Weekend Economists Visit Borinquen, La Isla del Encanto May 15-17, 2015

[Demeter]

23. QE Exit Strategy, Part One: ZIRP

http://www.nakedcapitalism.com/2015/05/exit-strategy-part-one-zirp.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+NakedCapitalism+%28naked+capitalism%29

By Perry G. Mehrling, Professor of Economics at Barnard. Originally published at his website

The Fed has announced plans to raise rates in the imminent future, but the market does not believe it. Why not? Conventional wisdom appears to be that the Fed will chicken out, just as it did during the so-called Taper Tantrum. The Fed has signaled its appreciation that “liftoff” will involve increased volatility, and has stated its resolve this time simply to let that volatility happen, but markets don’t believe it...I want to suggest a slightly different source of disconnect, concerning expectations about what exactly will happen in the monetary plumbing when the Fed raises rates. Case in point is the recent Credit Suisse memo, apparently the first of a series, that forecasts “a much larger RRP facility–think north of a trillion” whereas the FOMC itself “expects that it will be appropriate to reduce the capacity of the RRP facility soon after it commences policy firming”. That’s a pretty big disconnect.

Pozsar and Sweeney (authors of the CS memo) think about the exit from ZIRP (Zero Interest Rate Policy) from the perspective of wholesale money demand, which they insist is “a structural feature of the system” and “the dominant source of funding in the US money market”. Before the crisis, that money demand was funding the shadow banking system, largely through the intermediation of repo dealer balance sheets. Now, it is funding the Fed’s balance sheet, largely through the intermediation of prime money funds and US bank balance sheets, both of which issue money-like liabilities and invest the proceeds in excess reserves held at the Fed. The big problem that now looms is that neither prime money funds nor banks want that business any more. Capital regulations have made the bank side of the business unprofitable, and looming requirements that prime money funds mark to market (so-called floating NAV rather than constant NAV) will force them out of the business as well. Where is that money demand going to go? Pozsar and Sweeney say it will go directly to the Fed, causing the swelling of the Reverse Repo Facility pari passu with the shrinking of excess reserves. The mechanism will be a shift from prime money funds and bank deposits into government-only money funds, which will absorb the flow by accumulating RRP.

In other words, the Fed will not be able to shrink its balance sheet as part of this first stage of exit from quantitative easing. It will only be able to shift the way that balance sheet is funded–much less excess reserves held by banks, much more RRP held by government-only money funds. Nevertheless, because this shift will allow the Fed to regain control over the Fed Funds rate, it will accept that consequence. Exit from ZIRP comes before exit from QE.

Are you with me so far?

NO. I'VE ASKED YVES WHAT RRP IS....