Thank you, Mr. Chairman. I’ll be referring to the charts that Carol Low circulated a short time ago. In the intermeeting period, markets were generally calm, and investors perceived events with a generally positive outlook. Despite the Committee’s tightening of policy on August 10, yields fell across the coupon curve, spreads narrowed, equities rose, and asset markets continued to exhibit unusually low volatility.
The top panel on the first page graphs the three-month deposit rate in black and the three-month rate three, six, and nine months forward in the dashed red lines since mid-June. The cash rate rose commensurately with the increases in the target fed funds rate. But forward rates have been falling gently at the same time, apparently as the softer data and more-tepid corporate outlooks caused market participants to revise their expected path of further monetary tightening.
The coupon curve has also declined. Two-year Treasury yields, which tend to be very sensitive to the funds rate, held firm and actually declined a few basis points since the last meeting, as shown in the middle left panel. But the ten-year yield continued to fall. This morning the yield was at 4.07 percent, not far from the mid- March lows before the strong April employment report. At this point the ten-year yield is again close to hitting levels that may trigger mortgage hedging activity that could send yields lower.
In part the fall in yields seems associated with the softer data—the revised and lower forecasts—and in part the persistence of high oil prices. The market is viewing higher oil prices as a restraining force far more than as an inflationary one. The net result is that the yield curve has continued to flatten. A flattening yield curve is not unusual in a tightening cycle. But the typical pattern is that the short end rises faster than the long end—which also rises. This cycle has had the anomalous situation in which the very short end is rising and the rest of the curve is falling.
How unusual is this cycle? The top of page 2 graphs the change in the two-year yield measured in basis points indexed to the date of the first tightening in recent cycles—for 1994, the mini-cycle of 1997, 1999, and 2004. I did not include earlier cycles given the different policy and operating environment prior to 1994. As this graphs shows, the red line depicting 2004 stands out in that yields have fallen. We see the same pattern for ten-year yields in the middle panel. Finally, the bottom panel graphs the change in the swap spread also on the same basis. This last item has more variability, but again this cycle stands out in that spreads have actually narrowed since the beginning of the tightening cycle. Admittedly this is a limited sample, and one can argue whether 1997 should even be included, but it is notable in any case that the market’s reaction has progressively become more benign as the Committee has become more transparent and the communications policy has evolved.
Moving to page 3, breakeven rates on TIPS have narrowed and that fall even accelerated as the price of oil again headed higher in recent weeks. Whereas earlier this year the correlation between TIPS breakevens and oil price changes was positive, it has now turned negative—again suggesting that the economic tax of higher oil prices is viewed as a more powerful force than its inflationary impact. The middle panels graph corporate and emerging-market spreads, which continued to narrow. Corporate issuance was on the low side, while investors’ search for yield continued. And after a soggy July, equity prices have risen since your last meeting despite some downbeat corporate outlooks, the summer slowdown in retail sales, and a buildup of inventories in parts of the tech sector.
Extending this favorable picture is the continuing low volatility in many markets. Page 4 graphs the implied volatility for the S&P 500, the major currency pairs, and representative swaption contracts. These are similar to graphs I presented at the last meeting, so I won’t go through them in any detail but only to note that implied volatilities remain low and in some cases are going still lower. The VIX equity implied volatility index is at about 14 percent, its lowest level in about a decade. This combination of low volatility, narrow spreads, stable or rising equity prices, and lower yields, even in the face of tightening monetary policy, is about as benign an environment as one can imagine. What is unclear is whether this happy set of conditions will persist or whether this is the calm before the storm.
One market that did see a bit of volatility during the intermeeting period was the fed funds market. After my June briefing, when I described how the fed funds market had become less volatile, this is a development I should have anticipated! [Laughter] Ironically probably the main reason for the volatility around the time of the last Committee meeting is the transparency of monetary policy and the confidence this gives reserve managers at banks to buy reserves to meet requirements before a well- anticipated rate increase. I’d like to spend the rest of my briefing on this topic. But let me step back a bit to summarize what we at the Desk do on a day-to-day basis.
Keeping the funds rate close to its target involves providing enough reserves over a maintenance period to allow banks to achieve two objectives. First, the injected reserves should allow the banks to meet all their requirements as well as their precautionary demands for excess reserves. Second, the reserves need to be injected at a measured pace to avoid undue risks that some banks will end any day overdrawn or that some banks will accumulate so many reserves early in the maintenance period that they risk holding unwanted excess levels by the end of the period. But managing reserves becomes more complicated when there is a great degree of certainty regarding changes to the target fed funds rate around FOMC meeting dates. When the expectation of a potential rate hike becomes priced into the interest rate futures market, these expectations also begin to show through to the funds rate in the days of the maintenance period immediately prior to an FOMC meeting at which an increase in the policy rate is anticipated. Reserve managers begin to shift their demand for balances to meet more of their reserve requirements ahead of the meeting, when rates are expected to be relatively cheap.
This reaction was exhibited during the reserve maintenance period leading up to the August 10 increase in the fed funds target, as shown in the shaded portion of the top panel on page 5. That panel depicts the target funds rate in black and the effective rate in the horizontal red line, along with the highs and lows for each day. With near certainty that the Committee would raise the target funds rate, the incentive for reserve managers was to accumulate reserves and bid up the funds rate. The Desk sought to lean against those pressures by adding more reserves than is typical at that point in the reserve maintenance period. The green line in the bottom panel graphs the average level of excess balances in that period compared with more-normal levels, the blue line. Perhaps the funds rate would have been even firmer had we not added the extra reserves. However, as we witnessed in that reserve maintenance period, there are tradeoffs in how the Desk reacts to a widely anticipated rate hike. The added reserves may be of limited effectiveness if expectations are very firm. And any buildup of high cumulative excess reserve balances in the banking system during the first half of the maintenance period will leave banks holding a much higher than normal level of reserves than they typically want at that stage in a period once the meeting date has passed. That could possibly set up conditions in which downward pressure on rates would emerge—whether the funds target was raised at the meeting or not.
This risk materialized after the August meeting because the Desk did not feel that it had the scope to reduce cumulative excess positions following the meeting date. Given the upcoming high payment flow day of the Treasury’s mid-quarter refunding settlement on August 16, to do so seemed likely to exacerbate the expected upward rate pressures anticipated on that day. As we witnessed during this period, the high cumulative excess positions eventually led to very high levels of volatility. The latter worked their way into trading as the end of the maintenance period approached, with trading well below the new target rate as well. At the same time, it’s questionable what impact the high levels of excess reserves provided early in the period had in damping rate pressure before the change was announced. Evidence suggests that that effect was only limited.
As the Desk will continue to face these challenges in a rising interest rate environment, it may be prudent to battle firm trading conditions less aggressively prior to a widely anticipated hike in the funds rate. While providing some level of reserves in excess of median levels in the midst of firm trading may be warranted, we are likely to be cautious in our provision, recognizing the risks that arise from high cumulative balances subsequent to the actual rate movement.
Mr. Chairman, there were no foreign exchange operations in the period. I should note that tomorrow will mark four years since the last intervention by the U.S. monetary authorities. This continues the longest period of non-intervention by the U.S. monetary authorities in the floating rate period. I will need a vote to approve domestic operations.