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ECONOMICS
23 July 2014



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Extract from a report

Themes

A guide to the Feds new exit principles what we know so far

There are many questions regarding the Feds exit. On the question of when, our central
scenario remains for a Q3 2015 liftoff, followed by a faster normalization than currently
implied by the market. In this piece, however, we focus on the how, i.e. on the logistics of
normalizing policy. The FOMC is still deciding on the new set of exit principles and has
promised to deliver a new package before year-end. Here is what we know so far and what
it means for the markets.

IOER takes center stage The FOMC is essentially conceding on its ability to control the fed
funds rate. Instead, the interest on excess reserves (IOER) will play a central role during the
tightening cycle, with the fixed-rate reverse repo rate (ON RRP) playing a supporting role. The
fed funds target will play a background role, with the FOMC continuing to announce a range
rather than a specific level.
Reverse repos to play second fiddle The FOMC plans to maintain the current 20 bp spread
between IOER and the ON RRP. In contrast to our earlier expectations, the Fed seems reluctant
to rely too heavily on the repo facility in draining liquidity. The primary concern is that dealing
directly with non-bank counterparties could reduce liquidity available to banks and corporations,
particularly during periods of financial stress.
A cleaner liftoff Maintaining a wide spread between ON RRP and IOER means that the repo
rate will not be adjusted ahead of the liftoff and that all rates will rise in a parallel move on the
same day. This goes against our earlier assumptions and reduces the risk of premature
tightening of financial market conditions.
Less-than-perfect control of the fed funds rate At liftoff, we expect the IOER to be set at
0.50%, the ON RRP at 0.30%, and the fed funds target range at 0.25-0.50%. Whether the repo
rate will serve as a firm floor on fed funds will depend on the size limits imposed on the facility. In
any case, we expect the effective funds rate to trade closer to the ON RRP than the IOER.
Slower balance sheet normalization Balance sheet normalization will take considerably longer
than envisioned in the 2011 exit principles. The Fed no longer intends to sell assets and has
pushed back the timeframe for ending reinvestments until after the liftoff. Assuming that all
reinvestments are ceased in early 2016, we estimate that the size of the Feds balance sheet will
be normalized in roughly 6.5 years. If anything, the risk is that it takes longer.
The new exit sequence:


Source: SG Cross Asset Research/Economics

Market implications: What it means: SG timeframe:
1. Liftoff Rates on all Fed facilities to move up in parralel: IOER hiked to 0.5%, ON
RRP boosted to 0.3%, fed funds target range raised to 0.25%-0.50%,
effective fed funds rate to trade around 0.35%.
Active tightening Q3 2015
2. End of
reinvestments
We estimate that ending reinvestment in early 2016 would normalize the
Fed's balance sheet by 2022. In the early years, this would be equivalent
to a $30bn/month reverse QE, split about 70%/30% between Treasuries
and MBS securities. The effective supply of Treasuries would increase by
about $200bn/year.
Passive
tightening
about two
quarters later

Chief US Economist

Aneta Markowska
(1) 212 278 66 53
aneta.markowska@sgcib.com

































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23 July 2014 2



Box 1: Exit Strategy Principles Then and now
June 2011 guidance Subsequent changes in guidance SG view
1. As the first step toward
normalization, the Fed will cease
reinvesting mortgage principal
repayments.
The FOMC has signaled that this will likely come
after the first rate increase. The Committees
intention is to use rates as the primary tool in the
tightening process, with balance sheet
normalization occurring passively in the
background. Ending MBS reinvestments ahead of
the first rate increase would send the wrong
message, and risk a premature tightening in
financial conditions.

We now assume that MBS reinvestments will be
halted in 1H 2016, about six months after the
first rate increase.
2. At the same time, or sometime
thereafter, the Fed will modify
forward guidance on the fed funds
target and will initiate reserve
draining operations.
The latest FOMC minutes hint that there will be no
reserve draining operations ahead of the tightening
cycle. Instead, the Fed will rely heavily on the IOER
and the ON RRP facility in setting the floor under
the fed funds rate and guiding it to desired levels.

With no MBS runoff or reserve draining
operations ahead of the first hike, the FOMC will
have to verbally signal that the tightening cycle
is imminent. This may be done by dropping the
reference that the unemployment rate remains
elevated. We believe that the signal is most
likely to come in Q1 2015, about six months
ahead of the first hike.

3. The next step in the normalization
process will be to raise the fed funds
target. This will be supported by
adjustments to the interest rate on
excess reserves (IOER) and by
ongoing reserve draining operations.
According to the June 2014 FOMC minutes, the
IOER will play a central role during the
normalization process, with the ON RRP facility
playing a supporting role in putting a firm floor
under money market rates. The FOMC seems to
prefer a wide spread of about 20 bps between the
two rates.

The fed funds rate target will continue to play a
role in the new communications framework, but its
role will most likely be secondary. Many FOMC
participants prefer to maintain a range rather than
a specific target. The Fed is also examining the
possibility of changing the calculation of the
effective funds rate.

We expect the liftoff in rates to take place in the
third quarter of 2015. This will involve raising the
IOER from 0.25% to 0.50%, raising the ON RRP
rate from 0.05% to 0.30%, and raising the target
range on the fed funds rate from 0-0.25% to
0.25-0.50%. We expect the effective fed funds
rate to trade around 0.35% after the first hike.

Note: Given that the IOER is likely to take on a
central role during the normalization process,
the FOMC may at some point redefine the dot
plot which currently refers to the participants
forecasts for the fed funds rate.

4. Sometime after the first rate hike,
the Fed will begin selling agency
securities. The pace of sales is
expected to be steady, but could be
adjusted up or down in response to
material changes in the outlook.
Various FOMC officials have signaled that outright
asset sales are now extremely unlikely. Instead, the
Fed will ultimately allow the balance sheet to
shrink by ending the reinvestment policy in both
MBS and Treasury securities. Most FOMC
participants favor ending reinvestments after liftoff.
Our working assumption is that both MBS and
Treasury reinvestments will cease in 1H 2016,
roughly six months after liftoff.

5. The Feds agency holdings are to be
eliminated within a 3-5 year window.
This would normalize the size of
overall SOMA holdings over a period
of 2-3 years.

The timeframe for asset sales is no longer relevant
given the reliance on natural runoff of the Feds
balance sheet.

Based on the above assumption, we estimate
that the Feds balance sheet would reach a
normal size about 6.5 years later, i.e. by the end
of 2022.

Source: Federal Reserve Board, SG Cross Asset Research/Economics


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23 July 2014 3


Q1: What are exit principles, and why do they need changing?
Since 2007, US monetary policy has been anything but normal. The Federal Reserve was
forced to develop and deploy tools that did not exist prior to the crisis. As a result, the Feds
balance sheet has undergone a major transformation and many observers have expressed
skepticism about the Feds ability to normalize policy in an orderly fashion. To counteract
some of the skepticism and to provide transparency about its intentions, in June 2011, the
FOMC published its original set of exit principles, detailing the sequence and logistics of
exiting extraordinary stimulus. At that time, the focus was on winding down the balance sheet,
which would begin with ending MBS reinvestment, followed by reserve drain, the first rate
hike, and finally by asset sales. The FOMC planned to normalize the size and composition of
its balance sheet i.e. return to a short-duration Treasury-only portfolio within five years.
But then came operation twist and QE3 which significantly increased the size and duration of
the Feds security holdings. New research has also shed new light on the transmission of QE,
and on the optimal exit sequence. Moreover, the FOMC has recognized that raising rates may
prove challenging in the context of a large balance sheet, and that the tools developed in the
early phases of exit planning may not be effective in putting a firm floor under the fed funds
rate. As a result, the Fed has recently developed a fixed-rate overnight reverse repo facility
(ON RRP) more on this later but it has yet to decide on the extent to which it will rely on
this tool in the normalization process.
In light of these developments, the 2011 exit principles have become quite stale and are in
need of an overhaul. The FOMC has been working on a new package and held extensive
discussions about medium-term policy issues during the last two FOMC meetings. Chair
Yellen has promised to deliver the finalized set before the end of the year, but the latest FOMC
minutes have shed some valuable light on the Feds current thinking. In this note, we piece
together what we know about the new exit principles ahead of the final report to be delivered
by the FOMC later this year. We offer a summary in Box 1, and a more detailed analysis in the
Q&A that follows.
Chart 1a: The Feds assets Chart 1b: The Feds liabilities




Source: Haver Analytics, SG Cross Asset Research/Economics Source: Haver Analytics, SG Cross Asset Research/Economics

0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
00 02 04 06 08 10 12 14
USD bln
Other Assets
Gov't and Agency Security Holdings
QE3
QE2
QE1
exit
principles
published
Twist
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
00 02 04 06 08 10 12 14
USDbln
Other Liabilities
Currency in circulation
Term deposits + Reverse repo agreements
Reserve Balances
Short answer:
Exit principles detail
the Feds strategy for
policy normalization.
Last published in
2011, the old
principles have
become stale given
further balance sheet
expansion.
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Q2: Why cant they hike the old-fashioned way?
The Fed has traditionally controlled the price of money by manipulating the supply. This is
somewhat counterintuitive, because the FOMC has generally expressed its policy stance via a
fed funds rate target. But the rate itself is set by market forces. More specifically, its daily
fluctuations are driven by the demand for reserves (aka federal funds). So how was the Fed
able to control rates in this policy regime? By accurately predicting demand for reserves, and
expanding/contracting the supply of reserves via open market operations so that the fed funds
market would clear at or very close to the Feds target rate. As shown in chart 2, during the
pre-crisis period the effective fed funds rate fluctuated around the target within very narrow
range.
Post-crisis, the Fed is no longer able to control the supply of reserves because the
subsequent rounds of quantitative easing have caused an explosion from an average of $2bn
before 2008 to more than $2.5 trillion today (see chart 1b). This massive oversupply is putting
tremendous downward pressure on overnight rates. Since selling assets prior to the first rate
increase is not a viable option, the FOMC had to develop new tools that would allow it to
manage the level of short-term rates more effectively.
Chart 2: Short-term rates pre- and post-crisis


Source: Bloomberg, SG Cross Asset Research/Economics
Q3: The Interest on Excess Reserves (IOER) was supposed to serve as a floor. Why is it
not enough?
The IOER was introduced in October 2008, marking an early attempt by the Fed to maintain
control of overnight rates in the presence of a large balance sheet. It is a rate paid to
depository institutions on their reserve balances held at the Fed. Unlike the fed funds rate, the
IOER is explicitly set and controlled by the Federal Reserve. This is its main advantage in the
context of policy normalization.
In theory, the IOER should have set a floor under the effective fed funds rate because banks
should not lend to each other below the rate they can otherwise receive from the Fed.
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14
%
Fed Funds Effective
Fed Funds Target
Discount Rate (ceiling)
Interest On Excess Reserves (floor)
Oct 17, 2008: The Fed starts
paying interest on reserves
Short answer:
Because in the
presence of a large
balance sheet, the Fed
is no longer able to
control the supply of
reserves.
Short answer:
The largest lenders of
reserves are not
eligible to receive
interest on reserves.
And, new regulatory
costs are preventing
banks from borrowing
in fed funds and
closing the spread to
IOER.
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However, the floor-based system has proven quite porous. As shown in chart 2, since 2008
the effective fed funds rate has been trading consistently below the IOER. There are two
reasons for this:
First, as demonstrated in chart 3, some lenders in the federal funds market (notably GSEs
and Federal Home Loan Banks) are not eligible to earn interest on their reserve balances
and have been willing to lend below the floor. This represents an arbitrage opportunity for
banks which can theoretically borrow at fed funds and lend to the Fed at IOER. Yet, for
reasons outlined below, banks are unable to fully exploit this opportunity.
Second, various new regulations are increasing balance sheet costs for banks and driving
a wedge between the fed funds rate and the IOER. For example, in 2011 the Federal
Deposit Insurance Corp began to assess insurance premiums based on total assets
rather than domestic deposits. Since loans to the Fed constitute an asset, FDIC-insured
banks now incur a cost when borrowing in fed funds and depositing the proceeds at the
Fed. This friction prevents banks from taking full advantage of the theoretical arbitrage
opportunity and leads to a spread between the IOER and the funds rate. (Note that this
does not apply to foreign banks which do not take deposits in the US. This is why foreign
institutions hold a disproportional portion of excess reserves created by QE). Newly
proposed limits on leverage (Supplementary Leverage Ratio, or SLR) and liquidity
(Liquidity Coverage Ratio, or LCR) are likely to further increase balance sheet costs and
reduce the Feds control of the fed funds rate. Since the rules have not been finalized yet,
it is too early to assess their impact.
Chart 3: An illustrative chart of money market flows


Note: For the purposes of this discussion, we limit the chart to overnight wholesale funding. Other significant sources of
funding for banks are deposits and term wholesale loans.
Source: SG Cross Asset Research/Economics
Why can the Fed not simply let the effective fed funds rate trade slightly below the IOER and
call it a day? If the spread between the two rates was always constant, the Fed would simply
have to over-calibrate the IOER, with the only downside being a slightly higher cost to the
taxpayers. However, the Feds bigger concern is the possibility that the spread may widen as
it attempts to raise rates. In this scenario, the FOMC would not be able to tighten at the pace
that it desires, and its credibility would come into serious question.
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This is why the Fed has continued to expand its toolkit and devise new facilities for controlling
short-term rates. We summarize the tools in Box 2. Other early efforts include the creation of a
Term Deposit Facility (TDF), which is similar to the IOER but would involve term loans and thus
theoretically move funds out of reserves. However, like the IOER, this facility is also restricted
to banks and therefore unlikely to plug the leaky floor. The Fed could also drain liquidity by
taking term loans via the repo market, especially since it significantly expanded its
counterparty list beyond Primary Dealers in 2010. However, the rate on traditional repos is
determined through a competitive auction and not explicitly set by the Fed. As a result, both
of these tools are unlikely to overcome the challenges associated with the IOER and give the
Fed near-perfect control of the fed funds rate.
Box 2: The Feds toolkit for controlling rates


Source: Federal Reserve Board, SG Cross Asset Research/Economics
Q4: What exactly is the ON RRP rate and why is it more effective than IOER?
In order to set a firm floor under the fed funds rate, the Fed needed to create a facility that
would allow it to lend overnight to a broad range of counterparties at a pre-determined rate.
The solution: a fixed-rate overnight repo rate facility (ON RRP). Under this program, the Fed
can deal not only with banks and Primary Dealers, but also with Government Sponsored
Enterprises, Federal Home Loan Banks, money market funds and investment managers (there
are currently 142 counterparties on the Feds approved list). Allowing all cash-rich institutions
to lend directly to the Fed should eliminate much of the leakage in the IOER, giving central
bankers a stronger hold on overnight rates, even in the presence of significant excess liquidity.
Description Rate setting
mechanism
Term Counterparties Issues
Fed funds rate An overnight rate at which banks borrow
reserves from one another. Banks in an
excess reserve position generally lend
to those who find themselves short
relative to their reserve requirement.
Set by the market, but
Fed intervenes on supply
via open market
operations.
O/N banks -> banks In light of the large balance sheet and vast
excess reserves, the Fed can no longer
control the fed funds rate the "old
fashioned way".
Interest on
excess reserves
(IOER)
An overnight rate paid to depository
institutions on their reserve balances (i.e.
unsecured loans to the Fed). Introduced
in October 2008.
Administered by the Fed. O/N Fed -> banks The IOER was supposed to set a floor
under the fed funds rate, but the floor has
proven leaky because the largest lenders
in the fed funds market (GSEs) are not
eligible to receive interest on reserves.
Term deposit
facility (TDF)
A rate paid on unsecured term loans to
the Fed. The facility was introduced in the
early years of the crisis in order to drain
reserves from the system during policy
normalization.
Rate may be determined
through a single-price
auction format, a fixed-
rate format, or a floating-
rate format.
up to 84 days Fed -> banks Only depository institutions can participate
in the facility. This significantly limits its reach
and is unlikely to work as an effective floor.
Term Treasury
reverse repo rate
(Term RRP)
A repo rate paid by the Federal Reserve
on collateralized term loans. This is part
of the Federal Reserve's longstanding
toolkit, however in 2010 the Fed began
to expand the counterparty list beyond
primary dealers.
Rate determined through
a competitive auction
format.
up to 65
business
days
Fed -> primary
dealers, banks,
GSEs, mmkt funds
and investment
managers
This facility improves on the shortcomings
of the TDF in that it allows the Fed to deal
with broader range of counterparties. The
downside is the traditional auction format
which does not give the Fed explicit control
of the rate.
Overnight fixed-
rate reverse repo
(ON RRP)
A rate paid on collateralized overnight
loans to the Fed. The facility was
introduced in 2013 in an effort to shore
up the Fed's control of overnight rates in
the presence of large balance sheet
(and leaky IOER). Only Treasury
collateral to be used.
Rate determined through
a fixed-rate auction
format.
O/N Fed -> primary
dealers, banks,
GSEs, mmkt funds
and investment
managers
This facility overcomes the shortages of
the TDF and Term RRP and could give the
Fed a tight grip on overnight rates.
However, this comes at a cost: dealing with
nontraditional counterparties on a large
scale could drain liquidity from the banking
system, especially during periods of
financial stress.
Short answer:
The key distinction is
that the ON RRP rate
can be accessed by a
much broader range of
counterparties while
still giving the Fed
explicit control of the
rate.
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The Fed launched the ON RRP facility in 2013 and since then has conducted a number of
operational exercises. The rate is currently set at 0.05%, and the per-counterparty size limit
has increased steadily from $0.5bn to $10bn per day. There is currently about $115bn
outstanding under the ON RRP facility. Most market participants, including ourselves, believed
that the Fed would rely heavily on this facility during policy normalization. However, the latest
FOMC minutes suggest some reluctance, with the Fed instead preferring to use a mix of tools.
Q5: The FOMC seems reluctant to rely heavily on the ON RRP facility. Why?
There is no question that the ON RRP facility could be quite helpful in reinforcing the floor
under overnight rates. However, it could also fundamentally reshape the Feds role in financial
intermediation. As demonstrated in chart 3, traditionally only banks had direct access to the
Feds lending and deposit facilities, while borrowing funds from a wide range of counterparties
via a wide variety of instruments. The repo facility would allow those counterparties to bypass
the banks and lend directly to the Fed. This could represent a real challenge during periods of
financial stress, because cash-rich lenders could shift investments toward the facility,
reducing the liquidity available to banks and corporations, and thus magnifying a liquidity
crunch. Even in normal times, the facility could drain liquidity from the banking system if the
rate is set too high and the size of the ON RRP loans increases substantially. For these
reasons, the Fed does not want the ON RRP facility to become a permanent feature of its
operating framework.
After extensive discussions, the FOMC has concluded that the ON RRP should play a
secondary role during the normalization process while the IOER takes on a lead role. To
prevent the ON RRP facility from getting too big, the Committee is leaning toward setting a
relatively wide spread between two rates. The latest FOMC minutes suggested a figure around
20 basis points, which is in line with the current rate levels on the two facilities (0.05% and
0.25%, respectively). Fed officials also plan to constrain the size of the repo facility, either by
counterparty or in aggregate. This is in contrast to the initial plans to run the auctions at full
allotment.
Q6: Where does that leave the fed funds rate?
The Feds reluctance to rely more extensively on the repo rate means that it has to accept
less-than-perfect control of the fed funds rate. Targeting a specific level of fed funds is
therefore out of the question until the balance sheet is fully normalized. The FOMC has
acknowledged as much, noting in the latest minutes that it will probably continue to announce
a target range. This also means that the fed funds rate will not completely disappear from the
FOMC statement, but it will play a background role.
The inability to control market rates is only one reason for abandoning the fed funds target.
Another reason is that the rate is no longer as meaningful as it used to be, and it may never
return to its former glory. The volume of transactions in the fed funds market has shrunk
considerably in recent years. We estimate the current volumes to be about $50bn per day vs.
about $200bn per day prior to the crisis. Recall that the fed funds rate market has traditionally
involved banks borrowing reserves from one another in order to meet their reserve
requirements. Today, most banks are sitting on vast excess reserves and have no need to
borrow in the fed funds market. Most of the lending
1
is done by the Federal Home Loan

1
See Whos lending in the Fed Funds Market?, Liberty Street Economics/Federal Reserve Bank of New York
Short answer:
Allowing non-
traditional
counterparties to lend
directly to the Fed
could reduce liquidity
available to banks and
corporations,
particularly in periods
of financial stress.

Short answer:
The Fed is essentially
throwing in the towel
on the fed funds rate,
choosing to focus on a
rate that it can control,
i.e. the IOER. The
funds rate will
probably continue to
be part of the
statement, but in a
background role, and
with a target range.

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Banks, and the borrowers
2
are comprised primarily of foreign banks exploiting the arbitrage
opportunity between the fed funds market and the IOER (recall that foreign banks are not
subject to FDIC charges and therefore do not incur the same balance sheet costs on the
transaction as US banks). There is also a wide dispersion in prices paid for overnight fed
funds, with some transactions printing as low as 0.01%, and some printing above 0.30%, i.e.
through IOER.
For the reasons outlined above, the FOMC is also examining the possibility of changing the
calculation of the effective fed funds rate in order to obtain a more robust measure of
overnight bank funding rates. The Fed is reportedly looking into including Eurodollar
transactions, i.e. dollar loans between banks outside US markets. Today, this definitional
change would have no impact on the level because overnight Libor currently trades in line with
the effective fed funds rate, i.e. at 0.09%. However, historically Libor has traded higher by
about 7 bps, so in the long run this calculation change could push fed funds marginally higher.
Even if the Fed were to expand the definition of the fed funds rate, we are not certain that it
will be able to control the rate as it used to, for three reasons:
1. We estimate that the balance sheet will remain abnormally large for nearly another
decade (more on this later). Until then, banks will remain in excess reserve positions and
will have little to no need to borrow in the fed funds market.
2. As mentioned earlier, new regulations on leverage and liquidity are poised to further
increase balance sheet costs. This will discourage banks from borrowing in the fed funds
market, potentially widening the spread between the funds rate and the IOER.
3. The new regulations on liquidity (Liquidity Coverage Ratio (LCR), wholesale funding limits,
etc.) may permanently alter the nature of the fed funds market, even after the balance
sheet is fully normalized. In light of the new rules, banks may no longer be willing to start
the day structurally short reserves and expect to square their positions over the course of
the day, i.e. engaging in the type of activity that traditionally led to trading in the fed funds
market. Hence the funds rate may still be marginal, although more representative of a
market rate sometime in the future.
Q7: What will the liftoff look like?
Now that the FOMC has clarified certain elements of its new exit strategy, we can begin to
sketch the liftoff with greater precision. In contrast to our earlier expectations, we now believe
that all short-term rates will rise in parallel on the same day: the IOER will be lifted from 0.25%
to 0.50%, the ON RRP rate from 0.05% to 0.30% and the fed funds target will be probably be
raised from 0-0.25% to 0.25-0.50%.
Earlier, we believed that the repo rate may have to begin to be lifted early in order to narrow
the spread with IOER and constrain the fed funds rate to a narrower range. This posed the risk
of premature tightening of financial conditions. However, in light of the recent guidance, it is
clear that the FOMC is aiming for a very clean liftoff. Our central scenario continues to be for
Q3 2015.

2
See Whos borrowing in the Fed Funds Market?, Liberty Street Economics/Federal Reserve Bank of New York
Short answer:
At the time of the
liftoff, all rates/rate
targets will move up in
parallel, with the IOER
set at 0.50%, the ON
RRP rate at 0.30%,
and the fed funds
target range at 0.25%-
0.50%.

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Where will the effective fed funds
trade immediately after the liftoff?
Assuming that the size of the repo
facility is ramped up further, we
expect the 0.3% repo rate to serve as
a relatively firm floor for the fed funds
market. However, the Fed may want
to give itself some wiggle room,
setting the bottom of the range
slightly below the repo rate. The
ceiling is more difficult to determine,
given the uncertain balance sheet
costs associated with FDIC fees and
other regulatory restrictions. But we
would expect the funds rate to trade
closer to the repo rate than the IOER,
i.e. around 0.35%.
Q8: What will happen to the dots?
The FOMCs guidance regarding the appropriate pace of policy firming i.e. the dots is
currently expressed in terms of the target fed funds rate. However, if the Fed shifts the primary
focus to the IOER and continues to set a target range on the fed funds rate, it would make
sense to express its guidance in the same format.
Given the various leakages discussed earlier, it is clear that the IOER will have to be over-
calibrated relative to the desired fed funds rate during policy normalization. Therefore
expressing the appropriate monetary policy stance in terms of the IOER should theoretically
move the entire dot plot up by about 15 basis points. However, the actual impact on the
FOMC projections is not that obvious. Since they are expressed in 25-bps intervals, the 15-
bps adjustment is borderline and falls within the margin of error. More importantly, the Feds
rate projections are driven by a number of factors the economic outlook, changes in the
reaction function and changes in the FOMC compositions and any of these could overwhelm
the shift to IOER-based projections. Of course, the FOMC could choose to maintain a status
quo and continue to express its guidance in terms of the fed funds rate, but in our view this
would lead to unnecessary confusion about what the dots mean, further undermining their
usefulness.
Q9: Does the balance sheet matter anymore?
In a floor-based system of managing overnight rates, the size of a central balance sheet is
theoretically irrelevant. However, there are a number of reasons to eventually scale back the
size of the Feds security holdings:
Normalizing the balance sheet will allow the Fed at some time to return to the traditional
way of managing overnight rates and eliminate the need to deal with leaky floors.
Permanent intervention in credit markets can distort price signals, leading to sub-optimal
allocation of capital and sub-optimal economic outcomes.
Chart 4: Short-term rates after the liftoff


Source: SG Cross Asset Research/Economics
IOER (50bps)
IOER less balance sheet costs (???)
ON RRP (30 bps)
possible range for the effective fed funds rate
Short answer:
With IOER taking
center stage in the
normalization process,
it would make sense
to express rate
guidance in the same
format. All else equal,
changing the dot
plot from fed funds to
IOER should push the
projections up by
about 15 bps.

Short answer:
The balance sheet is
theoretically irrelevant
in a floor-based
system of managing
overnight rates.
However, there are
other reasons to
normalize the size and
return to a Treasury-
only portfolio.

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23 July 2014 10


Holding on to purchased assets indefinitely also constitutes monetization which can
adversely impact long-term inflation expectations.
Lastly, a large balance sheet exposes the central bank to potential losses. Though
technically booked as deferred assets (rather than eroding the Reserve Banks capital)
3
,
these earnings shortfalls could undermine the Feds political independence and
credibility.
For these reasons, the FOMC plans to eventually normalize the size and composition of its
asset portfolio.
Q10: How long will it take to normalize?
Currently, the FOMC has a policy of reinvesting all principal repayments on its holdings (but
not interest payments, which are transferred over to the Treasury at year-end, net of the Feds
operating costs). In the 2011 exit principles, the Fed said that it would begin the normalization
process by ending its reinvestment policy and that this process would commence before the
first rate increase. This would be followed by outright asset sales which would begin
sometime after the liftoff. The FOMC planned to normalize the size and composition of its
balance sheet within five years of the initial asset sale.
Chart 5: Feds security holdings projections assuming end of reinvestments in early 2016


Source: Haver Analytics, SG Cross Asset Research/Economics
It is now clear that the normalization process will take longer. First, Fed officials have already
indicated that they no longer intend to conduct any asset sales. They have also pushed back
the timeframe for ending reinvestments, which is now expected to commence after the first
rate increase. In the scenario depicted in chart 5, we assume that both MBS and Treasury
reinvestments cease in early 2016, i.e. about six months after the initial liftoff. Under these
assumptions, we expect the size of the Feds SOMA (System Open Market Account) holdings
to normalize within 6.5 years. However, we note that merely ending reinvestments will results
in a very uneven pace of reductions. Chart 6 shows the projected maturity profile of the Feds
Treasury holdings after the tapering process comes to completion. Note that the maturing
amounts fluctuate from $6bn to $40bn in the early years of normalization and the FOMC may
want to devise some kind of smoothing scheme to even out the runoff.

3
See The Federal Reserves Balance Sheet and Earnings: A primer and projections, Federal Reserve Board
0.0
0.4
0.8
1.2
1.6
2.0
2.4
2.8
3.2
3.6
4.0
4.4
00 02 04 06 08 10 12 14 16 18 20 22
$ tln
Treasuries
Agency Debt
MBS
Pre-crisis Trend
SG Forecast
Short answer:
Assuming that the Fed
ceases reinvestments
in both Treasury and
MBS securities in early
2016, it will take about
6.5 years to normalize
the size of the balance
sheet. In the early
years, this would be
equivalent to a reverse
QE of $30bn/month.

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23 July 2014 11


Chart 6: Projected maturity profile of the Feds Treasury holdings


Source: Federal Reserve Bank of NY, SG Cross Asset Research/Economics
Ending reinvestments will constitute outright monetary tightening, as it will shrink the Feds
balance sheet at a fairly rapid pace. If anything, the Fed may choose to slow down the
process by allowing only a portion of the maturing securities to run off. We estimate that in
2016, about $370bn in securities would roll off the Feds balance sheet in the absence of
reinvestment. This is comprised of $215bn in maturing Treasuries, $17bn in maturing agency
bonds, and an estimated $140bn in MBS securities. This is equivalent to a reverse QE of
about $30bn/month.
It is also worth noting that ceasing reinvestments will effectively increase the net supply of
Treasury and MBS paper that will have to be financed by private investors and/or foreign
central banks. In chart 7, we show our projections for Treasury supply net of Feds buying.
Note that FY2014 is the sweet spot in terms of the supply/demand balance, with the deficit
continuing to shrink and the Fed still buying a good amount of Treasury debt. This dynamic
will begin to go into reverse FY2016 and beyond: the fiscal deficit is projected to expanding
modestly after reaching a trough in FY2015, and with the Fed no longer rolling over maturing
securities, the Treasury will have to issue that much more to the public.
Chart 7: Projected Treasury supply, net of Feds reinvestments


Source: Haver Analytics, SG Cross Asset Research/Economics

0
10
20
30
40
50
60
70
U
S
D

b
l n
Maturityprofile of the Fed's Treasuryportfolio
12 month moving average
206
339
386
220
218
145
782
1,778
1,488
1,128 1,126
847
650
628
711
738 748
861
951
-
500
1,000
1,500
2,000
$bn
Treasury supply
Net of Fed buying
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23 July 2014 12


Global Head of Research

Patrick Legland
(33) 1 42 13 97 79
patrick.legland@sgcib.com







CROSS ASSET RESEARCH ECONOMICS

Global Head of Economics

Michala Marcussen
(44) 20 7676 7813
michala.marcussen@sgcib.com


Euro area

Michel Martinez

Anatoli Annenkov

Yacine Rouimi
(33) 1 42 13 34 21 (44) 20 7762 4676 (33) 1 42 13 84 04
michel.martinez@sgcib.com

anatoli.annenkov@sgcib.com

yacine.rouimi@sgcib.com




United Kingdom

Brian Hilliard
(44) 20 7676 7165
brian.hilliard@sgcib.com








North America

Aneta Markowska

Brian Jones
(1) 212 278 66 53 (1) 212 278 69 55
aneta.markowska@sgcib.com

brian.jones@sgcib.com






Asia Pacific China India

Klaus Baader

Wei Yao

Claire Huang

Kunal Kumar Kundu
(852) 2166 4095 (33) 1 57 29 69 60 (852) 2166 5436 (91) 80 6716 8266
klaus.baader@sgcib.com

wei.yao@sgcib.com

claire.huang@sgcib.com

kunal.kundu@sgcib.com


Japan Korea

Takuji Aida

Kiyoko Katahira

Suktae Oh
(81) 3-5549-5187 (81) 3 5549 5190 (82) 2 2195 7430
takuji.aida@sgcib.com

kiyoko.katahira@sgcib.com

suktae.oh@sgcib.com




Latin America Inflation

Dev Ashish

Herv Amourda

Shivangi Shah
(91) 80 2802 4381 (91) 80 2808 6779 (91) 80 3087 8603
dev.ashish@sgcib.com

herve.amourda@sgcib.com

shivangi.shah@sgcib.com




Poland Czech Republic Czech Republic Czech Republic

Jaroslaw Janecki

Jiri Skop *

Marek Drimal *

Jana Steckerov *
(48) 22 528 41 62 (420) 222 008 569 (420) 222 008 598 (420) 222 008 524
jaroslaw.janecki@sgcib.com

jiri_skop@kb.cz

marek_drimal@kb.cz
jana_steckerova@kb.cz


Russia Slovakia

Evgeny Koshelev *

Viktor Zeisel *
(7) 495 725 5637 (420) 222 008 525
ekoshelev@mx.rosbank.ru
viktor_zeisel@kb.cz







Research Associates
Harriett Beattie Tutku Siva Kizildag Emmanuel Claessens




* Contributions from other SG Group entities: Komercni Banka, Rosbank, BRD.



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