August 31, 2016

Specialist multi-asset investment management firm

The Foothills of Fed Firming

Opening remarks by Fed chair Janet Yellen at the annual Economic Symposium offered a clear glimpse of the foothills of Fed firming.

Vincent Reinhart

Chief Economist

The Foothills of

Fed Firming

August 30, 2016

Part of the attraction of attending the Federal Reserve Bank of Kansas City’s annual

Economic Symposium is the outstanding vista of the Grand Teton Mountains, right at your

doorstep. At this year’s event, however, five long-burning fires around the area obscured

the fine views and closed the southern entrance to Yellowstone National Park. On occasion,

though, the haze parted. The same could be said for the economic symposium itself, which

was mostly devoted to implementing monetary policy in a post-crisis world. This discussion

revolved around the mechanics of the money market and the appropriate size of a central

bank’s balance sheet, thereby shrouding the conference room in a thick blanket of technical

smoke.

The opening remarks by Chair Yellen, however, offered a clear glimpse of the foothills of Fed

firming. As we have noted before, the operative model of Federal Open Market Committee

(FOMC) functioning is one of delay at the top. Tightening has to be extracted from the

reluctant chair by the rest of her restive committee. Yellen accedes, on occasion, because

showing a willingness to tighten keeps her colleagues at bay. We believe the delay,

however, will keep the funds rate lower for longer.

In the weeks after the July meeting, we heard stirrings from FOMC participants, importantly

including Presidents Dudley and Williams and Vice Chair Fischer, that the widespread view

in markets that no action would be forthcoming in 2016 was puzzling. This assertion was

supported by a trip down memory lane. In the early summer, they had expected that

economy growth above trend would work down resource slack and push inflation up

toward their target of 2 percent. As a result, all of them anticipated tightening at least once

this year. The dismal nonfarm payrolls report for May and the unexpected UK referendum

result shook that collective confidence. In the event, the US economy and global financial

markets proved resilient. Indeed, the outlook was back on the track they expected in June

when they also expected to tighten this year.

Chair Yellen took ownership of this consensus view in Jackson Hole, reasoning:

“

In light of the continued solid performance of the labor market and our outlook for

economic activity and inflation, I believe the case for an increase in the federal funds rate has

strengthened in recent months.”

There were caveats. There are always the caveats that this was a forecast, not a promise,

and all decisions are data dependent and made meeting by meeting. But it was her

assessment, not a third-person attribution to most FOMC members.

This does put the September meeting in play, in a data-dependent sort of way. A solid

employment report in the neighborhood of June and July that put net job creation over the

latest three month at three-quarters million workers would make it hard for Fed officials

to wriggle out of their characterization that the pieces were in place to remove some

policy accommodation. They might still try to get off the hook, and an opportunity to do

so was offered during the rest of the symposium discussing the nuts and bolts of policy

implementation. Particular focus was directed on the wedges opening up across short-term

interest rates because of regulation and what that means for the pass through of policy action

to money market rates. These concerns may be especially salient at the FOMC September

meeting, given the shift in short-term funding patterns and pricing already in motion in

advance of the SEC requirement coming into force on October 14th that prime money market

mutual funds move to a floating net asset value and put up gates for investor withdrawals.

https://www.federalreserve.gov/newsevents/speech/yellen20160826a.htm, accessed August 27, 2016.

In the two-out-of-

three case that July

employment gains

fall short of 225,000

workers and policy

stays on hold, the

FOMC will send

the strong signal of

action in December.

In the two-out-of-three case that July employment gains fall short of 225,000 workers and policy

stays on hold, the FOMC will send the strong signal of action in December by releasing a dot chart

that shows virtually all participants anticipating one tightening in 2016.

In any event, more of

the dots at the far right of the chart depicting the long-run nominal funds rate will cluster below 3

percent, conveying that this will be an extremely gradual rate renormalization.

What of the nonfarm payrolls report to be released September 2nd? Some high-frequency reading

on the economy were mixed, but initial claims for unemployment insurance in the employment

report survey week came in at only 252,000 new claimants. As the scatterplot below depicts, claims

in such a low range have been associated with strong net payroll gains since 2010.

The association is somewhat deceiving, however, because quits have trended up over the period,

implying that there are now fewer new eligible claimants for unemployment insurance at the same

level of labor market tautness than earlier in the sample. The dashed line at the right shows the

forecast of monthly net payroll gains as explained by initial claims in the survey week and a time

trend. The point forecast for July, around 190,000, is probably not quite hot enough to trigger

FOMC action. In the Standish judgmental forecast, we nudge this lower, to 175,000, in light of the

past few weak August readings and some giveback after two strong months. But jaggedness of the

actual outcomes compared with the predictions cautions that there is a plausible probability (say,

one-out-of-three) on a payroll number that is strong enough to trigger a rate hike in September.

After Chair Yellen’s opening remarks, the proceedings settled into a discussion of policy

implementation, or should the Fed’s balance sheet stay big forever?

As shown in the chart below

after successive rounds of quantitative easing, the Fed’s footprint in finance topped out at $4-1/2

trillion of assets, or just under one-quarter of nominal GDP.

If this reminds you of this time last year, it should.

The academic papers presented at the symposium can be found at https://www.kansascityfed.org/publications/research/escp/

symposiums/escp-2016

Labor market indicators, 2010 to 2016 (monthly)

Changes in nonfarm payrolls and initial claim

Source: Bureau of Labor Statistics, accessed via FRED and Standish calculations as of August 26, 2016

-200

-100

100

200

300

400

500

600

Jan-10

Oct-10

Jul-11

Apr-12

Jan-13

Oct-13

Jul-14

Apr-15

Jan-16

Predicted change based on

claims

Change in NFPs

-200

-100

100

200

300

400

500

600

200

400

600

Changein payrollss (1000s)

Initial claims in survey week (1000s)

Federal Reserve's Financial Asset

Source: Federal Reserve, Financial accounts of the U.S. as of August 29, 2016

$500,000,000,000

$1,000,000,000,000

$1,500,000,000,000

$2,000,000,000,000

$2,500,000,000,000

$3,000,000,000,000

$3,500,000,000,000

$4,000,000,000,000

$4,500,000,000,000

$5,000,000,000,000

1945Q4

1954Q4

1963Q4

1972Q4

1981Q4

1990Q4

1999Q4

2008Q4

This additional

instrument to the

policy rate might

allow the Fed to

manage two goals—

price stability and

financial stability—

more effectively.

As balance sheets must balance, a large stock of assets also implies a large stock of liabilities,

offering pitfalls and opportunities in policy making on both sides of the ledger. My sense of the

bottom line listening to the discussions at Jackson Hole is that most—but decidedly not all—Fed

officials have learned to love a big balance sheet. Do not expect them to stop rolling over maturing

and prepaying securities anytime soon.

Why the support for something so as variance with the status quo ante bellum? A large stock

of assets gives them the option to adjust its composition so as to influence financial conditions

(think of the Maturity Extension Program redux or run in reverse). This additional instrument to the

policy rate might allow the Fed to manage two goals—price stability and financial stability—more

effectively. For instance, if officials were concerned about overheating in the housing market, they

could slow reinvestment (or sell outright) holding of mortgage backed securities and shorten the

average maturity of its Treasury securities without having to touch the fed funds rate.

The Fed, of course, will need a comparable volume of liabilities to fund those assets. The future

seems to be one in which those liabilities sit as reserves during the day, providing lubricant to the

funds transfer and clearing and settlement systems.

The Fed could drain a substantial fraction

of those reserves by the close of business through its reverse repurchase facility. That standing

facility provides as open, electronic auction of a super-safe asset—a loan to the Federal Reserve

collateralized by government securities—that fill a market gap. After all, regulation has significantly

expanded the demand for safe assets (as in the change the rules for money market mutual

funds) and made more costly the intermediation of them by banks (as in higher capital and the

supplementary leverage and liquidity coverage requirements). The New York Fed could arrange a

large rolling book of reverse RPs at varying maturities to provide a term structure of safe assets and

drain enough reserves to keep private market functioning of the reserve market active. In principle,

then, the FOMC could define the front end of the yield curve by setting the fixed rates on the reverse

RPs, perhaps even switching its formal target from the effective funds rate to these fixed rates.

For some in the room, all this sounded too good to be true. The future envisaged by the big-balance-

sheet lovers, it was feared, poses political risks and a permanently enlarged role for the Fed in finance.

In particular, a large stock of government assets pulls down Treasury funding costs and encourages

fiscal indiscipline. Moreover, holding that pot of bills, notes, and bonds might put the Fed in the

political crosshairs of a forced debt conversion at some later date. This risk might not be worth the

effort, especially if the efficacy of twists and turns in the composition of the portfolio were doubted.

As for the liability side, continuing to have a large volume of reserves outstanding will further

erode the functioning of the private market for reserves—the Fed funds markets—implying that its

effective rate will cease to be an accurate barometer of money market conditions. True, the reverse

RP facility can drain reserves, but given the enormous demand for safe assets, that may require very

large routine operations on a scale not imagined by the Fed founders.

As for financial stability, the presence of the super-safe asset may make investors quicker to run

from private alternatives at the first whiff of stress. And those first whiffs of stress might be harder

to detect if private activity at the front end of the yield curve is partly supplanted by official activity.

For now, all these issues are in play, as no note of urgency was voiced. They are also complicated.

But they also could redirect financial flows to the tune of trillions of dollars and change reference

rates. With the renormalization of the Fed’s interest rate policy stretching far into the future,

changes in balance-sheet policy seem even more remote. That provides time to study, and a cheat

sheet is provided below to help.

The Pros and Cons Of a Large Federal Reserve Balance Sheet

Assets

Liabilities

Advantages

•

Shifts in the composition of the

portfolio provide an additional

policy instrument.

•

A large stock of reserves keeps the

payments system lubricated.

•

Large volumes of daily reverse RPs

provide a safe asset.

Disadvantages

• Fine-tuning through portfolio

changes may be ineffective.

• Holding a large stock of assets

invites political interference.

• As the major participant in the money

market, the Fed overwrites price signals.

•

The private market for reserve may dry

up, rendering the effective funds rate an

unreliable indicator.

A comprehensive summary of this issue is offered in an FRBNY Staff Report by James McAndrews and Alexander Kroeger, “The Payment

System Benefits of High Reserve Balances” (June 2016), at https://www.newyorkfed.org/research/staff_reports/sr779.

The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not

provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not

intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These

views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed

by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of

such information. Please contact Standish for current information about our views of the economy and the markets. Portfolio composition is subject to change, and past

performance is no indication of future performance.

BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s affiliated investment management firms, wealth management

services and global distribution companies. BNY Mellon is the corporate brand for The Bank of New York Mellon Corporation. Standish is a registered investment adviser and

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