More clarity from the FOMC on the mechanics of liftoff

The latest FOMC minutes provided some clarification on the approach the Fed is expected to take as it begins normalizing short term rates in the US. Here is a quick overview of the Fed's strategy and potential implications.

The Fed has chosen the interest rate on excess reserves (IOER) as the primary tool to control interest rates during the normalization process. While working with IOER is certainly more effective than the Fed Funds rate, there are a some drawbacks. As banks pay nearly nothing on deposits and earn an increasingly higher rate on reserves, the Fed will be criticised for providing banks with more riskless profits (on some $2.5 trillion of excess reserves).

To mitigate this thorny issue, the Fed will also rely on the reverse repo program (RRP). The FOMC now views RRP as playing a "supporting role" of providing a floor on repo rates. Keeping repo rates from getting too low will allow money market funds to offer higher rates to their clients. At least in theory that is supposed to provide competition for deposits, forcing banks to raise deposit rates and limiting the deposit-to-reserves arbitrage. The FOMC wants to see the spread between IOER and RRP at around 20bp or higher.

Fed Minutes: - The appropriate size of the spread between the IOER and ON [overnight] RRP rates was discussed, with many participants judging that a relatively wide spread--perhaps near or above the current level of 20 basis points--would support trading in the federal funds market and provide adequate control over market interest rates. Several participants noted that the spread might be adjusted during the normalization process.

For example the Fed could set IOER to 50bp and RRP to 30bp. That would put money market rates at say 45-60bp and bank bank deposit rates at something like 25-35bp (currently the national average is 11bp on bank savings accounts), capping the IOER-to-deposit-rate spread.

The FOMC seems to be uneasy about a more aggressive use of the RRP, fearing that in times of crisis the participants will pile all their liquidity into the Fed facility, draining the reserves, and taking liquidity out of the private sector.

Fed Minutes: - Most participants expressed concerns that in times of financial stress, the [RRP] facility's counterparties could shift investments toward the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress.

Some are uneasy with RRP becoming a "window dressing tool", tightening liquidity at quarter- and year-end (see post). The spikes will become particularly severe during periods of financial stress, potentially causing disruptions in private funding markets.

Source: JPMorgan

Some of the Fed officials are also afraid that the Fed could quickly become the dominant player in the repo markets, potentially resulting in some "unintended consequences". RRP will therefore continue to have limits per counterparty and is not expected to persist as a tool much beyond the period of rate normalization.

Some market participants had hoped that the RRP program will release the much needed "quality" collateral into the system, alleviating collateral shortages. The rise in treasury delivery fails continues to plague the markets (see discussion).

Source: JPMorgan

The RRP's impact on collateral shortages however is expected to be limited. Part of the issue (in addition to the RRP being more limited in scope) is that the Fed posts treasury collateral via "tri-party" repo transactions. These securities are held by a custodian bank and will generally not be "reused" as collateral elsewhere.

JPMorgan: - Higher margin requirements as a result of recent regulations on OTC derivative markets, for example, have caused a rise in collateral demand. But securities held within the tri-party system in the US are typically not allowed to be used to satisfy margin requirements. This means that the USTs released via the Fed’s ON RRP facility will not have the same effect in alleviating increased collateral demand stemming from higher margin requirements, than if the Fed had directly sold these UST securities to open markets.

The shortage of collateral will continue to persist even after the end of quantitative easing, which has permanently removed too much collateral from private holders. The only solution is for the Fed to sell some of its holdings, a scenario which remains highly unlikely.

Once the FOMC is ready, the announcement of the rates "liftoff" will be accompanied by the following rate settings:

1. The Fed Funds target and the Discount window rate (traditional tool).
2. The IOER rate
3. The overnight RRP rate (20b or more below the IOER rate) and the size limit per counterparty

Other suggested tools such as term deposits (which the ECB has been using in a limited fashion for some time) are unlikely - too many moving parts for the FOMC.

Assuming things are going OK some time after the "liftoff", the Fed will announce the end of reinvestment, allowing the securities it holds to mature. This will need to happen as soon as possible in order to begin increasing the amount of collateral held by private participants.


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The question of crowding out with the Fed's reverse repo program

Some economists have raised concerns that the Fed's experimental reverse repo program (RRP) could crowd out banks. The latest data from Barclays shows that as RRP expanded, money market funds have been placing a greater percentage of their overnight liquidity with the Fed rather than with banks.

Source: Barclays Research

Before the Fed's program was launched, money market funds would have to go into the market daily to see where they can place their cash on a secured basis (take in securities as collateral). Given how awash the system is with liquidity these days, banks have had a fairly limited need for overnight funding from money funds. They would therefore offer near zero and sometimes negative rates, depending on how much liquidity money market funds wanted to park overnight. The process was stressful and competitive for these funds.

Now comes the Fed with a fixed rate offering - without the competitive pressures (although for a limited amount only). It's not a surprise therefore that money market funds are using RRP to the fullest extent allowed. The question of course is what will happen when the Fed begins to offer unlimited amounts of this product - which is ultimately the goal. Will all of this overnight liquidity go to the Fed and will it create a funding problem for banks? The answer is: banks will be just fine.

To the extent banks are flooded with liquidity and don't need this overnight capital from money market funds, a great deal of the funds' cash will indeed go to the Fed. However if some banks decide to keep their funding source from money funds, they would simply need to offer a slightly higher rate. At some level money market funds will take on some bank risk (with collateral) in order to get a better rate than what the Fed is offering. RRP simply becomes the absolute floor on secured funding rates - funds would only use it if better rates are not available. There is no "crowding out" risk with RRP.

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How bank reserves make the gap between deposits and loans disappear

Earlier this week, CNN Money ran a story on JPMorgan's quarterly results. Instead of focusing on the earnings, the author's (Stephen Gandel) discussed the fact that JPMorgan's loan-to-deposit ratio (LTD) hit a new low.

FORTUNE: - The nation's largest banks are healthier than they have been in years. Someone, apparently, forgot to tell their loan officers.

JPMorgan Chase reported its 2013 profits on Tuesday. The news was mostly good -- bottom line: $18 billion -- but there was one significant black spot, not just for the bank, but for the economy in general. A key lending metric, the ratio of the bank's loans-to-deposits, hit a new low.

In 2013, JPMorgan on average lent out just 57% of its deposits. That's down from 61% a year ago and the lowest that ratio has been in at least a decade. Back in 2004, JPMorgan's loan-to-deposit percentage was as high as 88%.

While JPMorgan's LTD is particularly low, the bank is by no means unique. As discussed earlier (see post), LTD in the US is at the lows not seen in decades. On an absolute basis the gap between deposits and loans is now at some $2.4 trillion and growing. This divergence seems completely unique to the post-financial crisis environment.

Red = loans and leases, Blue = deposits (all commercial banks)

As the CNN story suggests, there are a few possible explanations for this trend. Here are four of them.

1. Demand for credit remains weak due to economic uncertainty, large amounts of cash on corporate balance sheets, jittery labor markets, poor wage growth expectations, general unease with taking on debt, etc.

2. Regulatory uncertainty and tighter (and to some extent unknown) capital requirements are preventing banks from extending more credit.

3. Exceptionally low rates make some forms of lending unprofitable.

4. Banks are running unusually large excess reserve positions with the Fed that are "crowding out" lending.  These reserves are effectively "loans" to the Fed paying 25bp, funded with bank deposits that pay near zero, creating riskless profits with zero regulatory capital requirement.

There are arguments to be made for all four. The last one however is particularly intriguing because the $2.4 trillion gap between deposits and loans is a familiar number. The excess reserves in the banking system is now ... also around $2.4 trillion.

The chart below adds bank reserves held with the Fed to loans and leases - and the gap "disappears" (here we use total reserves vs. just the excess reserves, but the difference is not material to this trend.)

Red = loans and leases + bank reserves, Blue = deposits (all commercial banks)

Coincidence? Perhaps. But if there is any validity to the explanation #4 above, it would suggest that QE, which is directly responsible for the $2.4 trillion in excess reserves, was not helpful (and possibly harmful) to credit growth in the US.

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Fed contemplates creating "overnight reverse repo facility"

Today investors focused on the broad support for tapering in the July FOMC minutes, driving treasury yields sharply higher.

10yr treasury yield (source: Investing.com)

There was however another passage in the minutes that wasn't broadly covered in the mass media.

July FOMC minutes: - In support of the Committee’s longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee’s ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.

It's an interesting development because this project could potentially achieve three objectives:

1. The "full-allotment overnight reverse repurchase agreement facility" can provide competition for bank deposits. While deposits of under $250K rely of the FDIC insurance, corporate and institutional depositors remain concerned about bank credit risk because in a bankruptcy depositors become unsecured creditors. By allowing non-banks to participate, the Fed creates a deposit account that is free of counterparty risk (currently the only way to achieve this is by purchasing treasury bills).

2. Instead of just changing the interest paid on bank reserves to manage short-term rate policy (in addition to the fed funds rate), the Fed would now have another monetary tool - adjusting rates paid on these types of broadly held accounts.

3. By accepting broader deposits, the Fed can effectively "soak up" excess liquidity and "sterilize" some of its securities holdings. And by adjusting these rates, the central bank could fine-tune how much liquidity these accounts attract. This reduces the need to sell securities in order to drain liquidity from the system.

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The Fed's latest dilemma

The Fed continues to be divided over the next steps for its unprecedented monetary expansion program. Varying interpretations and conflicting headlines in the press leave the public bewildered and frustrated. The following two stories for example have appeared right next to one another on Bloomberg today.

But now the Fed has a new problem. The central bank's securities purchases are financed with bank reserves, which have been rising steadily in 2013 (chart below).

Source: FRB

And to many on the Fed that was justifiable as long as US commercial banks continued to expand their balance sheets. But recently that expansion has stalled.

Source: FRB

To some this calls into question the effectiveness of the whole program, since the transmission from reserves into credit is so weak. The Fed is now facing the following choices:
1. slow the purchases and run the risk of shrinking credit and rising interest rates or
2. continue with the program and risk QE "side effects" without the needed credit expansion (which has stalled).

That's why we are likely to see the Fed even more divided going forward, adding to more uncertainty and frustration by investors (including those outside the US) as well as the public.

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Outright asset purchases by the Fed will increase US banking system leverage ratios and potentially limit lending

There seems to be quite a bit of confusion about the impact of US banks' deposits at the Fed on the overall bank credit. People are asking "how can US banks be lending when they are keeping all this money in excess reserves (deposits) with the Federal Reserve"? "They are just hoarding cash, etc." But as discussed in this post on the ECB Deposit Facility, bank excess reserves are a function of the central bank's balance sheet, and have nothing to do with how much banks are lending. If banks in the US for example double their lending today, the deposit amount at the Fed would stay constant.

That's because if you borrow dollars from Bank A, you are going to deposit your cash at another bank (Bank B) or pay someone who will deposit this money at their bank (Bank C). Let's say Bank C buys securities with that money. But now whoever they bought securities from has that cash on deposit with Bank D, etc. Sooner or later some US bank will end up with that money and "deposit" it with the Fed - there is simply no other way around it. Here is a good quote from JPMorgan on how this works in practice:

"... increased (or decreased) lending will not change the amount of aggregate reserves within the banking system. For example, Bank A lends money to a business by writing that business a check. The business deposits that check in its own bank, Bank B, which presents that check to the Fed. The Fed then debits the reserves of Bank A and credits the reserves of Bank B. Reserves have been neither created nor destroyed, they have just changed hands. The Fed is the only institution that can change the aggregate amount of reserves."

When the Fed buys a security outright, it credits some bank the cost of the security (say X dollars) and the chain above begins until some bank (or multiple banks) ends up with that X dollars on deposit at the Fed, increasing total reserves. The only thing that could change this direct relationship between the Fed's balance sheet and bank reserves is the amount of physical cash notes under people's mattresses or in bank vaults. But that amount is small relative to the overall monetary base (total dollars) and tends to grow very gradually.

JPMorgan: - "The only thing a bank’s reserves can become—other than another bank’s reserves—is [physical] cash. ... the demand for cash changes slowly, so increasing vault cash will only increase banks’ storage and handling costs."

Fed's balance sheet vs. bank deposits at the Fed (reserves)

This means that as the Fed increases its balance sheet, it automatically raises bank reserves (deposits at the Fed) by roughly the same amount. And by doing so, the Fed grows the balance sheets of the US banking system (by increasing the amount of this particular asset banks hold). Even though deposits at the Fed do not require any regulatory capital (zero risk weighted assets), banks' reported leverage would increase, potentially causing them to limit lending activities.

JPMorgan: - "Although this asset has zero-weighted risk, it will increase banks’ leverage ratios. For this reason, banks may be inclined to reduce other forms of credit."

This is yet another reason the Fed will try avoiding outright asset purchases (QE3) for as long as possible, developing other easing alternatives instead.

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FOMC's new tools

FOMC Minutes (of the Meeting of June 19–20, 2012): - Several participants commented that it would be desirable to explore the possibility of developing new tools to promote moreaccommodative financial conditions and thereby support a stronger economic recovery.

This got a great deal of speculation going. What could be the "new tools"? Here are some possibilities:

1. Sterilized securities purchases: see item #2 in this post.

2. Sterilized securities purchases involving MBS: see this post for more detail.

3. Cutting rates on banks' excess reserves to zero. This is essentially what the ECB just did, resulting in negative yields for much of the stronger Eurozone government short term paper. It certainly has the potential of pushing the short end of the US curve deep into negative territory as well. Such a move may also have some unintended consequences such as weakening of the dollar, damaging the repo markets, and negatively impacting US money market funds.

4. Some have suggested that the Fed could potentially introduce a scheme similar to the UK’s cheap-funding-for-lending program. The Bank of England is putting in place a scheme to provide long-term funding to banks that commit to lend these funds to customers. In the US however there are legal restrictions that limit collateral types for any long-term lending by the Fed to residential (and some multifamily) mortgages. This program would therefore only work for banks who want to do more mortgage lending. It's not clear this approach would be helpful because lending in the US is not constrained by banks' funding needs but by risk aversion (and in some cases regulatory capital). This however would certainly qualify as a "new tool".

5. A commitment to hold the Fed Funds rate near zero for a defined (longer term) period. The current low rate statement is not a "pledge", just a forecast. An actual term pledge would involve a new approach. It's an interesting but a bit dangerous idea because it takes away the Fed's ability to raise rates in the near future in case of unexpected inflationary pressures.

6. An all-out "unsterilized" QE3: see item #3 in this post as to why such policy decision is unlikely at this juncture.

Other than this set of tools, it would be difficult for the Fed to implement another program under the current law (particularly with Dodd Frank in place). Some ideas thrown around such as the Fed lending to small businesses, issuing Fed bills to sterilize asset purchases, etc., would require the involvement/approval of the US Treasury. And that would create a prolonged political mess, something the Fed is likely to stay away from for now.

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Fisher rejects the need for QE3

In a recent speech in Dallas, the Dallas Fed President Fisher (non-voter) made some comments on the Fed’s monetary policy. He said that he is "personally perplexed" by the markets’ "continued preoccupation" with "so-called QE3." Unless the "patient" (the US economy) goes into "postoperative decline," he sees no reason for additional monetary easing.

Fisher’s view is that large asset purchase programs "injected money into the system," but that "most of that money has accumulated on the sidelines" in the form of excess reserves with the Fed.

US banks excess reserves

The negative view of QE3 is in agreement with other more hawkish FOMC members who don’t believe such a program's benefits justify the potential risks. The chart below is a good example of how relatively ineffective QE has been in increasing the broad money supply. M3 was already recovering when QE2 began, and it's unclear just how much of an impact asset purchases had on broader liquidity.

Source: Capital Economics (* M3 is their calculation, not the Fed)

Fisher also referred to the FOMC forecast for exceptionally low rates through 2014 as "not to be used externally, but also harmful if swallowed" (a quote from the 1966 FOMC forecast).

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Bernanke's next steps

Let's take a quick look at options currently available to the Fed and their potential next steps. With the dollar under pressure and bank reserves at historical highs, one would think the Fed is getting uneasy with all the liquidity in the system. Now that the short-term liquidity facilities are winding down, much of the new securities purchases will increase the balance sheet and grow the money supply. Many beleive this will surely lead to inflation.

To address this, the Fed has the following two tools (outside of outright securities sales):

1. Purchase new securities (RMBS, Agency paper, etc.) on repo (sterilized purchases). The Fed would effectively buy the securities and immediately lend them out for some period, taking in cash collateral. This takes these securities out of the market, but does not increase the money supply because the proceeds from these sales would not be available to the dealers (the proceeds become the cash collateral). This could be done not only with new purchases, but with securities already on Fed's balance sheet (about $1.5 trillion worth). To accomplish this on a scale that makes a difference, the Fed needs to set up repo lines with banks and dealers outside of the Primary Dealer group. The primary dealers may not have the capital to absorb such massive amounts of repo transactions on their own.

2. The Fed could also raise rates. But this wouldn't be simply raising the Fed Funds Target Rate. Instead the Fed now has the ability to raise interest rate on the reserves that banks keep with the Fed. That immediately creates a floor on rates because banks have no incentive of lending at levels at or below the reserve rate. Instead they can simply deposit the funds with the Fed on a riskless basis. This tool has been used by other central banks for decades.

The first tool may be set up relatively soon, particularly for new purchases, but it's usage should be fairly modest in the near-term. The rate increases however are months away. Here are two reasons for the Fed's dovish approach:

1. The Fed will not take any rate action until they see improvement in employment. And as we discussed earlier, this may take a while. This is particularly true because many recent jobs (the "bubble jobs") were created on the back of construction spending.

2. The Fed (among numerous measures available to them) watches one key indicator quite closely: the rate of change in "broad" money supply relative to the "narrow" money supply. It's a measure of how effective the liquidity injections have been in stimulating lending. Banks can be loaded with cash, but if they don't lend, the cash is not making it's way into the broader money supply (the banks effectively stay overcapitalized). And that means the broader economy is not benefiting from the liquidity the Fed had provided, which limits it's growth. The chart below shows the relative growth of M1 (narrow measure) and M2 (broader measure). Until M2 picks up significantly, the Fed will do very little in terms of tightening.


source: St. Louis Fed


Inflation is unlikely to pick up until credit is available in the broader economy to allow corporations and individuals to pay higher prices. With broader money supply responding this slowly, significant price and wage increases are unlikely in the near-term.

The possibility of the Fed actually selling securities from it's balance sheet outright is even less likely. Such sales may impact long-term rates, which may have a negative effect on housing and the consumer, and the Fed will categorically not go there. The RMBS securities, the agency paper, and even treasuries they have bought, will stay on Fed's balance sheet for years to come, possibly to maturity.

As LIBOR declines, banks hoard more cash at the Fed

US Banks continue to hoard over $850 billion in cash at the Federal Reserve. They are required to hold some reserves there, but since the Fed started paying interest on deposits last year, that amount spiked and stayed at these elevated levels.




In fact that deposit amount has been rising recently. The reason has to do with the collapse in interbank deposit rates (LIBOR). The chart below shows just how flat the LIBOR curve has become:




Out to 3 months the rate is almost the same as the overnight rate. It's an indication of the spectacular rise in confidence banks have in each other and their own ability to fund themselves short-term. If you are a bank treasurer however, and you have a choice of depositing your excess cash with other banks or with the Fed at almost the same rate, your preference would be to park the money with the Fed. And that is exactly what is taking place with the decline in LIBOR rates.

Part of the problem with Western banks these days is that much of the liquidity is trapped within the banking system. One way some central banks have been dealing with this is to lower the deposit rate on reserves to zero, and even below zero. This forces banks to look for a better place to put the money and possibly do some lending. But it continues to be a challenge to encourage banks to lend outside the banking system; they either lend to each other or to the central bank (via reserve deposits).

So far in the US there is no evidence that much of this cash is making it's way to the consumer. Consumer loans outstanding at commercial banks have actually been declining.


source: the Fed


That is why the expectation is for the Fed to stay put for a while with respect to rates. Until some of the liquidity the banks are hoarding in reserve deposits is unlocked, consumer credit will continue to stay constrained.

So where is the TARP money and all the other cash?

We've been getting numerous e-mails questioning what has happened to the TARP funds the banks still hold. Plus what about all the new debt banks have issued including the FDIC guaranteed debt. What happened to recent earnings? Why aren't banks lending? Where's the cash?

Let's see if we can shed some light on the issue using some data from the Fed. TARP funds (though helped add equity to banks) are actually a drop in the bucket in comparison to the overall deposits at banks, which continue to grow. Deposits are now at some $7.5 trillion:



What about the lending then? How have bank assets grown to date? Here is a chart that shows all the loans historically outstanding on banks' balance sheet:



The lending has leveled off at about $7 trillion. This includes corporate as well as residential and consumer loans. But relative to deposit growth one would expect to see more lending. Here is the total loan-to-deposit ratio:



So where are the banks placing all their cash? And NO it's not in the treasury certificates the two guys caught in Italy were carrying as many have suggested.

One place to look is at bank holdings of government or agency bonds - liquid paper held for emergency purposes that would not require significant amounts of capital. The amounts of liquid paper held. actually took a nose dive last year as banks were selling all liquid securities to raise cash. But now this is where some of the bank cash is going:



The most striking change however is the cash banks hold at the Fed. Banks are required to always hold some amount at the Fed as reserves (reserve requirements). But now banks use the Fed as a parking place for their cash, holding far more than the reserve requirements. It's about $800 billion in total vs. under $60 billion required, as the chart below shows:



Now that the Fed pays interest on cash deposits (a recent change), this in fact is the ultimate safe place to dump cash. It's a riskless deposit without any capital requirement that pays some interest. The Fed now pays 0.25% (annualized - which is better than T-bills) to banks, and the banks pay their depositors probably half that (unless a bank wants to grow deposit base and set an attractive rate).

So why hoard all that cash? Here are 3 reasons:

1. The demand for loans is actually not that great - at least for loans the banks want to underwrite. Companies that are profitable don't have immediate growth plans and don't want increase leverage. Why would they in this environment? Those who can issue bonds and pay down their loans have been doing so. Consumers who qualify for a mortgage are not in a hurry to buy either. Without the securitization market, banks have a limited appetite for other consumer loans unless they get TALF help (which they have been utilizing somewhat).

2. Banks are still paranoid about deteriorating assets and any unexpected growth in balance sheet. For example here is a chart that shows home equity loans on banks' balance sheets. Desperate consumers are drawing on home equity lines as they too try to hoard cash or just trying to survive (sometimes trying to get ahead of their bank cutting the line.) This is a scary trend for banks and they need to reserve for it to avoid finding themselves overleveraged again.



3. Banks are trying to deleverage. They are trying to raise new equity and a nice helping of cash on the balance sheet makes it easier for them do that. Here is a chart of overall bank net equity. It had an ugly dip last year and banks just don't want to be near there again. It's a race against time: recapitalization vs. asset deterioration.