The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.
-Ryan Avent as quoted in Why the Federal Reserve wants to drain excess reserves, Dec 2009
This is the problem for the US Federal Reserve. And now that people are talking seriously about exit strategies for the Fed, it makes sense to discuss these mechanics. Yes, I know some people are still talking about QE3, but let’s deal with that if and when the economy swoons after QE2 is over.
What got me to thinking about this was a Bloomberg article about James "Seven Faces of The Peril" Bullard. Remember, Bullard is the Fed official which got us started on the road to QE2 when he said:
Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.
When Bullard said those words, everyone knew the Fed was going to start buying up Treasuries. So, Bullard’s most recent statements bear remembering. These are very important words.
If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we’re going to start withdrawing our stimulus, and I’d start by pulling up a little bit short on the QE2 program.
Can we start dumping risk assets now? Seriously. The QE2 trade is now officially over. Remember guys like David Tepper telling us last September that they were going to run with the Bernanke put? Well now there’s the Bullard call instead of the Bernanke put. Bullard is telling us the jig is up. QE2 is finished.
Here’s the part I want to highlight though. The Bloomberg piece reads:
If the Fed opts to start withdrawing stimulus and tighten policy, it should start with the “balance sheet” by selling bonds first, then changing its wording about keeping interest rates near zero for an “extended period” and then raising interest rates, Bullard said.
If you go back to the Ryan Avent quote you will know why that’s the sequence of events. There’s no way the Fed can tighten with trillions of dollars of excess reserves in the system unless it raises the interest it pays on reserves in concert with its rate hikes. That’s a lot of interest payments. The Fed doesn’t want to make those payments. It would prefer to drain the excess reserves first and then start hiking rates later. That tells me that the fed funds rate will be effectively zero for some time to come.
So, the Fed has basically just announced it will stop QE2. It will then start selling Treasuries. And remember, this is at the same time the Treasury is selling $10 billion a month in mortgage securities. Only after this will rates be hiked. That doesn’t sound like a bullish scenario for risk assets. Could bond yields fall even though the Fed is selling if the economy swoons as a consequence?