Monetary policy for geeks
Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.
Although all eyes tend to be on how the US Federal Reserve will (the Fed) change interest rates (as heralded last week), it can be argued that the yield on 2-year US treasuries is a better guide. With quantitative easing coming to an end, thus removing distortions from the bond market, the ‘2-Year’ bond yield may gain even greater credence in the months ahead.
Chart 1: The spread between US 2-Year Treasury Bonds and the Fed Funds Target rate
Source: Bloomberg, March 2018
Chart 1 above illustrates the spread (the difference) between the yield on 2-year Treasury bonds and the Fed fund’s target rate. When spreads are zero (which is rare), investors and the Fed are in a state of equilibrium regarding the inflation outlook.
Most times the market and the Fed fund’s rate deviates, sometimes markedly. For example, in 2000/01 and 2007/08 the spread narrowed, and even went negative. When the spread is negative it means investors expect the Fed to ease monetary policy significantly by lowering interest rates; which turned out to be correct on both occasions.
Recently, spreads have widened, indicating that investors expect monetary policy conditions to tighten. Last week the Fed increased interest rates by 0.25% to a range of 1.5%-1.75%. In effect, the 2-Year Treasury yield spread acted as a lead indicator (one wonders if the Fed should outsource monetary policy to the market!)
With a 2-year forecast horizon, bond investors buying and selling 2-Year US Treasuries are in effect formulating short-term predictions for future interest rates. By extension, this means investors are taking a view on future inflation.
Balancing the Books
While all attention is currently on the 0.25% interest rate increase announced by the Fed last week, something receiving little comment was the rate of interest paid to banks holding required reserves, and excess reserves (a sum exceeding regulatory needs). The Fed announced that they would match the rate paid to banks holding reserves to the increase in the target rate.
The present level of required reserves for US banks is currently US $190.5bn. However, the amount held over and above required reserves is a whopping US $2.1trn.
Chart 2: Reserves within the US banking system
Source: Bloomberg, March 2018
The dramatic growth in excess reserves since the credit crisis in 2008 has caused a great deal of controversy. For some this largesse represents a latent inflationary threat, and evidence that banks have been unwilling to lend.
The thinking behind this is that if banks decide to deploy these reserves it would unleash a huge amount of lending and drive inflation to higher levels. Critics also object to banks being paid interest from an organ of the state while holding reserves. They see this as a scandal and object to tax payer money affectively supporting the US banking system – uncomfortable for those with a lasting memory of the financial crisis! In overall terms there is a lot of head scratching as to why bank reserves have grown so big and what this could herald in the future.
The reality is, there is no mystery. For monetary geeks who read widely, the US New York Federal Reserve explained in Staff Report 380 why US bank reserves have exploded. They also set out reasons why high reserves will not in themselves prove inflationary.
The paper we refer to was released in 2009 and as many people have neither the time nor the inclination to read it we can summarise the key points as follows:
1. The total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions.
2. Failure of the inter-bank lending system and the actions of the central bank to lend directly to firms is primarily what has boosted excess reserves
3. As the central bank withdraws from QE, excess reserves will recede.
4. By paying banks a rate of interest while holding reserves the Fed can strongly exert influence over market rates.
The conclusion to be drawn is that the people at the Fed are very clever. They have devised a system whereby excess reserves, a by-product of their non-conventional monetary policy, and paying interest on them, is helping to maintain stability and need not be inflationary.