Saturday, December 14, 2013

If QE is "heroin", what is "methadone" and how do we avoid "side effects"?

The Federal Reserve remains concerned about exiting the massive bond buying program that has been in place for over a year now. The program has become a bit of a trap (see post), creating a dependence on unsustainable levels of stimulus. The concern is that in an environment where inflation is at historically low levels, cutting back on monetary stimulus could put significant downward pressure on prices, creating deflationary pressures and forcing the Fed to resume or even increase the program (similar to Japan). Using the addiction analogy (see this video for example), this is the equivalent of a relapse risk for those suffering from substance abuse. It turns QE from an extraordinary crisis fighting mechanism meant to be used only under extreme situations into an ongoing monetary policy tool. The Fed desperately wants to return to the days of simply adjusting short-term rates to drive policy.

So how does one minimize the impact of taper to reduce the probability of returning to "unconventional" programs? One approach is something that opiate addiction clinicians have been using for some 30 years. An effective treatment for heroin addiction is the use another, less dangerous opiate called methadone. It reduces withdrawal symptoms without creating intoxicating or sedating results, helping many addicts quit. So if heroin is analogous to the Fed's QE program for the economy, what is the equivalent of methadone?

Many are arguing that lowering the Interest on Excess Reserves rate (IOER) could potentially counteract some of the QE withdrawal symptoms. IOER is currently at 25 basis points, and while that was considered to be extraordinarily low back in 2008 when it was introduced, in the days of record low short-term rates many view it as being too high. That's because banks are quite comfortable paying near-zero on deposits (including deposits from the Federal Home Loan Banks) and receiving 25bp on reserves - a riskless way to generate revenue (see post). That spread according to some is holding back credit expansion in the US. The chart below shows growth in non-cash assets of all banks operating in the US - an unsettling trend for many economists.

By making it less profitable to hold on to cash, some argue that lowering the rate on reserves should "dislodge" the barrier to a more vibrant credit expansion.
Reuters: - The [IOER] rate has been criticized, however, for encouraging banks to park cash idly with the central bank instead of using funds to lend to companies and consumers that many say is needed to stimulate the economy and reduce unemployment.

Yellen, who has been nominated to succeed Fed chair Ben Bernanke at the end of January, said on Thursday that cutting excess reserves is "something that the FOMC has discussed, and the board has considered, on past occasions, and it is something we could consider going forward."
When cutting this rate simultaneously with the first series of cuts in securities purchases, the Fed could attempt to blunt the "withdrawal symptoms". This may avoid the "cold turkey" taper, which many view as dangerous given the disinflationary trends in the United States (see Twitter chart) and elsewhere in the developed world. So why hasn't the Fed already taken this step? As with any medication, this form of "methadone treatment" may have some side effects.

Europe found out the hard way that setting the rate on reserves to zero can severely damage the money markets industry - which is basically what happened in the euro area after Mario Draghi's rate announcement in July of 2012 (see post). While we've received emails arguing that money market funds are irrelevant, one has to keep in mind that in the US and offshore the industry holds $2.7 trillion of dollar deposits. Nobody wants havoc in that sector, particularly as taper takes hold.

That's why the Fed has been working on a way to avoid this potentially dangerous complication. It is called the Overnight Reverse Repo Facility (discussed here). This tool gives the Fed some control over the short-term rates outside the banking system to make sure money market rates do not dive below zero. Money market funds would be allowed to effectively deposit cash directly at the Fed (technically they would be lending to the Fed) and earn rates that are above zero. The program would set a floor on the overnight rates and in the long run the facility could be used in conjunction with (or even instead of) the fed funds rate to drive monetary policy.
Reuters: - Market speculation that the Fed may be nearer to acting on a cut also increased on Thursday after influential firm Medley Global Advisors said in a report that the Fed may cut the excess reserve rate, noting that it has more flexibility to do so now that it has been testing its reverse repurchase agreement program.

In reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral. This helps the Fed control short-term rates as the supply of collateral can stop market disruptions from rates falling to zero or into negative territory as cash floods into short-term markets.

The Fed has been testing this program since September.

"The logic for cutting the IOER now, would be to better align the IOER with other short-term rates and hopefully encourage greater market-based lending," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.

"With the creation of reserve draining facilities, like the Overnight Reverse Repo Facility, the Fed now has the ability to better align rates without destabilizing money markets given that the Fed can essentially put a 'floor' on short-term rates by injecting collateral/draining reserves into the market. This would have a stabilizing effect," he said.
We could therefore see the Fed execute all three policy changes at the same time:
1. Taper (weaning the economy and the markets off QE "heroin")
2. Reduction in the IOER rate to encourage lending (methadone treatment for reducing withdrawal symptoms)
3. Introduction of the Overnight Reverse Repo Facility to keep the overnight rates from dropping below zero and destabilizing money markets (managing medication side effects).

Of course it is not entirely clear if lowering the IOER rate will encourage significantly more lending. However such action will certainly send lenders to seek out other sources of revenue in order to replace the easy money generated by the current spread between IOER and deposit rates.
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