What's Next for the Fed? A Hint Comes This Week

Paul Beaty/APFederal Reserve Chair Janet Yellen
By Alex Rosenberg

Minutes from the Federal Reserve's March 18-19 meeting are set to be released Wednesday, and they could be quite constructive for investors struggling to forecast the Fed's next move.

The minutes "always move the market," said Jeff Kilburg of KKM Financial. "Because at the end of the day, the Fed is still in complete control of the S&P 500" (^GPSC).

While most expect the Fed to continue to shave $10 billion off of its monthly quantitative easing program at each meeting, the open question relates to the Fed's ultralow target on the federal funds rate. Many were surprised when, in her March 19 post-statement news conference, Fed Chair Janet Yellen said the first rise in the target for the key institutional lending rate could come six months after the Fed wraps up QE.

Some reassurance came Monday, when Yellen said the Fed's "extraordinary commitment" to improving the labor market "is still needed and will be for some time, and I believe that this view is widely held by my fellow policymakers at the Fed."

What remains unclear is whether this was Yellen's way of walking back her now-infamous "six month" comment.
But given that the minutes will provide a record of the thoughts presented at the very meeting that Yellen's press conference followed, the document could help investors figure out how seriously this timeline should be taken.

"Investors want to know how much 'thought' went into her comment about a possible rate rise in six months," David Seaburg, head of Cowen sales trading, told CNBC.com over Twitter. "The minutes will show."

"I'd like to see Yellen's comments on rates to see if she reinforces that six-month period after the taper ends," echoed trader Anthony Grisanti of GRZ Energy.

Still, not everyone is confident that anything new will be revealed.

In the March meeting, the Fed shifted its guidance on the fed funds rate from quantitative guidance that was based in part on the inflation rate to a more qualitative approach. David Robin, managing director at NewEdge, says discussion of this change will dominate the fed funds rate assessments.

"I think the minutes will give very little insight in to the federal funds rate itself," Robin wrote to CNBC.com. "It will be much more informative about the level of debate relative to the shift in qualitative guidance and how that is going to be communicated."

Either way, one thing is widely agreed upon: Worries about the fed funds rate now far outpace worries about the future of the fed's bond buying program.

"Tapering is sooo 2013," Pimco market strategist and portfolio manager Tony Crescenzi wrote to CNBC.com this past week. "Focus on the policy rate. We see a hike in the latter part of 2015."

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The Fed faces a much larger looming problem, and it's one few outside the financial markets have even thought about, let alone understand.

As this article correctly suggests, the Fed's primary tool for manipulating monetary policy is the federal funds rate. This is the rate banks make overnight loans to each other for the purpose of complying with the Fed's reserve requirements. In other words, every bank is required to keep a portion of their demand account balances in either cash, or reserves at the Federal Reserve. So if Bank A has an excess of these reserves over the statutory requirement, and Bank B is short of their regulatory reserve requirement, B will borrow A's excess reserves at the federal funds rate.

But the federal funds rate is not some number magically imposed by the Federal Reserve. Instead, it is merely a byproduct of the supply of money and the demand for money, much like the mercury in the tube of a thermometer is a byproduct of the temperature. The Federal Reserve sets a TARGET for the federal funds rate, and seeks to reach that target by buying or selling bonds in the open market. When the Federal Reserve buys bonds, the purchases represent additional cash in the system, thereby decreasing the demand for federal funds borrowing. Or by selling bonds, the Federal Reserve accomplishes the opposite, thereby increasing demand for federal funds borrowing. These increases in supply or demand are then reflected in the price of money (eg, the federal funds rate)

But now we have quantitative easing. The Fed has built massive EXCESS reserves in the banking system by buying bonds and creating deposits to pay for them. This has led to the overall monetary base growing at a whopping 32% annualized rate since September 2008, resulting in an astounding $2.6 trillion in EXCESS reserves in the banking system. Remember, even with tapering, this number continues to expand, just at a slower than previous rate. And when QE finally tapers to zero, it will only mean the excess reserves are no longer growing, and not that they've begun to shrink by even one thin dime.

Because of these excess reserves, the Federal Reserve can't manipulate the fed funds rate by buying and selling bonds in the open market unless they first eliminate the existing excess reserves by unwinding QE (eg, selling the massive amount of bonds they've bought over the last 5 1/2 years). If the Fed were to merely lower excess reserves from $2.6 trillion to say $2.5 trillion, that wouldn't create any demand for federal reserve loans, which is what drives the rate higher. There'd STILL be $2.5 trillion in EXCESS reserves, meaning there'd by no shortage of supply of banks seeking to lend at the federal funds rate, but no demand from banks seeking to borrower at the federal funds rate.

This is where the significant risk to the economy lies over the next couple of years.

April 07 2014 at 10:46 AM Report abuse rate up rate down Reply
1 reply to tru.liberal's comment

I should have said THE OTHER significant risk.........the one that is in addition to the abysmal fiscal policy that has been holding back the economy as if it were a thoroughbred race horse shackled with a ball and chain.

April 07 2014 at 11:06 AM Report abuse +1 rate up rate down Reply