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Monetary Policy as we Move toward 2015
The Fed continued to use the dovish “considerable time” language last week (saying interest rates would *not* rise soon, after QE ends). But the Fed’s “dot chart” clearly showed rates increasing next year.
In the meantime, the Fed clarified the tools they would use (eventually) to tighten, with the interest on excess reserves (IOER) playing the primary role. Reverse repos (RRPs) would be used as a secondary tool. Then, the Fed plans to let the balance sheet passively decline.
Perhaps it is best to characterize Fed Chair Janet Yellen not as a hawk or a dove, but as a “scientist”: when the data changes, she will change policy. Today, slack in the U.S. economy requires dovishness. That will not always be true – and the Fed’s 2015 forecast has already started to prepare the market for this eventuality.
The current data also suggest that the U.S. economy is getting more normal. The NY Fed mfg index surged to 27.5 in September last week, and the Phil Fed index remained solid at 22.5. Our SLIM survey of manufacturers also registered strong growth. The NAHB housing market index made a new high at 59 in September. Weekly initial jobless claims fell to 280,000 last week. The U.S. LEI increased +0.2% m/m in August. U.S. consumer net worth continues to increase.
To be fair, not all the economic data has been strong, with U.S. mfg industrial production falling -0.4% m/m in August and housing starts declining to a 956,000 annual rate. But it’s difficult to continue to use “emergency” monetary policy tools, if the economy is looking more normal as a whole. Low inflation (CPI -0.2% m/m and PPI flat in August) give the FOMC some breathing room. But the Fed doesn’t need to be in crisis mode for the foreseeable future.
Looking out to 2015, it seems likely that the Fed can remove policy accommodation, even if that accommodation is “removed at a pace that is likely to be measured” (as it was in 2004 – that’s the phrase from the May 2004 Fed statement).
Strategas Research Partners
How Can the Fed Tighten with a Large Balance Sheet?
Fed tightening tools include using: 1) Interest on Excess Reserves (IOER), 2) Reverse Repos (RRPs), 3) a passive balance sheet decline (letting assets mature off the balance sheet), and 4) selling assets (though this is probably too brute-force).
Fed reverse repos are a way for the central bank to pay interest to “non-banks”. As the Fed (itself) has described these operations: a reverse repurchase agreement, also called a “reverse repo”, is an open market operation in which the Fed sells a security with an agreement to repurchase (that same security) at a specified price & at a specific time in the future. Thus, the desk receives cash, and then returns that cash in the future. The difference between the “sale” price and the “repurchase” price implies a rate of interest paid by the Federal Reserve on the cash. The collateral used is typically Treasuries.
This is why the program complements the interest on excess reserves (which is paid to banks). There are legal restrictions on paying interest to non-banks. But fortunately, the Federal Reserve Act allows additional tools – ie, reverse repos (RRPs).
So, combining 1) the interest paid on excess reserves (IOER) and 2) the reverse repo programs (RRPs), the FOMC can direct payments to both banks and non-banks, thereby having a broader impact on the economy. By this logic, it would naturally make sense for the rate paid on excess reserves to be close to the rate on the reverse repo program. Even if there is a small spread, raising these rates together should not be technically difficult. Since the Fed is already paying “interest,” if they wanted to raise interest rates, they would simply pay more.
Strategas Research Partners