The monetary policy experiment
Published: January 2020
Updated: April 2020
In this insight, we will highlight how the Federal Reserve (Fed) changed its monetary policy during and after the Great Recession in 2008.
In our previous insight Understanding the next bear market we highlighted the risk of a major stock market decline and a potential subsequent recession between the years 2019 to 2021. Of course, none of us could have predicted that the world would suffer a pandemic like Covid-19, but we believe that this should be seen as the ignition when the spark was already created and showed itself clearly in September of the previous year.
This insight will kick off during the Great Recession in 2008 to explain more clearly what led to this spark and the monetary policy experiment the US central bank has embarked on. Since we believe that the market has missed important aspects regarding how the Fed, during and after the previous financial crisis, has changed how they conduct monetary policy, the purpose of this insight is to try to clarify this. The first part of the insight has been written with information and inspiration from the Fed and above all analyzes published by St. Louis Fed's analysts while the second part is written with information from more market-oriented sources.
This insight is publication two in a series of publications which will have a more fundamental angle in comparison with the previous insights more technical perspective.
The first part: Introduction
The Federal Reserve (Fed) is the central bank of the United States. Since 1977, the Fed has operated under a mandate from Congress to "effectively promote the goals of maximum employment, stable prices and moderate long-term interest rates" - what is today commonly referred to as the Fed's "dual mandate".
Federal Reserve Reform Act of 1977
Federal Funds Rate (FFR)
In the decades before 2008, the Fed's Federal Open Market Committee (FOMC) adjusted monetary policy to match economic conditions by raising or lowering its policy rate target, ie the Federal Funds Rate (FFR), which is the interest rate that depository institutions lend reserves balances to other depository institutions overnight. The Fed can influence the general cost of borrowing through this interest rate because the short-term interest rates, even if they differ from each other, are closely linked. This phenomenon is called arbitrage - if a short-term interest rate is significantly lower than others, financial institutions tend to borrow in that market and then lend where the interest rate is higher, thus keeping interest rates linked.
By influencing an interest rate - FFR - the Federal Reserve can influence other short-term interest rates which in turn affects longer interest rates, consumer and producer decisions, and ultimately the level of employment and inflation in the US economy (the dual mandate). This chain of reactions is usually called the monetary policy transmission
mechanism (see Figure 1).
Figure 1 - The monetary policy transmission mechanism
Monetary policy with scarce reserves
Prior to September 2008, the Fed primarily bought and sold relatively small quantities of Treasury securities in the open market, via so-called Open Market Operations (OMOs), in order to adjust the reserves in the banking system and thereby influence the FFR. Bank reserves are the sum of cash that the banks have in their vaults and the deposits they maintain with one of the Fed's twelve regional central banks (Federal Reserve Banks). See Chart 1 for total reserves in the banking system before 2008.
Reserves are divided into two categories:
Banks hold the required reserves (that is, the reserve requirement established by the central bank), funds that must be held as cash in the banks vault or deposits with any Federal Reserve Bank
Banks may also hold excess reserves, funds held as vault cash or deposits with a Federal Reserve Bank in addition to the required reserves
Chart 1 - Monetary policy before 2008: Total reserves
Before 2008, the average total reserves in the banking system, between 1980 and 2008, was an estimated 50 billion USD.
Since the banks had to keep the required reserves and on which the Fed did not pay interest, the banks had long argued that these reserves could be equated with a tax. Without this requirement, banks would have been able to lend or invest these reserves elsewhere to earn interest. As a result, the banks maintained the required reserves but minimized the excess reserves due to the simple reason that they preferred to earn interest on these funds. As a consequence of this, when reserves in the banking system were scarce, banks often had to borrow on the Federal funds market (i.e., pay FFR) to ensure that they met their reserve requirements overnight.
Under this framework of scarce reserves, the Fed was able to raise or lower the FFR by making relatively small changes in the supply of reserves (see Chart 2). For instance, the Fed could have increased reserves by buying Treasury securities on the open market and crediting the seller's accounts with reserves as payments. A greater quantity of reserves shifted the supply curve to the right and put a downward pressure on FFR, which in turn tended to put a downward pressure on other interest rates in the economy.
Similarly, the Fed was able to reduce reserves by selling Treasury securities on the open market and debiting buyers accounts. As the supply of reserves decreased, the supply curve for reserves shifted to the left and put upward pressure on FFR, which also caused other interest rates to be pushed upwards.
Chart 2 - Monetary policy before 2008: Scarce Reserves
The supply of bank reserves is vertical because the supply of reserves held collectively by the banking system is determined by the Fed. When reserves are scarce, the Fed can move the supply curve to the right or left by adding or subtracting reserves from the banking system using open market operations (OMOs). The intersection between supply and demand is determined by FFR.
When supply was in the declining region in the demand curve, relatively small changes in supply had a significant effect on FFR. The Trading Desk at the Federal Reserve Bank of New York used open market operations to fine-tune the supply of reserves in order to achieve the target set by the FOMC for FFR. This fine-tuning was performed by selling or buying securities to move the supply curve for reserves to the left or right.
The Fed used these guidelines to achieve its dual mandate. For instance, the Fed was able to increase reserves to reduce the FFR and other interest rates, which encouraged economic activity during the economic recession (to achieve its maximum employment target). On the contrary, they were able to reduce reserves to increase FFR and other
interest rates in an attempt to limit consumption when inflation exceeded its two percent inflation target (to achieve its price stability target). The Trading Desk at the Federal Reserve Bank of New York conducted open market operations (OMOs) as needed, to maintain that the FFR remained very close to the FOMC's target rate (see Chart 3).
Chart 3 - Monetary policy before 2008: the FFR target
The FOMC's FFR objectives have varied greatly in response to changing economic conditions. Prior to 2008, the FOMC set a single target for the FFR and used open market operations (OMOs) to influence the interest rate towards its target.
"The Great Recession"
The financial crisis and the resulting recession, known as "the Great Recession", hit the US economy hard. In December 2008, the Fed had lowered the FFR to a target range of 0 to 25 basis points. In addition to provide stimulus and liquidity, the Fed later made a series of large-scale asset purchases (LSAP) between the end of 2008 and 2014. The primary purpose of these purchases was, according to the Fed, to lower long-term interest rates to subsequently encourage consumption and investment. The purchases which were also open market operations (OMOs), increased the size of the Fed's balance sheet and also dramatically increased the number of reserves in the banking system (see Chart 4).
Chart 4 - Monetary policy after 2008: Total reserves
After 2008, reserves in the banking system increased significantly due to the Fed's significant asset purchases which increased the size of their balance sheet. From the average level of $ 50 billion between 1980 and 2008 (see Chart 1 again), reserves increased to a maximum of $ 2.85 trillion at the end of July 2014.
During the crisis, the Fed also introduced two new monetary policy tools, which were:
interest on reserves (IOR) and
the overnight reverse repurchases agreement (ON RRP) facility
Congress adopted the IOR in 2006 which had an original plan of starting in 2011. Nevertheless, this was postponed until October 2008 in order for Fed to use this tool during the financial crisis. The new monetary policy tool was applied to both the required reserves (to pay interest on required reserves, or Interest on Required Reserves, IORR) and excess reserves (to pay interest on surplus reserves, or Interest on Excess reserves, IOER).
As previously mentioned, the IORR eliminates the implicit tax on the required reserves and since the IOER interest rate affects the banks decisions to hold more or fewer reserves, it provides the Fed with another monetary policy tool. By the summer of 2008, the excess reserves had not exceeded 2 billion USD; in December 2008, they reached 767 billion USD and later peaked at close to 2.7 billion USD in August 2014 (see Chart 5). This is a consequence of the Fed's large-scale asset purchases during this period.
Chart 5 - Monetary policy after 2008: Excess reserves
By the summer of 2008, the excess reserves had not exceeded 2 billion USD; in December 2008, they reached 767 billion USD to later reaching their peak of close to 2.7 billion USD in August 2014.
The second new monetary policy tool, the ON RRP-Facility, works when an institution uses the facility, the institution mainly deposits reserves with the Fed overnight (with US Treasury securities from the Federal Reserve's portfolio as collateral) to earn interest (ON RRP interest rate) on the deposit. This can be compared to when a consumer buys a
certificate of deposit (similar to a bond fixed with maturities for one year), which is then held for an agreed period and where the holder then receives his interest paid when the certificate is redeemed on the due date. According to the Fed, the purpose of the ON RRP-Facility is to establish a floor on other short-term market interest rates.
The current framework: Monetary policy with ‘’ample
Although the number of excess reserves has decreased since the peak in 2014, the banks excess reserves are currently far above their reserve requirements and the FOMC has indicated that in the longer term they will carry out their monetary policy with large reserves in the banking system.
The disadvantage of a large number of reserves in the banking system is that the Fed can no longer effectively influence the FFR through small changes in the supply of reserves. For example, a relatively small increase in reserves will not lower interest rates, just as a relatively small decrease in reserves will not raise short-term market interest rates (see Chart 6). Instead, the Fed uses its new tools - the IOER and the ON RRP facility to influence the FFR and short-term interest rates.
Chart 6 - Monetary policy after 2008: Plenty of reserves ("Ample Reserves")
In a world with ample reserves, the Federal Reserve operates where the following is true:
The demand curve is flat and close to the IOER rate.
The supply of reserves is large and far to the right of the intersection and crosses the demand for the flat part of the curve. This means that small adjustments to the supply of reserves no longer put upward or downward pressure on the FFR but are instead guided by the IOER and the ON RRP-interest rate.
For comparison between Chart 2 - Monetary policy before 2008: Scarce reserves and Chart 6 - Monetary policy after 2008: Plenty of reserves, read more.
The IOER rate offers a safe, risk-free investment alternative to banks that hold reserves with the Fed. Given this interest rate, banks will not lend reserves in the market at a lower interest rate than the IOER rate. Arbitrage plays a key role in guiding FFR towards the goal. For example, if the FFR falls well below the IOER rate, banks have an incentive to
borrow on the federal funds market (pay the FFR) and to deposit those reserves with the Fed, thus making a profit on the difference between the interest rates. This tends to pull the FFR towards the IOER rate (see Chart 7). Based on this, the Fed primarily implements its monetary policy, in order to move the FFR into the target range specified by the FOMC,
by adjusting the IOER rate. However, not all institutions can deposit their reserves with the Fed and receive the IOER rate, which leads us into the Fed's other tool, the ON RRP-Facility. Here you will find the list of counterparties in the Fed's RRP operations.
Chart 7 - Monetary policy after 2008: Interest on excess reserves
In a banking system with abundant reserves, the Fed primarily implements its monetary policy to move the FFR into the target range specified by the FOMC by adjusting the interest rate on surplus reserves (IOER).
More types of financial institutions can participate in the ON RRP-program compared to those that can earn interest on excess reserves (IOER). These institutions use the interest rate of the ON RRP-Facility to take advantage of arbitrage opportunities against other short-term interest rates. As these institutions will never be willing to lend funds for lower than the ON RRP rate, FFR will not be less than this interest rate. As such, the interest paid on ON RRP transactions acts as a floor for FFR.
Instead of setting a single goal for the FFR, the Fed is now communicating a range that is 25 points wide. As mentioned above, the IOER and ON RRP rates are used to control FFR within this target range (see Chart 8).
Chart 8 - Monetary policy after 2008: Feds "target range"
The FFR target is now communicated as an interval that is 25 basis points broad rather than a single interest rate.
Despite the recent changes, the FFR will, according to the Fed, continue to be the main way to adjust the direction of monetary policy (however, several market participants, including Pozsar (2016, p. 3) has highlighted the Federal Funds declining volume, with it not being linked to some collateral and the market irrelevance for banks in a banking system with ample reserves as an argument for the Fed to change interest rates as a benchmark for its monetary policy). The transmission mechanism is the same - the FFR affects other interest rates in the economy, which affects the decisions of consumers and producers (to see Figure 1 again, read more). In order to carry out its monetary policy, the FOMC increases or decreases the target range in a way that is consistent with its policy objectives of price stability and maximum employment (the dual mandate).
The second part: Monetary policy with ample reserves, but where is this level?
In mid-September 2019, we received the answer to this question i.e., the Fed itself did not know the answer. Despite the fact that the banks at this time cumulatively held about 1.3 trillion USD in the form of excess reserves (see Chart 9), it became a significant stress for institutions to find liquidity overnight, which was clearly noticeable in the markets for
very short-term financing.
Chart 9 - The stress level of ample reserves reached
At the time, in September (read 2019), when the stress in the markets for very short-term financing became extremely apparent, the banks held cumulatively about 1.3 trillion USD in the form of excess reserves (see arrow).
The reason why the larger banks which hold the majority of excess reserves, did not choose to lend these, is allegedly related to the stricter requirements (Basel III) imposed on the banks to prevent a new 2008 crisis. The stricter requirements mean that banks retain a large part of reserves in their HQLA (High-Quality Liquid Assets) portfolios to comply with their LCR (Liquidity Coverage Ratio) requirements (about LCR and HQLA read more). What is significant to understand here is the meaning of the Fed's changed monetary policy. In a banking system with plenty of reserves, it is the banks with these reserves that will provide the liquidity that the market demands, in other words, this responsibility is primarily due to a number of the largest American banks. In a system of scarce reserves, it was the Fed that provided this liquidity.
Nevertheless, it is not only new regulations on the banks that made us end up here but to find the primary problem, we must already go back to mid-2014 when the Fed started the normalization (the reduction) of its balance sheet by letting securities go to maturity, which had a direct impact on the excess reserves in the banking system.
The excess reserves decreased by almost 1.5 trillion USD from the peak in September 2014 to September 2019, which of course meant that the reserves in the banks balance sheets that hold these reserves decreased. This in combination with, as mentioned above, the Basel III regulation made it difficult for the banks to lend these reserves to the market
as according to the LCR requirements they had to keep a large part of them in their HQLA portfolios. In other words, the banks excess reserves were no longer excess but required.
Furthermore, it is not only the Fed's purchases and sales of securities that affect the reserves, but also their so-called “non-reserve liabilities” i.e., the Fed's liabilities that are not reserves. As these increases, the supply of reserves decreases and all other things being equal. These "non-reserve liabilities" consist largely of banknotes and coins in circulation but also the Treasury General Account (TGA, i.e. the US Treasury Department's account with the Fed) and the "Foreign Repo pool" (which is the Fed's "secret" monetary policy tool, which we will touch on in future text publications).
As banknotes and coins in circulation have a predictable increase (see Chart 10), it is further interesting to focus on TGA and “Foreign Repo Pool” which are significantly more volatile (see Chart 11).
Chart 10 - Banknotes & Coins in circulation
Chart 11 - TGA & Foreign Repo Pool
Banknotes and Coins in Circulation, TGA and Foreign Repo Pool are the Fed's so-called "non-reserve liabilities", which in the event of an increase drain reserves from the banking system. As Banknotes and Coins in circulation have a predictable increase (it being easy to model how this increase will affect reserves), it is further interesting to focus on TGA and Foreign Repo pool.
Starting in August 2019, we see in Chart 12 that the TGA and Foreign Repo Pool increased sharply, partly as a result of large auctions of Treasury securities from the US Treasury Department which led to further drainage of reserves from the banking system apart from the Fed's normalization of its balance sheet. This can be seen in the total reserves (blue line) that decrease in connection with the increase in "non-reserve liabilities".
Chart 12 - Reserves and "Non-Reserve Liabilities"
When non-reserve liabilities, here in the form of the sum of TGA and Foreign Repo pool, increases it will drain reserves from the banking system all other things being equal.
The Fed’s normalization, increases in "non-reserve liabilities", higher requirements on banks, corporations liquidity needs for for their quarterly tax payments and the banks' normal demand for liquidity at the end of the quarter created a perfect cocktail for a system-wide lack of liquidity in September.
This became most noticeable in the markets for very short-term financing, including the repo market (see Chart 14, here in the form of Secured Overnight Financing Rate, SOFR), where institutions borrow from each other overnight with certain securities (primarily US Treasury securities) as collateral. Many institutions have plenty of long-term assets which they can lend as collateral to cover their short-term liquidity needs, making this market vital for institutions to meet their daily financial commitments. Additional aspects of the stress in these markets as Pozsar (2019, p. 6) mentions are that the Fed's primary dealers (explanation of primary dealers can be found here) had to take larger parts of the US Treasury Department's auctions of Treasury securities when inversion of the yield curve in the US (taking into account currency hedge costs) made it unprofitable for foreign institutions (mainly Japanese and European) to buy longer US Treasury securities and finance them with short-term financing which usually is 3
months (so-called "carry trade").
As primary dealers are only intermediaries and do not intend to hold these securities (not "carry"), these purchases are usually financed through the repo market overnight where other financial institutions such as hedge funds have also increased demand to finance longer positions (this is seen by focusing on volume in Chart 13 which increased
steadily until September). The lack of liquidity, for the reasons mentioned above, eventually caused the repo rate to "spike up" sharply, while the Fed also lost control of the FFR, which was traded over their target range (see Chart 14).
Chart 13 - "Spike" in the Repo rate
Chart 14 - EFFR trades over their target range
A perfect cocktail for a system-wide lack of liquidity caused the repo rate to "spike" up and FFR to trade over FOMC's target range.
This caused the Fed to panic and cause them to act by providing liquidity through so-called Repurchase Agreement Operations ("repos"). The Fed announced that it would make repos of at least 75 billion USD overnight and 14-day repos of at least 30 billion USD (see Figure 2) to keep FFR within their target range. Due to technical problems, this repo was postponed the same day.
Figure 2 - Fed announsces repos
The Fed panicked and quickly provided liquidity to the markets for very short financing through overnight repurchases and 14-day repurchases of at least 75 billion USD and respectively 30 billion USD.
Why are these repos important in a historical perspective?
A picture is worth a thousand words...
As we began this insight, we are of the opinion that Covid-19 is the lighter fluid on the fire that was already ignited last year as described above.
The Fed and other central banks have responded to the pandemic with such a monetary policy force that has never been seen before. What can easily be said is that we have been welcomed further Quantitative Easing which is something we highlight for our clientele as a matter of course to keep the economy and sentiment up (regardless of pandemic or not). The Fed has also used its entire "the Great Recession" arsenal of monetary policy easing for just a few weeks and has furthermore initiated a number of new facilities expanding dollar swap lines to further central banks in addition to the BoE, BoJ, ECB, BoC and SNB.
We are fairly convinced that Covid-19 is here to stay for a longer period of time. This means that the Fed and the other central banks have an even greater responsibility to take the monetary policy measures required to assist politicians with sufficient arsenal to implement effective and surgical fiscal policy measures. This is to enable the basis for a future recovery and, above all, to prevent us from ending up in a deep depression.
We obviously believe that this is not a sustainable system where central banks are constantly allowed to flood the market with liquidity and further build on the asset inflation that we have seen. The Fed has acted quickly and on a large scale in a short time, now our focus is on understanding the fiscal policy package we may see from the current administration in the White House.
Organization: Zaree & Partners Ltd
Published: January 2020
Updated: April 2020
Source/Data: Thomson Reuters Eikon/Datastream