What the Fed Actually Said About Ending the QE Unwind

Wolf Richter wolfstreet.com, www.amazon.com/author/wolfrichter

A plan is forming with a slow-motion component, and everyone wants to get rid of MBS

In the minutes of the January 29-30 FOMC meeting, published yesterday, the Fed added some tidbits about how it wants to deal with its “balance sheet normalization.” These minutes are always the most mind-numbing repetitive prose available in the English language. They’re clearly designed to not ever be read by a human. So I sorted it out. Here we go.

Not a word about rate cuts; it’s all about hikes:

The Fed put the world on notice that it might remove the newly beloved “patient” when it comes to rate hikes:

Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different statement language.

And it also discussed rate hikes, when and if, while there was not a word about rate cuts: “Several of these participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook.”

And those that are little more eager for a rate hike: “Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year.

The QE unwind is still on autopilot:

That the QE unwind would continue on autopilot at least until the next meeting was clear from the post-meeting Implementation Notes, released on January 30. And it was repeated in the minutes – same language as it has been since late 2017.

“The Committee directs the Desk to continue rolling over at auction….” Up to $30 billion in Treasury securities and up to $20 billion in mortgage-backed securities would be allowed to mature and roll off the balance sheet without replacement, same as before.

Fed is stunned the little-bitty QE Unwind got blamed for suddenly sinking the market.

For about a year, the markets totally brushed off the QE unwind. Suddenly, in late 2018 all heck broke loose in the markets. Wall Street blamed the QE unwind. This is still puzzling the Fed. They’d expected “some upward pressure” on yields of Treasury securities and mortgage-backed securities (MBS) “over time,” but they didn’t expect a selloff in stocks, junk bonds, leveraged loans, and other risky assets:

Participants raised a number of questions about market reports that the Federal Reserve’s balance sheet runoff and associated “quantitative tightening” had been an important factor contributing to the selloff in equity markets in the closing months of last year. While respondents assessed that the reduction of securities held in the SOMA would put some modest upward pressure on Treasury yields and agency mortgage-backed securities (MBS) yields over time, they generally placed little weight on balance sheet reduction as a prime factor spurring the deterioration in risk sentiment over that period.

However, some other investors reportedly held firmly to the belief that the runoff of the Federal Reserve’s securities holdings was a factor putting significant downward pressure on risky asset prices, and the investment decisions of these investors, particularly in thin market conditions around the year-end, might have had an outsized effect on market prices for a time.

Paying Interest on “Excess Reserves” works in controlling short-term rates, but reserves have to be large enough, requiring a larger balance sheet than before:

By paying interest on required and excess reserves after the Financial Crisis, the Fed shifted its “operating regime” in how it implements its interest rate policy. Reserves are on the liability side of the balance sheet, along with “currency in circulation” (paper dollars used and hoarded globally). They must be balanced by assets on the asset side. In other words, a higher level of reserves and currency in circulation require a higher level of assets.

The “effectiveness and efficiency” of this operating regime determine what size the balance sheet should decline to. The goal is to whittle down the reserves, and therefore also the asset side of the balance sheet to “no more securities holdings than necessary to implement monetary policy efficiently and effectively.”

The Fed notes, after looking at the evidence, that the “current regime was therefore effective both in providing control of the policy rate and in ensuring transmission of the policy stance to other rates and broader financial markets.”

The “staff” presents some options on how to handle the reserves:

These reserves have already dropped by $1.2 trillion from the peak and continue to drop. But how much lower should they be allowed to go?

Some recent survey information and other evidence suggested that reserves might begin to approach an efficient level later this year.

So “later this year” would be the earliest opportunity. In this respect, the “staff presented options for substantially slowing the decline in reserves by ending the reduction in asset holdings at some point over the latter half of this year…”

The Fed laments that “market commentary” blamed the selloff on the QE unwind.

Participants discussed market commentary that suggested that the process of balance sheet normalization might be influencing financial markets. Participants noted that the ongoing reduction in the Federal Reserve’s asset holdings had proceeded smoothly for more than a year, with no significant effects on financial markets.

The gradual reduction in securities holdings had been announced well in advance and, as intended, was proceeding largely in the background, with the federal funds rate remaining the Committee’s primary tool for adjusting the stance of policy.

Nonetheless, some investors might have interpreted previous communications as indicating that a very high threshold would have to be met before the Committee would be willing to adjust its balance sheet normalization plans.

So the Fed took a new approach: communicating its “flexibility” to halt the selloff.

Participants observed that, although the target range for the federal funds rate was the Committee’s primary means of adjusting the stance of policy, the balance sheet normalization process should proceed in a way that supports the achievement of the Federal Reserve’s dual-mandate goals of maximum employment and stable prices.

Consistent with this principle, participants agreed that it was important to be flexible in managing the process of balance sheet normalization, and that it would be appropriate to adjust the details of balance sheet normalization plans in light of economic and financial developments if necessary to achieve the Committee’s macroeconomic objectives.

When will the QE Unwind end? Wait… there’s a slow-motion component.

Pretty soon, the Fed is going to announce its new plan: “Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.”

But here is the slow-motion component. Historically, the biggest driver of the level of assets on the Fed’s balance sheet was “currency in circulation” on the liability side. Assets have always risen with the increase of currency in circulation, which is determined by global demand for paper dollars through the banking system. Since the Financial Crisis, currency in circulation has risen more sharply than before, as folks around the world began hoarding paper dollars, and so the assets on the balance sheet, even without QE, would have risen more sharply as well.

The Fed is now considering keeping assets flat after the QE unwind ends, even as currency in circulation continues to rise. This would by definition whittle down further excess reserves, but very gradually, and effectively continue the QE unwind on super-slow-motion:

A substantial majority expected that when asset redemptions ended, the level of reserves would likely be somewhat larger than necessary for efficient and effective implementation of monetary policy; if so, many suggested that some further very gradual decline in the average level of reserves, reflecting the trend growth of other liabilities such as Federal Reserve notes in circulation, could be appropriate.

In these participants’ view, this process would allow the Federal Reserve to arrive slowly at an efficient level of reserves while maintaining good control of short-term interest rates without needing to engage in more frequent open market operations.

Only “a few participants” disagreed with this strategy. Those few participants thought that after the QE unwind ends, rather than maintaining asset levels roughly flat for years to come, the Fed “should begin adding to its assets to offset growth in nonreserve liabilities [cash in circulation], so as to keep the average level of reserves relatively stable.”

Everyone wants to get rid of MBS

The Fed’s “longstanding plan” is to “hold primarily Treasury securities in the long run.”  This seems to be the consensus. Participants commented that after the QE unwind ends, “most, if not all, principal payments received from agency MBS” should be invested in Treasury securities.

In fact, some participants thought it was “unnecessary” to retain the $20-billion-per-month cap for the MBS roll-offs; that all principal payments could be allowed to roll off, which could slightly speed up the process of shedding MBS, especially if a drop in mortgage rates causes borrowers to refinance their mortgages, which would speed up pass-through principal payments to the Fed.

My proprietary Fed Hawk-o-Meter quantifies and visualizes what the Fed wishes to communicate in the minutes. Read…  My Fancy-Schmancy “Fed Hawk-o-Meter” Ticks Down, Still Red-Lines. In Passing, Fed Plants Seed for Removing “Patient”