Has QE4 begun? The $1.2 trillion per month hole in the repo market.
In the two months since the repo market blow up, the Fed has been making repo open market operation purchases at a rate of $1.2 trillion per month.
Below is the monthly rate of Fed open market purchases since 2000. In the era of QE and ample reserves, the Fed has not touched open market operations for more than 10 years before 2019. Prior to that, the highest rate of open market operations we saw in history was roughly $300 billion/month briefly after the September 11 attacks, with long‐term averages of around $50 billion/month. To say the current rate of $1.2 trillion/month is unprecedented would be an understatement
The planned QE unwinding has hit a brick wall and the Fed balance sheet is now expanding at a rate matched only briefly by QE1, and faster than QE2 or QE3.
Is this a temporary rescue of the repo market or the start of a sustained QE4? To answer that question, we must look at how monetary policy has evolved since the Financial Crisis.
1. Pre‐2008, scarce reserves regime:
- Total reserves: small (<$50 billion)
- Excess reserves: none
- Interest on excess reserves: 0%
- Managing interest rates: to increase rates, Fed sells securities on the open market and reduces supply of reserves, vice versa to decrease rates.
- Banks: regulations are lax and risk tolerance is high
- Treasury department: carefully manages its cash flows to not impact the total reserve levels.
2. 2008‐2019, ample reserves regime:
- Total reserves: large ($trillions)
- Excess reserves: large ($trillions)
- Interest on excess reserves: positive at around Fed funds rate
- Managing interest rates: Because there is more reserves than the banks could possibly need, Fed sets interest rates by paying a floor rate on reserves.
- Banks: regulations are strict and risk tolerance is low
- Treasury department: no longer actively manages its cash flows, its activities directly affect total reserve levels.
3. 2019 onwards, scarce reserves regime again?:
- A combination of QE unwinding, strict banking regulations, and a concentration of reserves in a handful of banks have once again made reserves scarce, which means a rate floor is no longer effective at managing against rate rises. This was painfully obvious in December of 2018 and September of 2019. Thus far, the Fed has chosen their pre‐2008 strategy of temporary open market operations to manage rates in this new scarce reserves environment. But because the total pool of reserves is around 50 times larger now than pre‐2008, the size of the required open market operations is in the $trillions, not $billions, per month.
Going forward, the Fed must make a choice of staying in a regime of scarce reserves or going back to ample reserves. The Fed can lower interest on excess reserves and reduce bank incentives to hold excess reserves to some degree, but the new post‐2008 regulations will still necessitate a far larger base of reserves than pre‐2008. So managing a scarce reserves banking system on a large base of reserves will require continued massive open market operations. It will likely also require a change from the Treasury department’s cash flow management.
Alternatively, the Fed can recognize that they’ve found the floor for the total amount of reserves necessary in our new regulatory environment and add some reserves via another round of QE as cushion and grow the total reserves in line with our GDP. This would allow us to stay in the ample reserves regime.
The key metric I’d keep an eye on is the difference between interest on excess reserves and the effective Fed Funds rate, which I show below. We made the switch from an ample reserves regime to a scarce reserves regime in December of 2018.
If the system has more than enough reserves, the effective Fed Funds rate would be below the interest on excess reserves because not every participant is eligible for interest on excess reserves, hence they’d push the average Fed Funds rate below interest on excess reserves. In the 2019 environment of scarce reserves, market participants are starved for reserves and bid the average Fed Funds rate at or above interest on excess reserves. At the moment, the Fed has done enough open market operations to meet reserve demand and drive Fed Funds rate exactly back to interest on excess reserves.
Going forward, whether the Fed pushes effective Fed Funds rate below interest on excess reserves will signal the next era of monetary policy. If the Fed chooses the scarce reserves route, Fed funds rate will stay at or above interest on excess reserves. The Fed will continue to buy short‐term securities as necessary to meet demand for reserves and push down the short end of the curve and I’d bet on the yield curve steepening again. If they choose the ample reserves route, Fed Funds rate will fall back below interest on excess reserves, the Fed will go back to buying 10 year bonds, and I’d expect to see further flattening of the yield curve.
Unless banking regulations change dramatically, my guess is that QE4 is coming. The Fed would rather have a cushion of ample reserves against unexpected repo market blow ups than react retroactively with $trillions/month of open market operation purchases.
by Howard Wang of Convoy Investments