“As you are aware,” Federal Reserve Bank of New York President William Dudley said in a speech at the Fordham University Graduate School of Business on Monday, “at last week’s FOMC meeting we made no changes to our monetary policy. In particular, the Committee decided to continue to purchase long-term Treasury securities and agency mortgage-backed securities at a monthly pace of $45 billion and $40 billion, respectively.”
The news, announced on September 18 at the conclusion of a two-day policy meeting, came as a surprise to the markets. In the weeks heading into the meeting, many economists and traders had settled on the idea that the Fed would decide to taper assets purchases at least a little bit — estimates generally came in a range between $5 billion and $15 billion per month — and the markets began to price in such a policy change. Interest rates climbed a full percentage point between May and September, and equities experienced two fairly violent “taper tantrums,” one in June and one in August.
But the stimulus can’t last forever, and markets are constantly on the lookout for signs of when tapering will begin and what the wind-down of Fed assets will look like. The various iterations of quantitative easing have contributed to a dramatic expansion of the Fed’s balance sheet over the past few years. As of the second week of September, total assets held by the Fed exceeded $3.6 trillion, substantially above the $869 billion level maintained before the financial crisis.
This tremendous expansion in and of itself has been cited as a reason to curb the flow rate of asset purchases. At a glance, the theory is that the larger the Fed’s balance sheet is, the riskier it becomes, and the process of unwinding the monster grows increasing difficult. Somewhat addressing this concern, the Fed has stated that it could very well hold on to securities through maturation and simply let them fall off the balance sheet that way. This is in some ways preferable to evaporating liquidity by selling the securities.
However, this strategy has also attracted some criticism. About 25 percent of Treasury securities and nearly 100 percent of mortgage-backed securities held by the Fed have a remaining maturity of more than 10 years, while about 42 percent of Treasury securities held have a remaining maturity of between five and 10 years. The average maturity of the Fed’s entire portfolio is now more than 10 years, and it is expected to exceed $4 trillion by the end of the year.
In his September speech, Dudley outlined a new tool that the New York Fed will be testing in the coming weeks that is designed to address the issue of how to drain cash from the financial system when it becomes appropriate to do so. The tool — a fixed-rate, full allotment overnight reverse repo facility — will allow counter-parties such as banks and large money market funds to deposit cash at the Fed overnight and earn a modest interest rate on it. The Fed would give the banks Treasury securities as collateral.
With the right interest rate, the Fed could incentivize banks to remove cash from the system. “The higher the interest rate relative to comparable money market rates,” said Dudley, “the greater the participation is likely to be, and vice versa.”
Dudley continued: “There are several reasons motivating our interest in developing such a facility. First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates. By offering a new, essentially risk-free investment, one would expect that anyone with access to such a facility would generally be unwilling to lend instead to someone else at a rate below that posted for the facility.”
The most important thing that this does is put a floor beneath overnight rates. In the experimentation phase, rates will be set to just 1 basis point, or 0.01 percent. Again, the idea here is that the Fed has pumped so much cash into the system that people don’t really know what to do with it all. By making this facility available to certain institutions — namely, those with an excess of reserves — they can put those reserves to a productive use. At the same time, the Fed gets to soak up some cash.
“Second, this new facility is also likely to reduce the volatility of short-term interest rates,” Dudley said. “If a lender that cannot earn the IOER rate has an unexpectedly large amount of funds to invest, this lender currently may have to accept an unusually low interest rate. But with the overnight reverse repo facility in place, this lender could lend as much funds as desired to the facility at a fixed rate and this should reduce the downward pressure on money market rates.”
This tool could complement traditional measures such as raising the overnight lending rate to banks, which would make it more expensive for banks to borrow reserves.