More from Jackson Hole

More from Jackson Hole
David R. Kotok,
July 15, 2013

We thank readers for their emails and questions following our original report from Jackson Hole (July 13). Let’s use a metaphor and advance the discussion with this commentary.

On the Jewish holiday of Passover, we ask four questions. The first is “Why is this night different from all other nights?” Following the Jackson Hole visit, meetings, conversations, roundtable discussions, and presentations,

it seems to me that a similarly probing set of questions can now help us to explore the significance and ramifications of current monetary policy.

The first Passover question we might borrow has already been answered: the post-2008 monetary policy is different. Very different! And its deviations from conventional monetary policy are widely identified. But three other critical questions follow:

(1) How do we manage this issue of excess reserves?

(2) What about the issue of extraction of duration from the market as part of the transactions within the Fed’s balance sheet expansion?

(3) What is the size and meaning of the Fed’s (Federal Reserve) balance sheet?

Let’s take those in order.

Excess reserves are not required of the banking system. They are created by the Fed’s process of purchasing Treasuries and federally backed mortgage securities. Right now they are at an unprecedented size in the banking system and are on deposit back at the Fed. The Fed currently pays 0.25% (25 basis points) to banks that deposit excess reserves with it. The banks deposit these excess reserves because that is, at this time, the most prudently profitable way to deploy them.

The big future concern is this: what happens when the excess reserves leave the banking system for other assets? What happens when there are loans and investments? Is there a multiplier? Does too much stimulus result? Will inflationary impacts ensue? Will asset bubbles form? The answer to all of those questions is … yes and no. Remember, that for a given single transaction, most of the transfer between agents is of excess reserves from one bank to another: I buy something from you; my bank settles the transaction; and the total amount of excess reserves held by my bank is reduced, while the total amount of excess reserves held by your bank is increased. It takes a loan and credit expansion to increase the amount of required reserves.

What can the Fed do with this issue of large excess reserves? My colleague Bob Eisenbeis has written about the fact that they could raise the reserve requirement, such that the excess reserves become required reserves. Furthermore, they could change the amount of required reserves as needed in order to neutralize the impact of what is currently a large overhang of excess reserves.

Another option is that the Fed could change the interest rate on excess reserve payments. They have said that they could use this tool. At Jackson Hole there were discussions of these options, with lots of possibilities, combinations, permutations, and incantations. The bottom line is that the Fed has not figured out what it is going to do, or when, or how. The fact is that the Fed has these tools and can use them when and if it is ready. Markets seem to ignore this. My personal view is that if the Fed were to use one of these tools, the markets would respect the Fed’s decisive intervention; their response would actually flatten the yield curve; and long-term interest rates would fall.

Let’s get to the question regarding the size of the Fed’s balance sheet. Just how big is it? This is another serious issue. In the old days, the balance sheet was big enough to create enough reserves to meet the requirements of the banking system, plus fund the need for currency. The size of the Fed’s balance sheet was roughly $900 billion before the failures of Lehman Brothers and AIG (American International Group, Inc.).

The asset side consisted mostly of holdings of short-term Treasury securities. The liability side entailed the required reserves on deposit with the Fed plus currency in circulation worldwide. That is what the balance sheet looked like then.

Now that balance sheet contains a couple trillion more dollars and is growing every day. Doesn’t that make a difference? The Fed buys securities and creates excess reserves by paying for them, and three hours later those excess reserves are back on deposit at the Fed. They generate no multiplier now, sitting where they are as excess reserves, but they are high-powered money. So, they can potentially multiply with extensions of credit and they can have a stimulative effect when interest rates tick upward or when loan demand improves.

Under the present circumstances, credit multiplication is not happening – or if it is, it is doing so in a very small way. What happens now? The Fed buys more government-backed securities, and a few hours later the excess reserve balance is higher than it was the day before. The Fed holds the securities; the balance sheet and excess reserves are increased; and very little economic impact occurs. There may be a psychological impact. That is, the Fed may have seeded the notion that it is going to continue with stimulus until the economy becomes more robust. All of those things are true; however, the impact of the single transaction is negligible.

The third question concerns the duration of the assets the Fed holds. In the old days, the Fed held mostly short-term Treasury securities. Think of it as holding 90-day Treasury bills. Now the Fed is buying Treasury notes and bonds. Let’s look at two transactions. In the first, the Fed buys $1 billion worth of 90-day Treasury bills. In the second, the Fed buys $1 billion worth of 30-year Treasury bonds. In the first transaction, the amount of duration withdrawn by the purchase of the 90-day Treasury bills is negligible. It is a speck, a tiny amount. In the second transaction, the Fed has taken the duration of a 30-year Treasury bond out of the market. That is long duration. That is a lot.

The size of the Fed’s balance sheet does not change, whether it buys a 90-day Treasury bill or a 30-year Treasury bond. Using balance sheet size as a determinant of the outcome of Fed policy is not equal even though it measures the same.

Then what is the impact of buying the 30-year bond? It is that the Fed has extracted long duration from the market and put it on its own balance sheet. It has said to the market, “We are going to take duration away from you and keep it.” Therefore the market has had to adjust its duration outlook. Duration is a key ingredient in the pricing of home mortgages, bonds, corporate finance, and long-term finance of any type. By its action, the Fed has reduced interest rates in the long and intermediate sections of the public market.

That is what the Fed wanted to do. It wanted to bring down home mortgage interest rates and make longer-term financing more palatable to investors, speculators, businesses, and all sorts of agents that care about the duration of their own holdings. It wanted to say, “Look, you can play in the game now. We are backstopping the world, and there will not be another Great Depression.”

What happens if the Fed reduces the duration of its portfolio? What happens if it does not reduce its duration and the portfolio size stops growing? What happens if it does either of those things in the context of a federal deficit that is getting smaller versus one that is getting larger? Can the Fed reduce duration by buying fewer long-term bonds even as the federal government is issuing fewer long-term bonds in order to shrink the deficit? These are the types of questions we cannot answer. But we debated them in Wyoming.

The research literature does not help us here. It focuses on eras when we did not have this wild, exciting, and very different construction of these reserves. All this is new. Meaningful research will be done many years from now. Today we are throwing the textbooks in the trash and starting over.

Our view is from the bottom line. The interest rate of importance is going to be the short-term rate, which is the target of the Fed. It is near zero and is going to be there for the next two years or more. It is bullish for assets. We believe spread product in the bond market is a desirable thing to own. We particularly like municipal bonds. Stocks, real estate, and other asset classes are likely to rise in price as long as this current policy is in place, which will likely be, at least, a couple more years.

The latest reports on retail sales and manufacturing only affirm this outlook. We remain fully invested.

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David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors