Is The Fed Moving Away From LSAPs?

The Fed could be moving towards an operational framework where it directly targets access to credit in the real economy rather than targets financial conditions through LSAPs. If so, balance sheet growth could disappoint in Q3, and this could put a floor under the dollar, steepen the yield curve and still support equities through lower credit spreads volatility.

Following an unprecedented increase in the size of the balance sheet, the Fed has allowed reserves to shrink while providing unusually vague policy guidance (Chart 1). In my view these could reflect that the Fed is preparing for a very large Treasury General Account (TGA, the Treasury account at the Fed) rundown, which I have discussed on 18 June, as well as a move to a new policy framework.

A. The COVID-19 Emergency

Because of the nature of the COVID-19 crisis, the speed of transmission of monetary easing is a key driver of its success. COVID-19’s economic impact is mainly through an unforeseen decrease in cashflow, i.e. a liquidity rather than solvency crisis. If employers can receive government support fast enough to prevent liquidity issues from turning into large-scale insolvencies, the economy is likely to remain on a V-shaped recovery path.

It became clear early in the crisis that credit markets and banks were not going to provide the liquidity that employers needed to tide them over and the Fed decided to step in. At the same time, I expect lending to the non financial sector to remain in the Fed LT toolkit and to become more important than LSAPs in demand management for 3 reasons.

B. The Economic Impact of LSAPs Has Weakened

First, the canonical view on transmission of monetary policy, namely that policy rate cuts or LSAPs impact financial conditions, and financial conditions in turn impact the real economy, is no longer supported by the data. The correlation between monetary policy tools and FCI and that of FCI with growth have broken down over the past few years. This could reflect:

1. Policy rates are one of many factors impacting financial markets such as foreign flows, regulatory changes, investors’ risk appetite, economic surprises, etc.
2. Similarly, the apparent correlation of growth and FCI does not imply causation. For instance, factors such as Keynes’ ‘animal spirits’ are jointly likely to determine growth and FCI.

C. Main Street’s Rather Than Wall Street’s Central Banker

The second reason the Fed could be moving away from LSAPs is that they create perceptions that the Fed is working more for Wall Street than ‘Main Street’. Under Chair Powell, the Fed has launched into an unprecedented process of consultations with elected officials, academics and the broader public. In this context, the Fed is likely to be sensitive to public perceptions that it is supporting financial interests rather than the broader American public.

D. Too Many Reserves Have Been Crowding Out Bank Lending

Third, as argued in my 17 June note on the Fed balance sheet, LSAPs could have adverse effects on banks’ capacity to lend.

E. YCC: A Further Step Away From LSAPs

While the FOMC has yet to reach a consensus on YCC, I expect it to happen as a further step in the Fed moving away from LSAPs. The more influential members, Brainard, Clarida or Williams, have expressed their support and so has former Fed chair Ben Bernanke.

F. The Market Consequences

Because the impact of the Fed credit facilities has been largely though an announcement effect, this new framework focused on credit to the nonfinancial sector and away from LSAPs is likely to involve much less balance sheet growth.

At the same time, YCC would likely imply a decline in the SOMA portfolio duration since, as suggested by Bernanke, the Fed would be more likely to target a short term yield eg 2yrs than a long term one and since the average maturity of the SOMA portfolio is well above 2 years.

The Fed new framework could see a steeper curve as YCC would likely remove less duration from the market than if the Fed kept with traditional LSAPs. In addition, a smaller-than-expected balance sheet expansion could put a floor under the dollar. And corporate spreads would of course become less volatile.

These factors need not be negative for equity prices as the long-term correlation between equity markets and Fed balance sheet is limited. In addition, direct Fed support to credit markets is also supportive of equities since it reduces bankruptcy risks. And the impact of the new Fed framework on the USD could be limited if the Fed turns out to have started a trend among global central banks. In a 21 June column, the Bank of England governor, Andrew Bailey, warned that ‘central bank reserves can’t be taken for granted.’