bonds.  With that kind of "Treasury muscle", the great minds at the Federal Reserve should have a great deal of control over the direction of future interest rates; unfortunately, it doesn't necessarily appear to be the case.  Despite the fact that the Federal Reserve has announced that it is going to wean the American economy from its long-term monetary policy of pushing interest rates to the zero bound, the bond market, particularly in longer 10 and 30 year bonds has not reacted as one would expect.

Here is a chart showing what has happened to yields on 10 year Treasuries over the past year:

Yield on 10 year Treasuries are currently between 2.3 and 2.4 percent, down from a high of 3 percent back in January 2014.  Yields are just above their year-long closing low of 2.1 percent in mid-October 2014 around the time that the Fed announced that its purchase of Treasuries was coming to an end.

Here is a chart showing what has happened to yields on 30 year Treasuries over the past year:

Yields on 30 year Treasuries are currently between 3.0 and 3.1 percent, down from a high of 3.9 percent in January 2014.  Yields are just above their year-long closing low of 2.95 percent in mid-October 2014, again, around the time that the Fed announced the end of its monetary experiment.

One would think, that under normal circumstances, the Federal Reserve's announcements over the past year and a half that QE was coming to an end would push Treasury prices down (as the Fed's demand for Treasuries dries up) resulting in higher and higher yields  If you have forgotten, former Fed Chair Ben Bernanke first announced that the Fed could begin to taper back in June 2013 and reiterated his stance in the September 18, 2013 press conference where he stated:

"In light of this cumulative progress, the FOMC concluded at our June meeting that the criterion of substantial improvement in the outlook for the labor market might well be met over the subsequent year or so. Accordingly, the Committee sought to provide more guidance on how the pace of purchases might be adjusted over time. The Committee anticipated in June that, subject to certain conditions, it might be appropriate to begin to moderate the pace of purchases later this year, continuing to reduce the pace of purchases in measured steps through the first half of next year, and ending purchases around midyear 2014. However, we also made clear at that time that adjustments to the pace of purchases would depend importantly on the evolution of the economic outlook—in particular, on the receipt of evidence supporting the Committee’s expectation that gains in the labor market will be sustained and that inflation is moving back towards its 2 percent objective over time."

    

Instead of a gradual rise in interest rates over the past year, as you saw in the 10 and 30 year yield charts, interest rates have been stubbornly heading down, contrary to what one would normally expect.  This has happened in the past; back in 2004, Alan Greenspan began to raise the benchmark overnight rate to tighten credit.  This resulted in higher short-term interest rates but his plans completely failed when interest rates on the long end of the curve did not increase as they normally would.  From what long interest rates are showing us over the past year, it looks like history is repeating itself and the market for Treasuries is totalling ignoring the Fed's signals.  In response, the Federal Reserve may have to resort to selling at least part of its massive portfolio of Treasury bonds and notes to force interest rates up at the longer end of the yield curve.  Whether the Fed will be forced to sell their ample assets at a loss is anyone's guess.

Apparently even the smartest of central bankers may have forgotten the lessons taught by history.