FED'S QE EXIT MUST AVOID COLLATERAL DAMAGE / THE FINANCIAL TIMES MARKETS INSIGHT

MARKETS INSIGHT

May 22, 2013 10:22 am

Markets Insight: Fed’s QE exit must avoid collateral damage

By Manmohan Singh

With a quantitative easing exit now being eyed, many are beginning to worry about the possibility that the Federal Reserve will struggle to unwind its huge balance sheet in a controlled way. In reality, however, there is no reason to fear runaway rates provided authorities keep collateral market rates in mind during the exit process.

Among the unconventional tools the Fed introduced during the peak of the crisis was a “floor” mechanism known as “interest on excess reserves”. Less high profile than other unconventional policies such as asset purchases, IOER’s role in controlling rates has been under-appreciated by the market. Indeed, it is because of IOER that liquidity has been reabsorbed into the central bank system so efficiently. Above all, IOER has played an important role in ensuring that short-term rates did not fall too far below the critical floor of 0.25 basis points, despite all the additional liquidity that was pumped into the system.

Contrary to popular understanding, the Fed has in this sense been propping up the short-term rate market, not suppressing it. IOER’s power to steer rates could now be used to help manage money-market rates during the exit process. But IOER’s ability to influence money market rates for depository institutions has come at a cost. The short-term rates market is increasingly bifurcated, as it is only depository institutions that can really benefit from these freely distributed positive rates.

In contrast, non-depository institutions keen on keeping money invested in liquid and safe investments have to fight over an ever-smaller pool of good collateral. This is partly because quantitative easing has sucked a significant sum of quality collateral out of the public market, and partly because the risk averse are less inclined to part with the quality collateral that remains.

Both these changes lead to collateral scarcity in the private money markets, which is important because only the collateral markets can provide deposit-like safe investments, without unsecured bank credit risk, for non-depository institutions. This has caused a disruption in the market for repurchase (repo) agreements.

In a repo trade, an institution either pledges collateral for funding and pays for the privilege to receive those funds, or alternatively – on the other side of the trade – receives collateral as a guarantee for funds lent out.

Collateral shortage lowers the repo rate; collateral abundance increases it. In today’s market, repo rates arguably represent the true cost of money for non-depository institutions that do not have access to the Fed’s reserve system.

A central bank such as the Fed can try to dictate the cost of money by setting target interest rates for unsecured funds, but if the repo markets do not comply, the central bank can in some sense be judged to have lost control.

While the Fed has managed to influence the cost of Fed funds for depository institutions – in large part due to IOER, it has found it much harder to ensure those rates are available to all parts of the market.

In fact large cash positions of such non-banks in the midst of collateral shortage have now started to influence the key Fed funds rate, seeing it trade below the IOER “floor”.

But it is not just the Fed that has been suffering from such collateral pressures.

In the eurozone, collateral scarcity in German, French and Dutch short tenor bonds has even seen rates turn negative. The same has also been witnessed in Danish and Swiss bonds. So far the US has managed to avoid rates turning negative because IOER has helped to maintain short-end rates – both money and repo. It has been successful precisely because the average repo rate has tended to be lower than the IOER rate.

It is true that if the Fed was to release collateral and take in money as part of its unwinding process, there is a risk that the repo rate could begin to increase and start to influence market rates widely. However, provided the average repo rate remains near IOER, there is no real reason why other rates should rise precipitously, given the IOER incentive for depository institutions to keep liquidity parked at the central bank.

The repo rate overshooting IOER can lead to inflation, or expectations thereof, since depository institutions may switch liquidity from IOER to repo markets, thereby increasing the money multiplier. This is why any unwind should be focused on steering collateral to those non-bank areas that are currently suffering shortages, depressing rates, rather than to depository institutions whose cost of money can continue to be much more effectively controlled by using IOER. The Fed has been developing tools to do just that, including a programme of trading repo directly with large money market funds.


Manmohan Singh is a senior economist at the International Monetary Fund; views expressed are his own and not those of the IMF

Copyright The Financial Times Limited 2013.