Apr 2016 COVER STORY – Normalization of US Fed Policy: Liftoff of Interest Rates via Unconventional Means

The Federal Open Market Committee (FOMC) raised the target range for the federal funds rate by a quarter percentage point in December, marking the end of a seven-year period during which the federal funds rate was held near zero in a sustained effort to support recovery of the US economy from the worst financial crisis and recession since the Great Depression of the 1930s. Despite considerable progress in restoring jobs and incomes of millions of Americans and an expectation of further economic improvement, FOMC expects economic conditions will evolve in a manner that only warrants gradual increases in the federal funds rate

By Kenny Lau


The US economy has recovered substantially since the “Great Recession” following the global financial crisis of 2008 which prompted a market-shattering domino effect of collapses among large financial institutions and caused a chain reaction of business failures and panic selloffs in an economic meltdown ignited by an over-leveraged US housing market in the mid-2000s. Today, after nearly a decade of recovery, US economic output as measured by inflation-adjusted GDP has increased steadily, with unemployment falling from ten percent in 2009 to 4.9 percent in early 2016 – a remarkable achievement by any measure.

The “considerable improvement in the labor market” became a foundation upon which the US federal funds rate – the interest rate for overnight loans with reserves of a depository institution at the Federal Reserve to another depository institution on an “uncollateralized basis” – was increased by 25 basis points (0.25 percent) in December, lifting the target range to a bracket of 0.25 to 0.5 percent. It was a historic decision because US interest rates had been kept at near zero since December 2008 following a rapid downward drive from a peak level of 5.25 percent in August 2007.

“The economy has made further progress toward the objective of maximum employment,” US Federal Reserve Chair Janet L Yellen highlights in a testimony earlier before the Congressional Committee on Financial Services of the US House of Representatives. “In the labor market, the number of nonfarm payroll jobs rose 2.7 million in 2015, and posted a further gain of 150,000 in January of this year. The cumulative increase in employment since its trough in early 2010 is now more than 13 million jobs.”

With the anticipation of moderate economic growth over the medium term accompanied by further labor market improvement, current projections for US economic growth, unemployment and inflation are little changed from the time of the rate increase in December, she points out. “A key factor underlying such modest revisions is a judgment that monetary policy remains accommodative and will be adjusted at an appropriately gradual pace to achieve and maintain our dual objectives of maximum employment and 2 percent inflation.”

The pace of rate increases, however, is now expected to be somewhat slower “in light of global economic and financial developments since December, which at times have included significant changes in oil prices, interest rates, and stock values,” Yellen says. The median of the Federal Open Market Committee (FOMC) participants’ projections for the federal funds rate is now only 0.9 percent for the end of 2016 and 1.9 percent for the end of 2017, both half a percentage point below the medians in December.

The US economy’s “neutral” real rate – the level of an inflation-adjusted federal funds rate deemed neither expansionary nor contractionary in an economy operating near its potential – is now likely close to zero. And the current real federal funds rate is even lower, at roughly minus 1.25 percentage point. “The current stance of monetary policy, thus, appears to be consistent with actual economic growth modestly outpacing potential growth and further improvements in the labor market,” Yellen believes.

Recovery along a bumpy road

The strong gains in the job market last year were accompanied by a continued moderate expansion in economic activity. US real gross domestic product – although negatively affected by restrained US net exports as a result of the appreciation of the US dollar and subdued foreign growth particularly evident in the fourth quarter of last year – is estimated to have increased about 1.75 percent in 2015, Yellen points out. Nevertheless, “household spending has been supported by steady job gains and solid growth in real disposable income – aided in part by the declines in oil prices.”

One area of particular strength, she notes, has been the purchases of cars and light trucks by consumers – sales of motor vehicles in 2015 reached a record high. Although sharp declines in oil prices have caused companies in the drilling and mining sector to “slash jobs and cut capital outlays,” business investment continued to rise over the second half of last year, including those in homebuilding in spite of “a level of new construction well below the longer-run levels implied by demographic trends.”

The US labor force participation rate, however, remains somewhat below most assessments of its trend, and an unusually large number of people who would otherwise prefer full-time employment are only doing part-time work, Yellen cautions. “The numbers suggest some slack in labor markets remains, and there is still room for further sustainable improvement” – a reason for the decisions in January and March to maintain the target range of US interest rates at 0.25 to 0.5 percent, despite earlier hints of forthcoming rate increases throughout 2016.

Recent financial conditions in the US, she adds, have also become less supportive of growth: declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the US dollar. “These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market, although declines in longer-term interest rates and oil prices provide some offset. Still, ongoing employment gains and faster wage growth should support the growth of real incomes and, therefore, consumer spending.”

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Volatility in the global market – including uncertainty about China’s growth prospects and its policy on currency exchange rate – is an enormous risk to US economic growth, Yellen stresses. “This uncertainty led to increased volatility in global financial markets and, against the background of persistent weakness abroad, exacerbated concerns about the outlook for global growth, although recent economic indicators do not suggest a sharp slowdown in Chinese growth.”

“Although the baseline outlook has changed little on balance since December, global developments pose ongoing risks,” she says. “Readings on the US economy since the turn of the year have been somewhat mixed – while the labor market has added a monthly average of almost 230,000 jobs over the past three months, manufacturing and net exports have been hard hit by slow global growth and significant appreciation of the dollar since 2014, weighing on business investment by limiting expected sales and reducing demand for capital goods.”

“These growth concerns, along with strong supply conditions and high inventories, contributed to the recent fall in the prices of oil and other commodities,” she further points out. “In turn, low commodity prices could trigger financial stresses in commodity-exporting economies, particularly in vulnerable emerging market economies, and for commodity-producing firms in many countries. Should any of these downside risks materialize, foreign activity and demand for US exports could weaken, and financial market conditions could tighten further.”

The role of inflation

The decision to raise the US interest rates in December was based on the “substantial improvement” in labor market conditions but also an expectation that inflation would rise over the medium term, in accordance to a congressional mandate “to pursue a monetary policy that fosters maximum employment and price stability defined as 2 percent inflation.” Deflation, in economic terms, delays consumer spending and business investment because it leads to an assumption of price drops, repressing money markets and propelling a vicious cycle of dampened economic activities.

A problem facing the Fed in its effort to “stimulate” the US economy is the current level of inflation – which remains stubbornly below the FOMC’s longer-term goal of 2 percent. The price index for personal consumption expenditures (PCE) was only up by 0.5 percent over the 12 months ending in December. This is largely due to the declines in energy prices and non-oil import prices as well as further declines in commodity prices. A stronger US dollar in the foreign exchange market and a “slack” in labor markets are also key reasons.

“Inflation ran well below our target last year, held down by the transitory effects of declines in crude oil prices and also in the prices of non-oil imports. Prices for these goods have fallen further and for longer than expected,” US Fed Vice Chairman Stanley Fischer reiterates. “Once these oil and import prices stop falling and level out, their effects on inflation will dissipate, which is the main reason we expect inflation will rise to 2 percent over the medium term, supported by a further strengthening in labor market conditions.”

There was little change in food prices during the second half of 2015 after “edging down” during the first six months of last year. The level of consumer food prices in 2015 was a reflection of “falling food commodity prices” as a “source of downward pressure on consumer food price inflation…but futures markets suggest that these commodity prices will flatten out, implying that this is likely to wane.” The PCE price index excluding food- and energy-related items is a “better indication of future inflation,” but it, too, remained subdued, increasing by 1.5 percent over the same period.

Actual inflation as a result of “wage- and price-setting decisions” is heavily influenced by market expectations, and market expectations “have drifted down a little since the middle of last year” and are “near the lower ends of their historical ranges,” as indicated in University of Michigan’s Surveys of Consumers on expectations over the next five to ten years and Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters on the annual rate of increase in the PCE price index over the next ten years – a deviating trend from past survey measures of longer-term inflation expectations which, until recently, had been “stable” over the past 15 years.

Market-based measures of inflation compensation, meanwhile, are also down. The difference of medium- (5-year) and longer-term (5-to-10-year-ahead) inflation compensation between yields on nominal Treasury Securities and yields on Treasury Inflation-Protected Securities has further narrowed over the second half of 2015 following a closing gap between mid-2014 and mid-2015. In other words, inflation is a non-risk in money markets today, although “the decline has largely been driven by movements in inflation risk premiums and liquidity concerns rather than by shifts in inflation expectations.”

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Increased concern about the global outlook, particularly the ongoing structural adjustments in China and the effects of the declines in the prices of oil and other commodities on commodity exporting nations, appeared to have triggered volatility in global asset markets early this year, Fischer notes. “If these developments lead to a persistent tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the US. But we have seen similar periods of volatility in recent years that have left little permanent imprint on the economy.”

“I would note that our monetary policy remains accommodative after the small increase in the federal funds rate adopted in December,” he adds. “And, at the time of our January decision, my colleagues and I anticipated that economic conditions would evolve in a manner warranting only gradual increases in the federal funds rate, and that the federal funds rate would likely remain, for some time, below the levels that we expect to prevail in the longer run. I should emphasize, however, that that was an expectation, not a decision. Our future policy actions are by no means predetermined.”

Redistribution of assets

Over the spring and summer of 2014, participants of the FOMC – well aware of the fact that conventional means of implementation of monetary policy will no longer be effective – started discussing for a plan to “normalize” the stance of US monetary policy, formulating steps to raise the federal funds rate and other short-term interest rates more aligned to pre-crisis levels. And there are two major challenges: a “superabundant” level of reserve balances in the banking system and the Fed’s enormous balance sheet of securities holdings.

The FOMC in the past was able to set and achieve a target rate effectively “through small purchases and sales of securities in the open market” in what is called “open market operations.” That is, by driving up or down the level of excess reserves – remainder of balances after all reserve requirements are met – which depository banks would normally keep to a minimum because of its non-interest-bearing nature. Essentially, FOMC could effect a rate change by refilling or draining banks’ “extra” reserve balances through buying or selling securities.

Today, circumstances are quite different: reserve balances of the banking sector have increased exponentially since the financial crisis, from an aggregate total of US$15 billion (and excess balances of less than US$2 billion) to more than US$2.6 trillion (and excess balances amounting to all but about US$90 billion of the total) by December 2014, largely because the Fed started paying interest on excess reserves (IOER) in September 2008 and incentivized banks to deposit their reserves at the Federal Reserve.

It was a critical step allowing policymakers to “increase the level of reserves and still maintain control of the federal funds rate” as the Fed became “a lender of last resort” and needed a large amount of liquidity to support stability of the US financial system – an amount much greater than the total required reserves of depository institutions at the time. IOER can be described as a double-edged sword: it provided a new liquidity facility to save the US economy from complete annihilation but also made it difficult to move the target funds rate up because of extraordinary downward pressure.

The reversal of “reserve scarcity” among banks, likewise, came from a series of large-scale asset purchase programs (LSAPs) between November 2008 and October 2014 when the Fed purchased in the secondary market about US$1,690 billion in Treasury securities, US$2,070 billion in agency mortgage-backed securities (MBS), and US$170 billion in debt issued or guaranteed by government agencies. The Fed, less than a decade ago, had assets mostly of Treasury securities holdings worth about US$791 billion and liabilities in the form of reserve balances of about US$15 billion.

The purpose of LSAPs and IOER was to “counteract the devastating effects on the US economy of the financial crisis and the subsequent Great Recession.” But they also created a Fed portfolio of securities holdings nearly 5.5 times their pre-crisis level and liabilities in reserve balances amounting to US$2.6 trillion. As such, “small” transactions of securities and reserves by the Fed are no longer sufficient tools for adjusting the federal funds rate, particularly in an environment where banks and financial institutions have a record level of excess reserves.

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A return to historical norm

The FOMC, instead, will continue to leverage IOER to “move the federal funds rate into the target range by adjusting the interest rate it pays on excess reserve balances” during normalization. In attempts to drive the federal funds rate up, it would create upward pressure by paying higher interest on reserves, thereby also allowing the Fed to place a “floor” on the federal funds rate. That’s because banks now have an incentive to borrow in the federal funds market at rates below that of IOER and then make a deposit at the Fed for a profit. Conversely, they have little incentive to lend at rates below IOER.

An overnight reverse repurchase agreement (ON RRP) facility is another unconventional supplementary tool being employed by the Fed for the purpose of “causing a temporary decline in reserve balances in order to put upward pressure on the federal funds rate.” In the past, it was only done occasionally with a group of institutions known as “primary dealers.” Today, it is conducted on a daily basis with a pre-announced offering rate for a broader set of counterparties as an option of investment, effectively increasing “reserve scarcity” on a much large scale.

“The FOMC has indicated that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively – which will require us to reduce the size of our balance sheet substantially. But that statement leaves open the question of when we should begin that process,” Fischer explains. “Because payment of interest on reserve balances and the overnight reverse repurchase facility can be used to raise the federal funds rate independent of the size of the balance sheet, we have the flexibility to adjust the size of our balance sheet at the appropriate time.”

The plan in short, according to the FOMC, is to adjust the payment of interest on excess reserve balances of financial institutions, continue to increase the scarcity of reserves in the banking system through ON RRP operations, reduce securities holdings in “a gradual and predictable manner” by ceasing to reinvest repayments of principal on securities held in the System Open Market Account (SOMA) managed by the Federal Reserve Bank of New York. The Fed, however, does not anticipate selling agency mortgage-backed securities as part of the normalization process.

“Removing monetary policy accommodation by the traditional approach of raising short-term interest rates is preferable to selling longer-term assets because such sales could be difficult to calibrate and could generate unexpected financial market reactions,” Yellen rationalizes. “The FOMC is continuing its policy of reinvesting proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities until normalization of the level of the federal funds rate is well under way.”

“Maintaining our sizable holdings of longer-term securities should help maintain accommodative financial conditions and reduce the risk that we might need to return the federal funds rate target to the effective lower bound in response to future adverse shocks,” she explains. “With the federal funds rate near zero, we can respond more readily to upside surprises to inflation, economic growth, and employment than to downside shocks. It is appropriate to be more cautious in raising our target for the federal funds rate than would be the case if short-term nominal interest rates were appreciably above zero.”

“However, we must also take into account the well-documented lags in the effects of monetary policy,” Yellen cautions. “Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.”

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