2 May 2011

Economics
Beyond the Cycle
www.sgresearch.com

American Themes
Fed Exit Losing the weight before raising the rate
US Economic Team
Aneta Markowska (1) 212 278 6653
aneta.markowska@sgcib.com

The easing cycle is set to end in June. The Fed is likely to take a brief pause before moving on to outright tightening. We look for exit steps to be staggered, starting around September. Rate hikes themselves should come late in the exit process. Relative to market expectations for a Q12012 rate increase, we see the risks skewed toward a later tightening.
Easy bias until proven wrong Baseline economic forecasts point to rate hikes in early

Rudy Narvas (1) 212 278 76 62

rudy.narvas@sgcib.com

Brian Jones (1) 212 278 69 55

brian.jones@sgcib.com

Martin Rose (1) 212 278 7043

martin.rose@sgcib.com

2012, consistent with current market expectations. Yet, the Fed has undershot in the past two cycles and is likely to do so again. For this reason, our tightening scenario is late but hard as opposed to the smoother path currently priced in.
Fiscal headwinds The economy has reached cruising altitude, but is still flying at a slow

speed as consumers spend reluctantly. Meanwhile, fiscal clouds are building and threaten the outlook. We do not assume severe austerity in the next two years, but the mere risk could slow the Fed.
Baby steps We see rate hikes as a later step during the exit process. Before hiking, the Fed

has to end MBS reinvestments, tackle excess reserves and drop the extended language. We believe that these steps will be taken cautiously, one at a time. Doing it all at once and hiking rates within a six-month period may be too aggressive.
Asset sales will come last

Asset sales will have to be done eventually, but the Fed is

unlikely to rush this step. We adopt the Feds baseline scenario of a gradual balance sheet normalization starting in 2012 and ending in 2016. This will likely involve MBS sales first, and eventually include Treasury redemptions.
Exit Timeline
7 Step 1: End of QE2 (June) Step 2: End MBS Rei nvestments (Q3) Step 3: Begi n reserve drai n (Q3/Q4) Step 4: Remove "extended" promise (Q4) Step 5: Start rai sing rates(mi d-2012) Step 6: Asset sal es (2H'2012) 07 08 09 10 11 12 13 2600

Fed Funds Rate (LHS) Fed's Securities Portfolio (RHS)

USD bln

2100

1600

1100

600

100

-400

Source: Global Insight, SG Cross Asset Research/Economics

Macro

Commodities

Forex

Rates

Equity

Credit

Derivatives

Please see important disclaimer and disclosures at the end of the document

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No more easing, but dont expect fast tightening

The Feds easing cycle is coming to the end. QE2 is set to end in June and naturally the focus will shift to exit strategies. We do not anticipate QE3, both because the economic outlook
Bernanke on QE3: Why not do more [QE]? The trade-offs are gettingare getting less attractive at this point. Inflation has gotten higher. Inflation expectations are a bit higher. It is not clear we can get substantial improvements in payrolls without some additional inflation risks. Ben Bernanke, April 27, 2011

does not warrant it, and because the Fed views the trade-offs as increasingly less attractive. We see the exit process as a long series of baby steps which are likely to be taken individually, allowing the Fed to evaluate the impact of each one, before moving on to the next. Among the first steps will be ending MBS reinvestments, which we expect during Q3. Next, the Fed will have to tackle excess reserves which are currently putting downward pressure on the overnight rate. The extended language will also have to go, most likely late in the fourth quarter. We see all these steps as pre-conditions to actual rate hikes. We do not expect outright rate increases until mid-2012, with a bias toward Q3. This view reflects what we believe is a bias at the Fed toward the unemployment mandate. It also reflects the risk that fiscal headwinds may dampen the recovery. To protect against the downside, the Fed is likely to wait until inflation risks actually materialize. This is why our tightening scenario is late but hard. Asset sales will be an integral part of the Feds tightening cycle, but those are likely to come last. We adopt the Feds baseline scenario of a gradual balance sheet normalization starting in 2012 and ending in 2016. This will likely involve MBS sales and Treasury redemptions.

An easy bias until proven wrong

The Feds bias is clear: protecting against downside risks and taking its chances on future inflation. This is where the Fed differs considerably from its European counterparts. We see several reasons for the different reaction functions. The dual mandate means that the Fed cannot focus solely on inflation; unemployment remains very high and the less generous welfare system in the US gives further urgency to this part of the Feds mandate. Lastly, the contrasting approaches to policy also have strong roots in history. Ben Bernanke, a student of the Great Depression, has concluded in his past research that monetary policy errors were a significant factor behind the long economic slump of the 1930s. One of those errors was the premature tightening of both monetary and fiscal policies in 1936, which induced another deep recession that pushed the unemployment rate from 14% back to 19%. These lessons seem to figure prominently on the minds of many Fed officials who are not yet convinced that the economy has reached escape velocity. They are also concerned about maintaining growth in the face of fiscal austerity which is inevitable over the next five years. A sharp rebound in economic activity like those that often follow deep recessions does not appear to be in the offing. One key factor restraining the pace of recovery is the construction sector []. In addition, spending by state and local governments seems likely to remain limited by tight budget conditions. Yellen, April 11, 2011 We are probably going to have excess slack in the US labor market at least through the end of 2012, and thats one reason that colored my view that we shouldnt be overly e nthusiastic about tightening monetary policy too early Dudley, April 11, 2011 The public sector in the United States must stabilize its finances and reverse the accumulation of debt that has accelerated in recent years. This process of public sector deleveragingan element of fiscal rebalancingis mostly ahead of us. Lockhart, April 4, 2011

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Not out of the woods yet fiscal challenges lie ahead

The course of monetary policy in the coming years will be heavily influenced by what happens on the fiscal front. US public finances are a train wreck waiting to happen and there is no doubt that significant fiscal consolidation will have to occur over the next five years. The question is not if, but when. In a perfect world, the fiscal drag will be offset by e xternal demand and by business investment needed to support that demand. This scenario is certainly achievable, but there is also a lot that could go wrong if the timing of these adjustments is mismatched.
Chart 1: Not out of the woods yet Next up, government de-leveraging
Bernanke on fiscal/monetary interplay: Now, my preference in terms of addressing the long-term deficit is to take a long-term perspective. [ ] If the changes are focused entirely on the short run, then they might have some consequences for growth. And in that case, the Federal Reserve, which is as always going to try to set monetary policy to meet our mandate, will take those into account appropriately. Ben Bernanke, April 27, 2011
8 % of GDP

Savings-Investment Balances by Sector

US Households US Businesses US Governm ent Rest of World

-2

-7

-12 70 75 80 85 90 95 00 05 10
Source: Global Insight, SG Cross Asset Research/Economics

The Fed would like Congress to take a long-term approach to deficit reduction, in line with the proposals of the bipartisan commissions recommendations. If those recommendations were adopted, the fiscal drag would start in 2013, shaving about 0.5-0.9% from GDP growth, and increasing to 0.8%-1.8% by 2015. By that time, the economy should be on a firmer footing and have a better chance of withstanding the shock. However, Republicans in Congress are pushing for more immediate spending cuts which, if passed, would only delay Fed tightening.

How much easing has been done?

The Feds easy bias is quite apparent in the amount of easing the Fed has done to date. Using a simple Taylor Rule with the most relaxed assumption on NAIRU (non-accelerating inflation rate of unemployment) suggests that the neutral fed funds rate reached a low point of -2.2% in late 2010. How much easing has the Fed actually done? A recent study performed jointly by 1 the San Francisco Fed and the Federal Reserve Board has attempted to quantify the impact of QE1, QE-lite and QE2 on the economy. The study concluded that the balance sheet effects associated with all three phases of quantitative easing have reduced the 10yr Treasury yield by roughly 60 basis points. This is equivalent to a 300 basis point reduction in the short-term interest rate. Therefore, we can conclude that the Fed is targeting a fed funds rate of -3%, which is below even the more conservative Taylor Rule estimates. This extent of undershooting the prescribed policy rate is consistent with the Feds decisions during 2002 2005 when policymakers were responding to deflationary risks amid a sub-par recovery.

Chung, Laforte, Reifschneider, Williams, Have we underestimated the likelihood and severity of zero lower bound events, Federal Reserve Bank of San Francisco, January 2011
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Chart 2: How much easing has been done? Taylor Rule vs. adjusted overnight rate
10.0 % 8.0

6.0

4.0

2.0

0.0

Fed Funds Rate Fed Funds Target, w ith QE

-2.0

TR (based on Fed's NAIRU)

TR (based on SG NAIRU)

-4.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

We converted the impact of QE1, QE-lite and QE2 to equivalent rate cuts based on conclusions of the Feds study cited in the text above.
Source: Global Insight, SG Cross Asset Research/Economics

What do the Feds own forecasts imply for tightening? Running the Feds latest economic projections (and a still relaxed NAIRU assumption) through a standard Taylor Rule suggests that the neutral rate will turn positive in early 2012. This is consistent with the timeframe for rate hikes currently priced in the market. The question is, will the Fed stick closely to the rulebased approach? If the 2003-2005 tightening cycle is any indication, it is unlikely that it will. During that cycle, the Fed undershot the prescribed rate by a wide margin and for a long time.
Chart 3: Feds economic forecasts point to rate hikes in early 2012
2011 3.10 - 3.30 8.40 - 8.70 1.30 - 1.60 2012 3.50 - 4.40 7.60 - 7.90 1.30 - 1.80 2013 3.70 - 4.60 6.80 - 7.20 1.40 - 2.00 LT 2.50 - 2.80 5.20 - 5.60 1.70 - 2.00

Real GDP (Q4/Q4) Unem pl. Rate (Q4 avg) Core PCE (Q4/Q4)

Taylor Rule Estim ates

High 0.60 avg

Low - -0.15 0.23

High 1.70 avg

Low 0.65 1.18

High 2.80 avg

Low 1.50 2.15

Feds economic projections as of April 2011

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

Our tightening scenario late but hard

We believe that the Feds easy bias will remain in place until inflation risks actually materialize. The implication is that rate hikes will come late, but will be aggressive. We look for rate increases to start around mid-2012, with a bias toward Q3.

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Chart 4: NAIRU makes all the difference in the world

10.0 % 8.0

SG Forecasts: YE 2011: YE 2012: YE 2013: US / Core PCE 8.4% / 1.5% 7.8% / 1.8% 7.0% / 2.0%

6.0

4.0

2.0

0.0

Fed Funds Rate TR (based on Fed's NAIRU)

-2.0

TR (based on SG NAIRU)
SG Forecast

-4.0 90 92 94 96 98 00 02 04 06 08 10 12 14

Source: Global Insight, SG Cross Asset Research/Economics

We believe that the Feds NAIRU assumptions are too low and that core inflation could very well overshoot the Feds projections. However, the latest indications from Bernanke suggest that he is willing to wait until proven wrong. Once core inflation and wage growth start surprising on the upside, the Fed will have to reassess its assumptions about excess slack, which will likely trigger a period of aggressive tightening. We can demonstrate this by drawing two Taylor Rule projections, one based on the Feds low NAIRU assumption; and the other based on what we consider a more realistic assessment of NAIRU (6.5%). We believe that the Fed will move along the lower line until its assumptions are proven wrong, forcing it to shift to the higher trajectory (see Chart 4).

Triggers for rate hikes

Bernanke on employment: The pace of improvement is still quite slow, and we are digging ourselves out of a very, very deep hole. We are still something like 7 millionplus jobs below where we were before the crisis, and so clearly the fact that we're moving in the right direction, even though that's encouraging, doesn't mean that the labor market is in good shape. Ben Bernanke, April 27, 2011

The Fed has two sets of conditions for tightening one good and one bad. Under the good scenario, the Fed will start hiking once it sees consistent progress on employment and evidence on inflation showing up not just in prices, but also in wages. The Fed would also feel compelled to act if inflation expectations started to move higher this is a bad scenario because it could rate hikes even in the context of weak economy. 1a. Consistent progress on employment. The Fed needs to see significant progress on reducing unemployment, which will take several quarters of solid employment growth. We look for average payroll growth of 220k workers per month in 2011. All else being equal, this would reduce the unemployment rate to 8% by the end of the year, but the improvement is likely to be tampered by a rise in the participation rate, as discouraged workers slowly return to the labor force. As a result, we are likely to end the year closer to 8.4%, which we view as too high a hurdle to begin hiking rates.

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Chart 5a: Upside risks Correction in the Okuns residual

6 Output Gap (LHS) 3 2 1 0 -1 -2

Chart 5b: Downside risks Correction in participation rates

68 % 67 66 65 64

pct pts
4 2 0 -2 -4

Em ploym ent Gap (RHS)

63
62 61 Labor Force, % of Working Population

-6
-8 -10 58 63 68 73 78 83 88

This divergence is also referred to as Okun's residual

93 98 03 08

-3
-4 -5

60
75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

Source: SG Cross Asset Research

An upside risk is that we could see some normalization in the Okun s residual. Okuns law is the relationship between activity and employment growth which broke down during the latest recession as employment losses exceeded output losses. The recent sharp drop in the unemployment rate has raised some hope that the Okuns r esidual may be correcting. This is not in our central scenario, which assumes that the Okuns residual is explained by a rise in structural employment. If so, the correction should be very slow. 1b. Evidence of building price pressures. Headline inflation has not been and will not be a
Bernanke on inflation: There's not much that the Federal Reserve can do about gas prices per se, at least not without derailing growth entirely, which is certainly not the right way to go. After all, the Fed can't create more oil. We don't control the growth rates of emerging market economies. What we can do is basically try to keep higher gas prices from passing into other prices and wages throughout the economy and creating a broader inflation, which would be much more difficult to extinguish. Ben Bernanke, April 27, 2011

trigger for the Fed. Indeed, the Feds prescribed policy response to oil and commodity shocks is to do nothing. We would even argue that oil shocks tend to induce an easing bias because the lack of pass-through implies a purchasing power squeeze which tends to be recessionary. Until the Fed sees evidence that higher commodity prices are being passed through to goods prices and wages, it will continue to view inflation spikes as transitory. Vice Chairman Yellen reinforced this view recently, stating that it would be difficult to get a sustained increase in inflation as long as growth in nominal wages remains as low as we have seen recently. Other Fed officials have pointed out that labor costs constitute the largest chunk of corporate cost structure and unit labor costs have been essentially unchanged since 2007.
Chart 6: Unit labor costs no sign of inflation here
14.0 12.0 y/y %

10.0
8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0

50

53

56

59

62

65

68

71

74

77

80

83

86

89

92

95

98

01

04

07

10

Source: Global Insight, SG Cross Asset Research/Economics

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2. An upward drift in inflation expectations Though the majority of Fed officials appear sanguine on inflation, even the doves admit that they would change their mind once long-term
Bernanke on inflation expectations: Ultimately, if inflation persists or if inflation expectations begin to move, then there's no substitute for action. Ben Bernanke, April 27, 2011

inflation expectations started to drift higher. Thats because expectations are believed to be self-fulfilling: once workers start believing collectively that they have pricing power and demanding wage increases, those are more likely to come through; the same holds true for businesses because collective action increases the chances that price increases will stick. There is no perfect measure of long-term inflation expectations. Of the imperfect measures, we believe that the Fed watches two particularly closely: long-term consumer expectations from the University of Michigan survey and the 5y5y forward inflation breakeven implied by the Treasury market. The Fed also has its own measure of the 5y5y forward which adjusts for liquidity and other distortions. So far, neither of these measures gives the Fed cause for alarm.

Chart 7a: Consumer inflation expectations

4.00
3.50 3.00 2.50 2.00 1.50 Expected inflation, 5-10 year ahead 1.00 0.50 0.00 00 02 04 06 08 10
Source: SG Cross Asset Research/Economics

Chart 7b: Market inflation expectations

4.0

%
3.5 3.0 2.5 2.0 1.5 1.0

0.5
0.0 06

Fed's adjusted 5y5y forward From Inflation Swaps

07 08 09 10 11

Exit steps LIFO, FIFO, or a custom strategy?

The chronology of exit steps is crucially important in timing the first hike, even if we get the economic outlook right. The Taylor Rule suggests that the neutral rate has started to move higher, but should the Fed be responding by shrinking the balance sheet or raising rates? Some Fed officials have been advocating a last in, first out approach which implies that the balance sheet should be normalized before rate hikes. This would certainly be the more elegant approach, which would allow the Fed to keep rates at zero until the neutral rate turns positive. Yet, other Fed officials worry that a rapid unwinding of the balance sheet could trigger dislocations in the financial markets and instead have argued for a first in, first out approach. Yet, hiking the overnight rate when the neutral rate remains deeply negative is also a risky strategy. Other voices at the Fed are calling for a hybrid approach which combines rate hikes with gradual asset sales.

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Chart 8: Chronology of exit steps LIFO, FIFO or a mix?

8.0 %
6.0

4.0

2.0

0.0

-2.0

Fed Funds Rate TR (based on Fed's NAIRU)

QE QE unwind? 11 12

-4.0

95 3.00 2.50 2.00 1.50

1.00

96 USD trln

97

98

99

00

01

02

03

04

05

06

07

08

09

10

13

14

Fed's Securities Portfolio Securities Trend

0.50 0.00
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Source: Global Insight, SG Cross Asset Research/Economics

Tackling the balance sheet will the Fed ever sell assets?
We believe that asset sales will be an integral part of the Feds exit strategy; however it is likely to be the last step and one that is taken gradually. The most explicit guidance on asset sales was given in the April 2010 FOMC minutes, where most participants expressed a preference for strategies that would eventually entail sales of agency debt and MBS in order to return the size and composition of the Federal Reserves balance sheet to a mo re normal configuration more quickly than would be accomplished by simply letting MBS and agency securities run off. On timing, most FOMC members agreed that the required sales should be spread over five years.
Bernanke on MBS reinvestments: At some point, presumably early in our exit process, we will [] stop reinvesting all or part of the securities which are coming -- which are maturing. But take note that that step, although a relatively modest step, does constitute a policy tightening, because it would be lowering the size of our balance sheet and therefore would be expected to essentially tighten financial conditions. Ben Bernanke, April 27, 2011

Chart 9a: The Feds securities portfolio with MBS/agency runoff

2.8 $ tln 2.4 2.0 1.6 1.2 0.8 0.4 0.0 00 02 04 06 08 10 12 14 16 Treasuries Agency Debt MBS Pre-crisis Trend SG baseline scenario

MBS/agency runoff would still leave the Fed with a balance sheet that is $700bn too large

The charts above assume that the Fed ends its reinvestment policy in September 2011. MBS portfolio runoff based on a CPR of 0.20. Agency portfolio runoff based on actual maturities.
Source: Global Insight, SG Cross Asset Research/Economics

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More recently, Vice Chairman Janet Yellen reaffirmed the five-year baseline scenario which 2 would normalize the Feds balance sheet by mid-2016 . She did not do so explicitly, but by endorsing a recent Fed study in which the authors assumed full normalization of the Feds balance sheet by mid-2016, with outright sales beginning in mid-2012. We have adopted this as our baseline scenario. Given these assumptions, how much assets will the Fed have to sell per month? First, it must be noted that the underlying trend line for the size of the Feds security portfolio is a moving target which tends to rise in line with demand for money, or broadly in line with nominal GDP. We estimate that by mid-2016, the Fed should be targeting a $1.3tn securities portfolio. The actual size of the Feds securities holdings will reach $2.6tn by the end of QE2, suggesting that over the next 5 years, the Fed will have to somehow dispose of $1.3tn of assets. As was confirmed by Chairman Bernanke during his inaugural post-FOMC press conference, ending MBS reinvestment will be one of the first steps in the exit process. Estimating the size of principal repayments is not an easy feat as it depends on interest rates, home prices, housing demand and other factors. Instead, we make a simple assumption that the recent prepayment speeds continue. For agency debt, we use actual maturities to estimate the runoff. Combined, these two portfolios should reduce the Feds balance sheet by about $600bn through 2016, leaving it still $700bn above the target (see Chart 9a).
Chart 9b: The Feds securities portfolio with MBS and agency runoff and outright sales
2.8 $ tln 2.4 2.0 1.6 1.2 0.8 0.4 0.0 00 02 04 06 08 10 12 14 16 Treasuries Agency Debt MBS Pre-crisis Trend SG baseline scenario

MBS/agency runoff and sales would still leave the Fed with a balance sheet that is $400bn too large

The charts above assume that the Fed ends its reinvestment policy in September 2011. MBS portfolio runoff based on a CPR of 0.20. Agency portfolio runoff based on actual maturities. Outright sales begin in mid-2012 at $9bn per month for MBS and $500mln per month for agency debt.
Source: Global Insight, SG Cross Asset Research/Economics

As indicated in the April 2010 FOMC minutes, the next likely step will be outright sales of MBS and agency debt, in line with the Feds goal of normalizing not just the size, but also the composition of its portfolio. Assuming that outright sales begin in mid-2012, we estimate that the Fed will have to sell about $9bn in MBS securities and $500mln in agency debt per month in order to fully dispose of these assets by 2016. We believe that the market will be able to absorb this pace of sales relatively easily. But, before the Fed begins, it will have the opportunity to gauge the market impact based on Treasurys experience. The Treasury Department acquired its own MBS holdings following the collapse of Fannie Mae and Freddie Mac in 2008. It recently announced that it would gradually dispose of its holding by selling
2

Unconventional Monetary Policy and Central Bank Communications, speech by Janet Yellen, February 25, 2011
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about $10bn per month through mid-2012. Perhaps it is no coincidence that the Fed plans to begin its asset sales around the same time. As for the market impact, so far the Treasury has sold about $5bn with no noticeable impact on spreads.
Chart 9c: The Feds securities portfolio with MBS/ agency runoff and sales; plus Treasury redemptions
2.8 $ tln 2.4 2.0 1.6 1.2 0.8 0.4 0.0 00 02 04 06 08 10 12 14 16 Treasuries Agency Debt MBS Pre-crisis Trend SG baseline scenario

The charts above assume that the Fed ends its reinvestment policy in September 2011. MBS portfolio runoff based on a CPR of 0.20. Agency portfolio runoff based on actual maturities. Outright sales begin in mid-2012 at $9bn per month for MBS and $500mln per month for agency debt. Treasury runoff based on actual maturities.
Source: Global Insight, SG Cross Asset Research/Economics

Disposing of all its agency and MBS holdings will still leave the Fed with a portfolio that is $400bn above target (see Chart 9b). That means that the Fed will have to reduce its Treasury holdings at some point. However, rather than outright sales, it could do so simply via redemptions of maturing bonds. Based on current maturities, we estimate that about $600bn of Treasury notes and bonds will mature between 2012 and 2016. Allowing all of these issues to roll off would actually shrink the Feds balance sheet ahead of schedule (see Chart 9c). Instead, the Fed could reinvest $200bn of those proceeds into Treasury bills. This would return the Feds portfolio to the desired size and also help reduce the duration which is another stated goal.

Excess reserves a thorn in the Feds side

One of the problems with a gradual reduction of the Feds balance sheet is that the liability side, or excess reserves, will also normalize very slowly. This may become a problem when the Fed attempts to raise rates, because the effective overnight rate will be pressured lower in the presence of large excess reserves. The interest paid on excess reserves (IOER) is a tool that should be putting a floor under the effective fed funds rate, but there are a number of players in the overnight market who do not have the ability to deposit funds at the Fed. This has been a source of slippage and the reason why the effective rate has been trading 10bps to 15bps below the IOER. The recent change in FDIC rules has widened the spread further.

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Chart 10: Excess reserves a thorn in the Feds side?

0.10 % 0.05 FF-IOER Excess Reserves USD trln 1.4 1.6

0.00
1.2 -0.05 -0.10 -0.15 0.8 -0.20 0.6 -0.25 1

-0.30 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11
Source: Global Insight, SG Cross Asset Research/Economics

0.4

Given the remaining QE2 purchases, excess reserves are likely to reach $1.7tn by the end of June. Our equations suggest that at this level of reserves, an IOER of 1.0% would produce an effective fed funds rate between 0.82% and 0.86%. In order to restore the effectiveness of the Feds corridor system (with IOER being a floor and the discount rate being the ceiling for the overnight rate), the Fed will have to tackle excess reserves before attempting to raise rates. This will likely be done through a combination of reverse repos and term deposits. The Fed could also bring back the SFP (Supplementary Financing Program) whereby the Treasury issues bills to mop up liquidity and deposits the proceeds at the Fed. Before reviving this program, however, Congress will have to increase the debt ceiling.
Chart 11: A broken rate corridor
7.0 6.0 5.0 4.0 3.0 % Fed Funds Effective Discount Rate Interest paid On Excess Reserves (IOER)

2.0 1.0 0.0 Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Source: Global Insight, SG Cross Asset Research/Economics

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Conclusion Exit steps, in order

Based on the above considerations, we assume the following sequence and timing of exit steps: 1. End of QE2 The April FOMC statement confirmed that QE2 will end on schedule; that is at the end of June and after reaching the $600bn target. This will mark the official end of the Feds easing cycle; it is not the beginning of tightening. 2. Halting MBS reinvestments Bernanke noted during the press conference that halting MBS reinvestments will most likely occur early in the exit process. We assume that the Fed will wait a few months following the end of QE2 to assess the impact before taking this next step. The August 9 FOMC meeting may be a little too early, and therefore we assume that MBS reinvestments will be ended in September. 3. Liquidity draining operations We believe that this needs to be done ahead of rate hikes, or else the effective fed funds rate will trade away from the target. This is not an issue today with the fed funds target being a range, but could become a problem as the Fed attempts to push rates higher. Ending the policy of MBS reinvestments will help to shrink excess reserves but only by about $25bn per month. Therefore we look for the Fed to take additional steps to drain excess reserves via a combination of reverse repos, term deposits, and possibly by restoring the Supplemental Financing Program (SFP), however the latter is subject to Congress increasing the debt ceiling. We assume that the Fed will announce this step in the second half of the year, most likely in November. This will be an early signal to the markets that the Fed is preparing for an eventual hike in the fed funds rate. 4. End of extended language During his press conference, Bernanke indicated that extended means a couple of meetings, though it could be more or less i f conditions warrant faster or slower adjustments. His definition is broadly consistent with indications from other Fed officials who have estimated extended to mean about 6 months. Given the timing of our rate call and the timing of the first two steps, we assume that the extended language will be dropped at the end of the year, most likely during the December 13 FOMC meeting. 5. Rate hikes Our call is for mid-2012, with a bias toward the third quarter. We assume that the fed funds target and the Interest On Excess Reserves (IOER) will move at the same time. 6. Asset sales We believe that outright asset sales will begin around the time of the first rate hike. The Fed has indicated a goal of returning the size and composition of its securities portfolio to pre-crisis trend over 5 years. We believe it will start by selling about $10bn per month, evenly split between Treasuries and MBS securities. The reduction of the Treasury portfolio could alternatively be achieved via partial redemptions of maturing securities.

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2 May 2011

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This document is being provided for the exclusive use of MARTIN ROSE (SGCIB)