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Prepared by Rebecca McCaughrin (MCM) and Tao Wu (ICD).
On the third challenge, see Box 2 in IMF (2013), which estimates potential losses on a net present value basis under different macro scenarios, ranging from 1 to 4.5 percent of GDP.
Chairman Bernanke indicated in his Congressional testimony to the Joint Economic Committee (May 22, 2013) and in his comments during the June 2013 FOMC meeting press conference that the Committee does not anticipate selling MBS from the Fed’s portfolio, except perhaps to reduce or eliminate residual holdings.
See speech by Janet Yellen, “Communication in Monetary Policy,” April 4, 2013.
The Fed committed to keep the federal funds rate close to zero at least as long as the unemployment rate remains above 6½ percent, inflation projected 1–2 years ahead is not above 2½ percent, and longer-term inflation expectations remain well-anchored. The Fed’s forecasts suggest that macroeconomic indicators are consistent with keeping the federal funds rate exceptionally low at least through mid-2015.
See FOMC: Press Conference on June 19, 2013.
Some of the repricing may also reflect an increase in term premia as well as increased margin requirements on Eurodollar interest rate futures by the Chicago Mercantile Exchange.
The historical norm is defined as a growth rate consistent with growth in estimated currency in circulation.
The Fed has already allowed to run-off or sold all treasuries under 3-year tenors, so it will take a few years before passive run-off starts to reduce Treasury holdings significantly.
Mortgage conditional prepayment rates of 15–20 percent are assumed in the near-term before returning to 10 percent in the longer run, based on Bank of America Merrill Lynch’s prepayment model estimates.
Assumptions on the pace of tapering are based on median market expectations.
During his press conference remarks following the June 2013 FOMC meeting, Chairman Bernanke noted that “in the longer run, limited sales could be used to reduce or eliminate residual MBS holdings.”
The Fed has also expanded its counterparties for reverse repo operations beyond its usual set of primary dealers to include banks, money market mutual funds, and the GSEs.
The Fed has already conducted reserve-draining operations to test out the functionality of these tools on a limited basis, and will likely step up its test transactions as the exit period nears.
The FDIC asset-based fee levied on depository institutions has reduced the incentive for banks to arbitrage away the difference. At around 10 bps, this fee lowers the returns gained from borrowing in the fed funds market from the GSEs and then depositing the funds at the Fed. Some banks that are exempt from the FDIC fee (e.g., foreign-owned branches and other banks with small deposit bases) have sought to arbitrage the difference, but not enough to diminish the spread.
Fed funds effective trading volumes were around $250 billion pre-crisis and have fallen to approximately $50 billion per day currently. Repo (GC treasury, tri-party) volumes have fallen as well, but by much less: pre-crisis volumes were around $450 billion per day versus $350 billion currently. See Bech and Klee (2009).
If reverse repos occur in large size, there is the potential to cause repo rates to rise notably relative to other money market rates, which could have adverse effects on other large repo borrowers. Such spillover effects could increase the cost of reserve-draining via a large-scale reverse repo program.
The substantial variations and possible non-linearity in the bond market’s response to the Fed’s unconventional monetary policy measures suggest that changes of such a magnitude are plausible. For reference, the estimated elasticity in Table 2 implies a total effect of -35 basis point of QE I on the ten-year term premium, while the literature has provided a wide range of estimated effects of QE I, from 30 basis points to 100 basis points. Increasing the elasticity by two standard deviations raises the magnitude of the estimated effect from -35 to -51 basis points, almost identical to the -50 basis points as assumed by Chung, Laforte, Reifschneider, and Williams (2012).
The sizes of such volatility increases are slightly smaller than those as observed in the first two quarters of the 1994–1995 tightening; therefore shocks of such sizes are quite possible.