September 24, 2013
|Alan Levenson, T. Rowe Price Chief Economist|
The Federal Reserve has supported the economy and the financial markets for several years with ultra-low short-term interest rates and asset purchases to suppress longer-term interest rates. With the Fed likely to begin tapering its asset purchases before the end of 2013—assuming that the economy evolves in line with the Fed's projections—investors are increasingly interested in what steps the Fed may take in the months and years ahead as it begins the process of normalizing its monetary policies.
As Federal Reserve Chairman Ben Bernanke testified to Congress earlier this year, the Fed's plans to taper its asset purchases are not "on a preset course." Beyond that, the policymaking Federal Open Market Committee (FOMC) published a set of "Exit Strategy Principles" in the minutes of its June 2011 meeting, which laid out the eventual renormalization of monetary policy—restoring interest rates to more normal levels and the Fed's balance sheet to its pre-crisis size and composition. The sequence of steps outlined below is based on that document and on subsequent adjustments announced by the FOMC.
Step 1: The Fed Slows the Pace of—and Eventually Stops—Its Asset Purchases (Late 2013-Mid-2014)
The Federal Reserve is currently purchasing $45 billion in Treasuries and $40 billion in agency mortgage-backed securities (MBS) every month. Before the end of 2013, we believe that the Fed will decide to reduce the monthly pace of its asset purchases by approximately $10 billion to $20 billion.
While some believe the end of asset purchases will be tantamount to a tightening of policy, we think that the end of these purchases just means that the Fed is not easing monetary conditions any further. In general, the Fed believes that the size of the balance sheet (the "stock effect" of asset purchases) is a stronger channel for monetary stimulus than the pace of asset purchases (the "flow effect").
What may trigger this step: If the economy continues to expand in line with the Fed's forecasts, we believe that similar purchase reductions will be announced after subsequent Fed meetings. This would translate into a smooth and gradual phaseout of asset purchases by around mid-2014.
Step 2: The Fed Stops Reinvesting Proceeds From Its Holdings (Second Half of 2014, Possibly Later)
At present, the Fed acts to prevent passive shrinkage of its securities portfolio by reinvesting principal payments from its maturing holdings of agency debt and agency MBS into agency MBS and by rolling over maturing Treasury securities at auction. Once the Fed is finished with its large asset purchases, the central bank is likely to stop reinvesting some, if not all, of its principal payments from maturing securities. However, this step—which would represent reduced monetary accommodation from the Fed—could be deferred until after the Fed's first interest rate increase.
What may trigger this step: The June 2011 Exit Strategy Principles had indicated that the first step in policy renormalization would be to cease reinvestment of securities principal, allowing the Fed's balance sheet to shrink as securities matured or were prepaid. Since then, however, the FOMC has indicated that it will likely not engage in outright sales of agency MBS (these had originally been slated to begin sometime after the Fed commenced rate hikes). In light of this adjustment to the Exit Strategy Principles, we think it is possible that the Fed may adjust the planned change in its reinvestment policy as well, committing to continue reinvestment until sometime after rate hikes have begun.
Step 3: The Fed Alters Its Interest Rate Guidance (Late 2014-Early 2015)
According to the June 2011 Exit Strategy Principles, the Fed will alter its interest rate guidance at the same time as or soon after it ceases to reinvest securities proceeds. When the exit strategy principles were enunciated in June 2011, the interest rate guidance was not defined relative to economic conditions: "…economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate for an extended period." Last December, the Fed reformulated its interest rate guidance, indicating that it anticipates keeping the fed funds target rate between 0.00% and 0.25% at least as long as the unemployment rate remains above 6.5%, inflation over a 12- to 24-month horizon is projected to be no more than 2.5%, and longer-term inflation expectations continue to be well anchored.
What may trigger this step: The FOMC's latest economic projections suggest that the 6.5% unemployment rate threshold for considering an initial rate increase will be reached early in 2015, but we believe unemployment could fall to 6.5% in the fourth quarter of 2014. We would anticipate a change in interest rate guidance in the latter part of 2014. This will indicate that rate increases are getting closer.
Step 4: The Fed Begins Adding Reverse Repos and Term Deposits to Its Portfolio (Late 2014-Early 2015)
The extraordinary expansion of the Fed's balance sheet over the last five years, to $3.6 trillion as of August 31, 2013, has been financed by the creation of bank reserves—demand deposits held by banks at the Fed. This oversupply of liquidity into the overnight funding market has reduced the Fed's control of the fed funds rate, which had been its principal tool for tightening monetary policy.
The Fed gained authority in 2008 to pay interest on these excess reserves in order to keep them from entering the fed funds market, thus improving the Fed's control over the fed funds rate in the presence of excess reserves. Yet the fed funds rate has traded below the rate paid on excess reserves because nonbank institutions with short-term liquid assets do not have access to reserve deposits and thus continue to invest in the fed funds market.
The Fed has developed the capacity to issue reverse repurchase agreements (reverse repos) and term deposits—longer-term assets—in the place of bank reserves. While the latter may only be issued to banks, the former will be available to a wider set of financial counterparties. Building up these balances, reducing the quantity of excess reserves, and generally reducing the supply of funds entering the fed funds market will tighten the relationship between the interest rate on excess reserves and the fed funds target rate.
The June 2011 Exit Strategy Principles indicate that the Fed intends to begin adding these reserves substitutes to its balance sheet at the same time that it alters its interest rate guidance as described in Step 3. Initiating temporary reserve-draining operations will help support the implementation of increases in the federal funds rate at an appropriate future date.
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Step 5: The Fed Begins Raising Short-Term Interest Rates (First Half of 2015)
In previous cycles of monetary tightening, the Fed has used the fed funds target rate as its primary policy instrument. This time, because of the extraordinary volume of liquidity that the central bank has provided to the financial markets in the last five years, the Fed will focus primarily on raising the interest rate on excess reserves that banks have deposited with the Fed to tighten monetary policy. The Fed is also likely to adjust the level of reserves in the banking system to help bring the fed funds rate toward its target.
To be sure, the fed funds rate is also likely to rise, and we currently expect it will increase in the first half of 2015 to approximately 1.0% by the end of 2015. Rate hikes are likely to be gradual; the Fed has stated that it will reflect a "balanced approach" consistent with its longer-run goals of maximum employment and 2% inflation. As a benchmark for various lending rates, a higher fed funds target rate should translate into higher yields for money market investors, as well as higher interest rates that various borrowers will need to pay.
What may trigger this step: The Fed's 6.5% unemployment rate "target" is really a threshold, rather than a target to be immediately followed by a Fed rate increase. While we believe unemployment will fall to 6.5% in the fourth quarter of 2014, we also believe that Fed rate hikes will depend on a broader assessment of labor market tightness and inflation risks.
This information is provided for informational and educational purposes and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. Past performance cannot guarantee future results. All charts and tables are shown for illustrative purposes only. The views contained herein are as of September 2013 and may have changed since that time.