BofA's Smedley on Fed Exit Strategy
Bank of America Merrill Lynch's Rates Strategist Brian Smedley wrote a piece Friday entitled, "Fed exit framework begins to take shape." Echoing comments he made at last month's Money Fund Symposium, he writes, "The June FOMC minutes provided a window into the FOMC's views on some critical questions related to the framework for managing short term rates during the eventual normalization of policy. This report discusses our thoughts on the likely evolution of the Fed's policy rate framework and market implications.... The discussion of rate management tools at the June FOMC meeting, while preliminary and set to continue at upcoming meetings, represents the clearest indication to date of the Fed's preferred framework for policy normalization. Of particular note, "most participants thought that the federal funds rate should continue to play a role in the Committee's operating framework and communications during normalization." Participants also discussed possibilities for "changing the calculation of the effective federal funds rate." Most participants "agreed that adjustments in the rate of interest on excess reserves (IOER) should play a central role during the normalization process." For its part, the O/N reverse repo facility "could play a useful supporting role by helping to firm the floor under money market rates." The appropriate spread between IOER and the O/N RRP rate was discussed, with many participants judging that a relatively wide spread -- perhaps near or above the current level of 20bp -- would be appropriate. The emerging Fed consensus around exit mechanics described above is consistent with our own views, but differs from the views of many in the market. Since testing of the RRP facility began in September 2013, many market participants have come to expect the Fed to replace the fed funds target with the RRP rate, and for the latter to be harmonized with IOER. This (revolutionary) approach was advocated in a paper published in January 2014 by the Peterson Institute for International Economics. In May we noted that a "compelling reason to maintain a wide spread between the RRP rate and IOER is to encourage trading in the fed funds market." We also wrote that "the path of least resistance seems to be maintaining the status quo." The fed funds rate will likely continue to be the FOMC's primary tool for communicating the stance of policy, though the difficulty in managing the fed effective with precision warrants the continuation of a 25bp target range. Since an increase in the fed funds target range on its own would be essentially meaningless, commensurate increases in IOER and the RRP rate will be necessary to achieve "liftoff." An appealing approach, in our view, would be for the Board of Governors to set IOER at the upper end of the fed funds target range, and for the FOMC to set the RRP rate at the lower end. This will help to ensure the primary role of banks in the implementation of monetary policy and maintain liquidity in overnight markets." See also, Gulfnews.com's "SEC considers exit fees and gates for money market funds", which says, "US regulators are close to agreeing long-delayed new rules for the $2.6 trillion (Dh9.54 trillion) money market fund industry to help avert a repeat of the "runs" some funds suffered during the financial crisis. The Securities and Exchange Commission is expected to vote this month on a proposal to force prime institutional money market funds (MMFs) used by large institutions to abandon their fixed $1 share prices and transact at a floating net asset value."
