Wednesday, February 17, 2010

The IOER Traget Is Now in Play; The Fed's Scary Take on Draining Reserves

The Federal Reserve has come up with a new acronym, IOER. It stands for interest rate on excess reserves. In the FOMC minutes released today, it is clear that the Fed is considering a major role for the IOER when it comes to managing the money supply. Here's the Fed discussion on the IOER and methods they are considering to control the money supply:
Staff also briefed policymakers about tools and strategies for an eventual withdrawal of policy accommodation and summarized linkages between these tools and strategies and alternative frameworks for implementing monetary policy in the longer run. The tools for moving to a less accommodative policy stance encompassed (1) raising the interest rate paid on excess reserve balances (the IOER rate); (2) executing term reverse repurchase agreements with the primary dealers; (3) executing term RRPs with a broader range of counterparties; (4) using a term deposit facility (TDF) to absorb excess reserves; (5) redeeming maturing and prepaid securities held by the Federal Reserve without reinvesting the proceeds; and (6) selling securities held by the Federal Reserve before they mature. All but the first of these tools would shrink the supply of reserve balances; the last two would also shrink the Federal Reserve's balance sheet. The Desk already had successfully tested its ability to conduct term RRPs with primary dealers by arranging several small-scale transactions using Treasury securities and agency debt as collateral; staff anticipated that the Federal Reserve would be able to execute term RRPs against MBS early this spring and would have the capability to conduct RRPs with an expanded set of counterparties soon after. In coming weeks, staff would analyze comments received in response to a Federal Register notice, published in late December, requesting the public's input on the TDF proposal. Staff would then prepare a final proposal for the Board's consideration. A TDF could be operational as soon as May.

Staff described several feasible strategies for using these six tools to support a gradual return toward a more normal stance of monetary policy: (1) using one or more of the tools to progressively reduce the supply of reserve balances--which rose to an exceptionally high level as a consequence of the expansion of the Federal Reserve's liquidity and lending facilities and subsequent large-scale asset purchases during the financial crisis--before raising the IOER rate and the target for the federal funds rate; (2) increasing the IOER rate in line with an increase in the federal funds rate target and concurrently using one or more tools to reduce the supply of reserve balances; and (3) raising the IOER rate and the target for the federal funds rate and using reserve draining tools only if the federal funds rate did not increase in line with the Committee's target.

Participants expressed a range of views about the tools and strategies for removing policy accommodation when that step becomes appropriate. All agreed that raising the IOER rate and the target for the federal funds rate would be a key element of a move to less accommodative monetary policy. Most thought that it likely would be appropriate to reduce the supply of reserve balances, to some extent, before the eventual increase in the IOER rate and in the target for the federal funds rate, in part because doing so would tighten the link between short-term market rates and the IOER rate; however, several noted that draining operations might be seen as a precursor to tightening and should only be undertaken when the Committee judged that an increase in its target for the federal funds rate would soon be appropriate. For the same reason, a few judged that it would be better to drain reserves concurrently with the eventual increase in the IOER and target rates.

With respect to longer-run approaches to implementing monetary policy, most policymakers saw benefits in continuing to use the federal funds rate as the operating target for implementing monetary policy, so long as other money market rates remained closely linked to the federal funds rate. Many thought that an approach in which the primary credit rate was set above the Committee's target for the federal funds rate and the IOER rate was set below that target--a corridor system--would be beneficial.

How confident is the Fed about the proper method to drain the huge amount of reserves that now sit on the Fed's balance sheet? Not very.

This is truly remarkable, the Fed has pumped all these reserves into the system and they really are not sure how they should drain them (my emphasis):
Participants recognized, however, that the supply of reserve balances would need to be reduced considerably to lift the funds rate above the IOER rate. Several saw advantages to using the IOER rate, rather than a target for a market rate, to indicate the stance of policy. Participants noted that their judgments were tentative, that they would continue to discuss the ultimate operating regime, and that they might well gain useful information about longer-run approaches during the eventual withdrawal of policy accommodation.

Finally, staff noted that the Committee might want to address both the eventual size of the Federal Reserve's balance sheet and its composition. Policymakers were unanimous in the view that it will be appropriate to shrink the supply of reserve balances and the size of the Federal Reserve's balance sheet substantially over time. Moreover, they agreed that it will eventually be appropriate for the System Open Market Account to return to holding only securities issued by the U.S. Treasury, as it did before the financial crisis. Several thought the Federal Reserve should hold, eventually, a portfolio composed largely of shorter-term Treasury securities. Participants agreed that a policy of redeeming and not replacing agency debt and MBS as those securities mature or are prepaid would contribute to achieving both goals and thus would be appropriate. Many thought it would also be desirable to redeem some or all of the Treasury securities owned by the Federal Reserve as they mature, recognizing that at some point in the future the Federal Reserve would need to resume purchases of Treasury securities to offset reductions in other assets and to accommodate growth in the public's demand for U.S. currency. Participants expressed a range of views about asset sales. Most judged that a future program of gradual asset sales could be helpful in shrinking the size of the Federal Reserve's balance sheet, reducing reserve balances, and shifting the composition of securities holdings back toward Treasury securities; however, many were concerned that such transactions could cause market disruptions and have adverse implications for the economic recovery, particularly if they were to begin before the recovery had become self-sustaining and before the Committee had determined that a tightening of financial conditions was appropriate and had begun to raise short-term interest rates. Several thought it important to begin a program of asset sales in the near future to ensure that the Federal Reserve's balance sheet shrinks more quickly and in a more predictable manner than could be achieved solely by redeeming maturing securities and not reinvesting prepayments; they judged that a program of asset sales spread over a number of years would underscore the Committee's determination to exit from the period of exceptionally accommodative monetary policy in a manner and at a pace that would keep inflation contained without having large effects on asset prices or market interest rates. A few suggested that the pace of asset sales, and potentially of purchases, could be adjusted over time in response to developments in the economy and the evolution of the economic outlook. The Committee made no decisions about asset sales at this meeting.
The only thing you can read into this is that the Fed is going to "try stuff" and see what happens. There is no other way to interpret this sentence:
Participants noted that their judgments were tentative, that they would continue to discuss the ultimate operating regime, and that they might well gain useful information about longer-run approaches during the eventual withdrawal of policy accommodation.
Scary. I emphasise we are talking about the control of the money supply of the country and they are going to play it by ear, to see what works.


  1. Hi Robert,

    John Hussman has laid out a scenario at, do you agree with his assessment or do you see any chinks in his argument?

  2. It's a possible scenario. I have pointed out a number of times that the excess reserves would most likely be involved in the drain of reserves. The Hussman scenario does that. He does make a couple of assumptions that would need to be explained, for example, why and how do the banks begin to suddenly use their excess reserves to buy Treasuries versus making other laons? What is the dynamite that is suddenly going to cause banks to do this?

    The FOMC minutes clearly indicate the Fed isn't sure what is going to happen. If the Fed thought the Hussman scenario would go smoothly they might be all for it. On the other hand, it puts another trillion plus dollars of debt on the books of the Treasury.

  3. Did you find a host for your blog? I hope you will let readers know a head of time.

    Thanks for all the great information Mr. Wenzel!

  4. There's no one flying the plane! lol

    Banks will go where they see the best option for them, not the Fed. Keep in mind, they are keenly looking at options that not only make more than 25 bps, but have satisfactory interest rate and prepayment risk. I'm not holding my breath here that these conspirators have my best interest at heart. [pun intended]

    What we have here is desperation on a part of the Fed. They've painted themselves into a corner in which they know they cannot stay.

    How do you devise a scheme to make it go away without breaking something and making matters worse? Reading this Fed fantasy does not inspire confidence.

    Yeah, it's scary alright. Scary in that these jokers don't have anything on the line--they get paid just the same. We who fight the good fight on Main Street (4th Avenue, actually) have retirement and college funds hanging in the balance.

  5. Perhaps the only thing worse than a calculating socialist-- a calculating socialist who isn't sure how to calculate.

  6. Thanks for your analysis; I agree with it completely.

    You mention the Fed is considering raisng the interest rate paid on excess reserve balances (the IOER rate).

    Well, there is a problem here for either the banks or the FED, as market interest rates are headed higher, as The US Treasury Bond Market broke down on Wednesday 2-10-2010

    Said another way, when the Fed goes to auction next week, it will do poorly, and the market will be calling interest rates higher.

    So my question is: as the Fed is guardian of the Treasuries, does the loss of value on the Treasures go to the Fed, or does it go to the banks. I would assume the banks, and the banks are not going to be happy with deteriorating principle.

    If I were a banker, I would dump the Treasuries, which make up their excess reserves, and go short Treasuries with TBT, and short the markets with EEV, REW, SJH, TWM, EPV.