Simon Potter

The FOMC’s current asset purchase program has some key differences from earlier policy initiatives… Under the current asset purchase program, the FOMC has announced only the monthly pace and composition of purchases and noted that purchases will continue until there is a substantial improvement in the outlook for the labor market in the context of price stability. The Committee has also indicated that it will take appropriate account of the likely efficacy and costs of its purchases when adjusting their size, pace, and composition… Instead, under this conditional, outcome-based approach, the Committee has enacted a policy that will adjust to incoming information about labor market conditions and the broader economy, as well as its ongoing assessment of the efficacy and costs of purchases. Retaining the flexibility to adjust purchases is an important feature of the program, given our relatively limited experience with the use of the balance sheet as a monetary policy tool and the uncertainty about the policy’s effects.

There are some key differences between our Treasury and MBS operations that I would like to discuss. As counterparties in our operations, you know that outright purchases of Treasury securities are conducted through large-scale, multiple-security auctions via the Desk’s FedTrade platform, which allows all primary dealers to place multiple offers across all eligible securities simultaneously. Purchases of MBS, on the other hand, are currently conducted using TradeWeb, a commercial trading platform. The platform allows buyers to solicit offers for one security at a time from up to four counterparties, so the Desk includes dealers in operations on a rotating basis. As a result, the Desk purchases MBS in a series of smaller-scale, more frequent auctions. We are currently expanding the FedTrade platform, in order to have more flexibility in conducting MBS auctions in the future.

For these reasons, it can be useful to gauge our purchases both relative to gross issuance as well as the amount of outstanding stock that can likely be delivered into the Desk’s TBA purchases. Since the current purchase program began, the Desk’s purchases have accounted for about 50 percent of gross issuance on average, below the average monthly purchase rate of roughly two-thirds during the first round of large-scale MBS purchases in 2009. If refinancing activity declines, leading to a decrease in gross issuance, our purchases could exceed these levels. Such higher levels still seem unlikely to cause significant market functioning issues, given the considerable supply of existing stock that we believe could be delivered into the Desk’s TBA purchases over time. Nevertheless, not all new securities are issued in the TBA market, and it is difficult to estimate future gross issuance, so the Desk monitors the purchasable supply of MBS closely.

Investors’ disagreement and uncertainty about the overall stance of monetary policy will reflect their views on the future evolution of both the federal funds rate and the SOMA portfolio. One way to get a sense of the overall level of policy uncertainty is to convert the SOMA portfolio into “fed funds equivalents.”[8] With this translation, it is possible to estimate the hypothetical level of the federal funds rate that would provide a similar amount of monetary policy accommodation as both the actual level of the federal funds rate and the size of the SOMA portfolio.

[8] Fed funds equivalents are calculated by comparing the change in the 10-year Treasury yield due to asset purchases to the change that historically occurred following movements in the target federal funds rate. This is a simple framework, so the uncertainty around this measure is likely large

The effectiveness of an overnight, fixed-rate, full-allotment facility in helping to control overnight money market rates will depend on a range of factors, including whether a sufficiently wide set of non-bank counterparties has access to the facility… More counterparties could certainly be added, and we’re in the process of considering how best to proceed. The efficacy of the facility will also depend on factors such as the regulatory and balance sheet constraints of counterparties and the level of competition in the markets. However, the facility’s value in terms of monetary policy implementation wouldn’t necessarily be determined by the amount of usage. If the facility increases bargaining power for market participants, it could conceivably provide an effective floor for short-term rates, giving the Desk tighter control of money market conditions even with usage of the facility that’s low on average.

A key Federal Reserve Bank of New York staffer said Monday markets may not have been as surprised by the central bank’s decision to press forward with its easy-money policies in September as many now assert.

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The official observed surveys taken ahead of the Federal Open Market Committee showed it isn’t so clear markets and the Fed were on totally different pages.

“What was actually priced into markets, it’s hard to say,” Mr. Potter told attendees at a gathering held by the Money Marketeers of New York University. Mr. Potter said it is true the market’s reaction after the September FOMC showed many were expecting a cutback in bond buying, but it nevertheless remains the case that things are a bit cloudier than the conventional wisdom now seems to hold.

“Market participants had a range of views” about what would happen, but they didn’t have strong conviction, Mr. Potter said. He explained that it may have been overseas investors and traders, who were less connected to the flow of U.S. news, who may have been the only ones truly caught off guard by the Fed’s choice to press forward with its stimulus.

As reported by the Wall Street Journal

In sum, arbitrage activities by banks, complemented as needed by ON RRP operations, should cause a higher IOER rate to lead to higher levels of market rates. However, if the pressure on market rates from the Feds administered rates turns out to be insufficient, the Committee has a range of other tools including term deposits, term RRPs, and asset salesthat could be used to help tighten the stance of policy. Given the array of tools at our disposal, I am confident that the FOMC can adjust and control short-term interest rates as needed to foster its objectives of maximum employment and price stability. Given the range of available tools, I am confident in our ability to raise short-term interest rates from the zero lower bound when the time to do so arrives. Nevertheless, the FOMC is prepared to adjust the details of its approach to policy normalization in light of economic and financial developments and the Desk stands ready to innovate in order to efficiently and effectively implement policy consistent with the Committees directive.

The Committees normalization principles and plans do not detail the manner in which IOER as a primary tool would be combined with supplementary tools such as ON RRPs to move the fed funds rate into the target range. However, as reflected in the minutes to the July FOMC meeting, most Committee participants anticipate that, at least initially, the IOER rate could be set at the top of the target range for the funds rate, and the ON RRP rate could be set at the bottom of that range. This is also consistent with the views of many market participants as reflected in surveys conducted by the Desk. [A]s the Chair noted during her September press conference, the Committee expects that the effective fed funds rate may vary within the target range and could even move outside of it on occasion. For example, the effective rate could move outside the target for a day or two around key financial reporting dates, such as quarter-ends, when some banks marginal balance sheet costs are particularly high. However, such transitory movements should have no material effect on financial conditions or the broader economy. What matters for policy transmission is the predictability that on most days money market rates will be close to the target range set by the FOMC.

Our analysis has found that, offered at a spread of 20 basis points to the IOER rate, ON RRPs have kept overnight repo rates above where they would otherwise have been, in part by influencing the bargaining power of our counterparties. So what are the benefits of moving from a structure with individual caps alone to one with an aggregate cap as well? One benefit is that, in limiting the overall take-up but not individual take-up, an aggregate cap should produce a more efficient allocation of usage among counterparties than would a system of individual caps. Further, an aggregate cap should better balance efficient control of money market rates under normal conditions with the risk of a destabilizing surge in use of the facility in times of stress. The reduced risk of a surge in use in a system with an aggregate cap comes from the fact that take-up across counterparties is not perfectly correlated. As a result, an aggregate cap that binds at some frequency can be set below the sum of individual caps that would bind for at least one of the counterparties at the same frequency. The aggregate cap also raises the individual bargaining power of counterparties relative to a system of lower individual caps, since in normal times counterparties can be relatively certain that larger bids at the ON RRP facility will be filled. However, the possibility that the aggregate cap could bind even in only limited circumstances may undermine this effect on bargaining power.

In discussing why I view the framework as effective, it’s helpful to start by explaining what it means for the tools to work well. I think about this issue through three lenses: interest rate control, avoiding unintended impact on the structure of the financial system, and avoiding financial instability...

It is of great importance that the public is confident that the federal funds rate will be, on average over time, within the target range set forth by the FOMC, and that other money market rates will continue to move closely with changes in the federal funds rate...

A second lens for evaluating the operational framework is the extent to which it avoids creating incentives that might result in undesirable changes in the structure of the financial system. This means that the framework shouldn’t have lasting unintended effects on how people invest their money or on how financial institutions interact with each other...

In particular, the framework shouldn’t create a risk that, in times of stress, money market lenders will rapidly disintermediate their usual counterparties and come to the Federal Reserve instead, such as through the ON RRP facility.

The success of the new tools so far has been important for instilling confidence that policymakers can control overnight interest rates at levels appropriate to meet their goals. It also means that, in future, the Federal Reserve will not have to face the same technical constraint that leads to a conflict between easing strains in broad money markets and controlling the policy rate whether it uses a floor or corridor system. This could make the Federal Reserve System more agile and better able in future circumstances to provide the elastic currency that has been one of our stated purposes since the Federal Reserve Act became law more than a century ago.

Individuals might act according to their subjective beliefs without being able to fully articulate in standard forms their underlying probability distribution. Thus, a need arises to elicit these views in order to understand behavior more fully.

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From the results of our cognitive interviews and experimental surveys, we decided in the Survey of Consumer Expectations to elicit medium-term inflation expectations at the one-year two-year-forward horizon. For example, in this month’s edition of the SCE we ask respondents what they expect the rate of inflation to be “over the 12‐month period between May 2018 and May 2019.” Our testing suggests that respondents understand this format better than that of the 5-10 year Michigan question; consumers are better able to provide their expectations over a specific time period in the future, and there is little value in asking them about a longer time horizon. In addition, we believe that the one-year two-year-forward horizon adopted in the SCE is better suited to measure inflation expectations at the medium-term horizon that matters most for central bankers, since monetary policy is expected to exert its full effect within that time frame.