Back in early April, one of the foremost experts on the practical applications of QE (there are many more “experts” on the discredited theoretical framework of QE, most of whom are career economists), Credit Suisse’s Zoltan Pozsar wrote a note titled “What Excess Reserves”, in which the former NY Fed analyst made a very clear case for why the Fed’s balance sheet will never shrink again (particularly in the context of the broken Fed Funds market). Some of the note’s highlights:
Instead of asking when the Fed will shrink its balance sheet, it’s about time the market gets used to the idea that we are witnessing a structural shift in the amount of reserves the U.S. banks will be required to hold, where reserves replace bonds as the primary source of banks’ liquidity. And that this shift will underwrite demand for a large Fed balance sheet.
Back in April, ge also laid out the role of the Fed’s massively expanded balance sheet in the context of the prime money fund shrinkage as a result of the October 14 money market reform deadline:
[W]e are witnessing a structural shift in the amount of reserves held by foreign banks as well. Gone are the days when foreign banks settled their Eurodollar transactions with deposits held at correspondent money center banks in New York. Under the new rules, interbank deposits do not count as HQLA, and foreign banks are increasingly settling Eurodollar transactions with reserve balances at the Fed. Foreign banks’ demand for reserves as HQLA to back Eurodollar deposits and as ultimate means of settlement for Eurodollar transactions will underwrite the need for a large Fed balance sheet as well. Prime money fund reform is a very important yet grossly under-appreciated aspect of this, one with geo-strategic relevance for the United States.
Prime money funds have been providing the overwhelming portion of funding for foreign banks’ reserve balances. If the prime money fund complex shrinks dramatically after the October 14th reform deadline, funding these reserve balancees will become structurally more expensive. This in turn means that for foreign banks across the globe running Eurodollar businesses – lending Eurodollars and taking Eurodollar deposits – will become structurally more expensive. Why? Because if the LCR requires banks to hold more reserves as the preferred medium for settling Eurodollar transactions and the funding ofthese balances become more expensive, funding the liquidity portfolio corresponding to Eurodollar books may become a negative trade. Will that somewhat diminish the dollar’s pre-eminence as the global reserve currency and play into China’s hand? You bet…
Naturally, the loss of the dollar’s reserve status has to be avoided. But Pozsar’s conclusion was simple: the size of the Fed’s balance sheet isn’t going down, and the Fed will have to accept and admit it:
with the private sector’s ability to issue money market claims sharply limited by Basel III, money can only find a home on the sovereign’s balance sheet: either through the Treasury bill market or through the Fed’s o/n RRP facility. Either option will mean that demand for a large Fed balance sheet will remain: reserves will not be eliminated, but swapped into other liabilities – larger cash balances for the U.S. Treasury (and on the flipside more bills for institutional cash pools) and more o/n RRPs for money funds (and on the flipside safer money funds for institutional cash pools).
Oddly, however, the Fed keeps emphasizing that the o/n RRP is not there for the long haul or to meet money funds’ demand for safe assets, but to put a floor under interest rates.
We disagree. Quantities matter again, in ways the Fed has yet to appreciate.
Well, after this weekend’s Jackson Hole symposium it is clear that quite a few of the Fed members have read the Pozsar piece and are now appreciating that it is very unlikely that the Fed’s balance sheet will ever shrink again.
To be sure, that’s not quite framed as policy just yet. In a presentation by the head of the NY Fed’s capital markets head, Simon Potter, he projected that the Fed’s SOMA Holdings of domestic securities would begin declining between 2018 and 2020. Granted, this is long after the December 2014 forecast, which anticipated that the Fed’s balance sheet would have declined substantially by now. It did not.
The head of the PPT then said the following prepared remarks:
Today, many advanced economy central banks find themselves in a situation where their policy rate is at or close to zero, and policy accommodation is being added or maintained by asset purchases and forward guidance. For example, the FOMC has indicated that it will continue reinvestment of principal payments on its portfolio until normalization of the fed funds rate is well underway. As can be seen in Figure 7, market estimates of when the SOMA portfolio will start to normalize have moved out from the end 2015 to the middle of 2018 or even later.
In retrospect, this appears to be merely padding to a Fed which realizes it will never be able to unwind its balance sheet again. As Reuters commented overnight, “policymakers think new tools might be needed in an era of slower economic growth and a potentially giant and long-lasting trove of assets held by the Fed. And they are convinced the time to vet them is now, while rates look to be heading up.”
“Central banking is in a brave new world,” Atlanta Fed President Dennis Lockhart said in an interview on the sidelines of the conference.
At the center of the Fed’s discussions is its $4.5 trillion balance sheet, built up by bond-buying sprees to combat the 2007-09 recession but which has been criticized by many lawmakers.
While policymakers have maintained the Fed should eventually reduce its bond holdings, Lockhart said some officials were closer to accepting that they needed to learn to live with them. “I suspect there are colleagues who are contemplating at least maybe a statically large balance sheet is just going to be a fact of life and be central to the toolkit,” he said.
So far the official narrative has been that the balance sheet will shrink only very slowly, a process that would take years and would not begin until interest rate increases are well underway. Progress could be made only in a very long-lived economic expansion. “I am sure everyone in the audience would be happy if this were the reality. I certainly would be,” Simon Potter, the New York Fed’s markets chief, said during the conference.
Instead of expecting balance sheet shrinkage, think more QE: Yellen, in her speech on Friday, said balance sheets would likely swell again in future recessions as the Fed snaps up assets to stimulate the economy.
But whether or not the Fed’s balance sheet ever srhinks again (it won’t), there are bigger issues, as noted earlier: the conference presented a menu of more exotic proposals. This included a Fed takeover of short-term debt markets and abolishing cash in order to charge negative interest rates.
Many of the more radical proposals, including one to abandon monetary policy altogether and focus on urging runaway deficit-spending, were seen as ivory tower musings. Most policymakers, including Yellen, said it was likely the tools the Fed used to fight the last crisis, including rate cuts, bond purchases and jawboning on rate expectations, will be adequate.
Still, she said, “future policymakers might choose to consider some additional tools that have been employed by other central banks,” including buying a wider range of assets or raising the inflation target. She also cited the possibility of targeting the average level of prices in the economy rather than their rate of change.
Her laundry list of possible tools did not include negative rates, an idea that has been nearly universally panned by Fed officials. She said the Fed is not actively considering additional policy tools but participants at the conference suggested the process is already well underway. “You are seeing an exploration of how are we going to operate in a quite different world than before the crisis,” Lockhart said.
A world, incidentally, where the Fed’s $4.5 trillion holdings of government debt are seen as perfectly normal. Which is why our advice for anyone who is asking how the Fed continues to spin the current monetary policy as tightening when it still is pregnant with trillions in debt which will never be reduced (and can barely muster a 25 bps rate hike every year), is to stop asking silly questions and move on.
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