November 2, 2016
Letter to the Secretary
Dear Mr. Secretary:
The pace of economic activity picked up in the third quarter after a slow start to the year. Real GDP rose 2.9% (annual rate) in the third quarter with notable contributions from inventory investment and net exports. Consumer spending slowed to a moderate increase following a robust gain in the spring. Business fixed investment was weak, and residential investment has remained disappointingly soft. In contrast, net exports have proved surprisingly strong, led by agricultural exports. Smoothing through the volatility, real GDP has expanded a moderate 1-1/2% over the last four quarters and appears to be on track for a similar or better increase in the current quarter.
Since the Committee last met in early August, investors’ fears about more serious near-term risks from the United Kingdom’s vote to leave the European Union have further abated, and uncertainty stemming from the US election seems to be having little, if any, economic repercussions. Since early August, financial conditions have tightened modestly but remain accommodative, with mortgage rates little changed, equity prices slightly lower, and the exchange value of the US dollar having resumed strengthening. The drags from an inventory overhang and declining activity within the domestic energy sector appear to be waning. Meanwhile, household spending is supported by favorable fundamental factors, including healthy balance sheets, healthy employment gains, and improved wage prospects. Looking ahead, these factors point to a sturdy backdrop for the ongoing economic expansion.
Consumer spending grew 2.1% in the third quarter, slowing from the second quarter’s torrid 4.3% clip. Spending on durable goods remained strong, and auto sales have held up at high levels. Non-durable goods spending was somewhat weak among a number of categories. In addition, consumption of health care services slowed in the third quarter, after relative strength in the first half of the year. Consumer sentiment measures have generally remained range-bound despite the hotly contested presidential campaign season. Household balance sheets have been buoyed by rising home prices, the improvement in equity wealth in recent years, and disciplined debt growth. Those strong fundamentals, combined with ongoing gains in employment and wages, suggests household spending will continue to carry the expansion in the coming quarters.
Nonresidential fixed investment edged up in the third quarter at an annual rate of 1.1%, reflecting mixed contributions from the major categories. Equipment investment declined for the fourth consecutive quarter, which is unprecedented outside of recessions. However, drilling activity has risen over the past several months and was a positive contribution to structures investment in the third quarter, which rose 5.4% at an annual rate. In addition, investment in intellectual property continues to expand at a moderate rate. Looking forward, orders of nondefense capital goods excluding aircraft have improved a little in recent months, and suggest the corresponding capital goods shipments, which rose in September, may be carving out a bottom. Residential investment fell for the second quarter in a row, as the housing market expansion has paused this year. However, ongoing gains in household formation and historically low mortgage rates should support activity going forward, even if high and rising home prices crimp overall affordability. Inventory investment—after subtracting from growth for five quarters—contributed 0.6 percentage point to real GDP growth in the third quarter. While such a large contribution is unsustainable, inventory investment should add somewhat to growth going forward as stocks are realigned with sales.
Foreign trade has been a bright spot for the US economy in the last few quarters. Despite the sharp appreciation of the US dollar, net exports have contributed positively to growth in each of the first three quarters of the year. In the third quarter, net exports contributed a hefty 0.8 percentage point to real GDP growth, driven by a sizeable increase in agricultural exports, in particular soybeans. The 14% annualized jump in real goods exports in the third quarter seems unlikely to persist, and may pull back in the coming quarters, however. More broadly, the outlook for global growth, though subdued by historical standards, has largely held up well since last summer, with few new concerns. The performance of the UK economy following the “Brexit” referendum has provided some hope that their economy may fare better than expected. These factors bode well for foreign trade going forward, provided US dollar appreciation is contained and tensions among trading partners are managed.
Following the decline in the second quarter, government spending and investment was a small addition to growth in the third quarter. Defense outlays rose after two quarters of contraction and nondefense federal spending continued to expand apace. Spending and investment by state and local governments fell for the second quarter in a row, and the high frequency data on construction spending by state and local governments on schools, roads and other infrastructure has deteriorated over the past year. Presumably, the generally improved fiscal health over the past few years should support some improvement in investment going forward, despite some states and municipalities remaining under pressure and some continuing to struggle with their pension obligations. On balance, with the modestly positive fiscal impetus expected from federal fiscal policy over the next year, overall government spending and investment should provide modest support for growth in the coming quarters.
The slowing in growth over the past year has in turn slowed the pace of labor market expansion. Nonfarm payroll employment has slipped from an average monthly pace of almost 230,000 jobs a month last year, to roughly 180,000 jobs a month through the first three quarters of this year, and roughly 160,000 in August and September. At the same time, the average work week has declined somewhat, contributing to a deceleration in the growth of total hours worked. The unemployment rate has essentially moved sideways over the course of the year, sitting at 5.0% in September, where it was last December. Over that same interval, the labor force participation rate has moved modestly higher, which has mechanically pushed up the unemployment rate even though higher participation is welcome news. Broader measures of labor underutilization have been little changed thus far this year. Nominal wage inflation as measured by the Employment Cost Index and average hourly earnings has been moderate, suggesting that there’s some degree of slack remaining in labor markets.
Consumer price inflation has moved higher in recent quarters. The price index for personal consumption expenditures (PCE) rose just 1.0% over the year ended in the third quarter, as past declines in energy prices are still working to hold down headline inflation. Recent increases in the price of oil and gasoline suggest that drag should be coming to an end. Excluding food and energy, core PCE prices rose 1.7% over the year ended in the third quarter. That’s a notable improvement from a year earlier, and inching closer to the Federal Open Market Committee’s (FOMC) target of 2.0%. The lingering effects of past US dollar appreciation and energy price declines have weighed on core inflation, though these influences appear to be waning. Survey-based measures of inflation expectations have declined, on net, recently, while market-based measures of inflation compensation have bounced along with higher long-term nominal interest rates. Downside risks to the inflation outlook stem from the marked deterioration in survey measures of inflation expectations and the potential for a more rapid appreciation of the US dollar. At the same time, upside risks stem from unit labor costs that are rising faster than business selling prices as well as higher energy and commodity prices.
In recent months, Federal Reserve communications have suggested an increase in the target range for the federal funds rate would be appropriate this year so long as there’s continued progress toward the Committee’s objectives for employment and inflation. At its most recent meeting in September, the FOMC left the stance of policy unchanged. With labor market slack being taken up at a somewhat slower pace in recent quarters, and inflation remaining below target, the FOMC decided to wait for further evidence of continued progress, especially in the labor market. Overall, communications have noted the substantial progress made in recent years toward the FOMC’s objectives, and expectations for further progress. The most recent FOMC statement noted risks to that outlook were “roughly balanced.” That said, policymakers seem intent on proceeding cautiously given an asymmetric ability to respond to new economic developments because the target federal funds rate remains close to the zero lower bound, and an increasing realization that equilibrium interest rates are historically low, and thus the stance of policy may not be as accommodative as the level of the federal funds rate would have historically implied.
Against this economic backdrop, the Committee reviewed Treasury’s November 2016 Quarterly Refunding Presentation to the TBAC. During the third quarter of 2016, corporate tax receipts have been weaker than during the equivalent period last year, potentially attributable to the extension of bonus depreciation and weaker corporate profits. In FY 2016, Treasury net outlays were $166 billion higher than in FY 2015, primarily attributable to increased HHS payments which partly owes to a one-time calendar shift. The budget deficit for FY 2016 was $148 billion higher than the FY 2015 deficit.
Based on the Quarterly Borrowing Estimate, Treasury’s Office of Fiscal Projections currently projects a net marketable borrowing need of $188 billion for the first quarter of FY 2017, with an end-of-December cash balance of $390 billion. For the second quarter of FY 2017, net marketable borrowing need is projected to be $56 billion, with a cash balance of $100 billion at the end of FY Q2.
In FY 2017, OMB projects that borrowing from the public will decline to $573 billion. In FY 2016, net marketable borrowing totaled $795 billion, in part reflecting a $155 billion increase in cash balance. In terms of risks to the baseline projection, Treasury’s borrowing from the public could rise sizably if the Federal Reserve ceases reinvestment of maturing Treasury securities held in the SOMA portfolio. As of September 2016, the survey of primary dealers suggest the median expectation was for SOMA reinvestments to continue until June 2018. In terms of portfolio metrics, bid-to-cover ratios were little changed except for TIPS, which increased slightly in recent months. In the T-bill market, bid-to-cover ratios increased at the short end and decreased at the 26- and 52-week tenors.
The Committee’s charge was to discuss the impact on the Treasury market from the newly implemented money market fund reform. In particular, how have the new rules affected the demand for Treasury bills and other high-quality liquid assets? And, what changes to the existing auction schedule should Treasury consider in response to changes in the demand for T-bills and HQLA?
One member began by reviewing the impact of money market reform on borrowing costs in various markets. The most dramatic development has been in the reshuffling of assets under management in the money market industry, with institutional prime funds losing $800 billion over the last year, most of which has flowed into government-only funds. In anticipation of the rules coming into force in October 2016, prime funds significantly shortened their weighted-average maturity. Since last summer, LIBOR rates have moved up by about 1/4 percentage point, pulling up some short-term private-sector borrowing rates as well. As prime funds gain experience managing less AUM and outflows abate, the member anticipated that they would extend their weighted average maturity. That should cause the LIBOR curve to flatten. However, the member speculated that it may take a yield pick-up of perhaps 40 basis points compared with government funds in order to attract end users back into prime funds.
The economic impact of the smaller prime fund sector has been felt most noticeably in the commercial paper market, which has shrunk. Over the past year, the market has decreased by $118 billion, led by the drop in foreign financial borrowing. Some of that decline should have no noticeable market impact because foreign banks were merely issuing at levels below the Fed’s interest rate on excess reserves and then placing the proceeds with the Fed to earn IOER. Meanwhile, non-financial issues still remain well-received by buyers given their attractive yields and diversification benefits.
The member suggested that efforts to diversify sources of funding by foreign banks have affected pricing in other markets. In addition to wider LIBOR/OIS funding spreads, the demand for US dollar funding from both Japanese and European borrowers has increased which may have been contributed to the widening in cross-currency bases in various currency pairs.
Going forward, the member expects the 3-month LIBOR/OIS spread to remain wider by anywhere from 20 basis points (recent readings) to 35 basis points (where the forwards are trading), a gap directly attributable to money market reform which will result in increased funding costs for foreign banks. As a consequence, short-dated bank funding CP/CD levels out to one year should remain structurally elevated as issuers attempt to term out funding. The gap appears to be 15-30 basis points greater than before the new rules took effect.
The shift from prime funds to government-only funds has increased the demand for HQLA, which has been met by a combination of T-bills, agency discount notes and the Fed’s overnight reverse repo facility. Due to regulatory changes, dealer balance sheets cannot expand in order to accommodate elevated demand for repo. Thus, the Fed’s ON RRP facility has served as a critical buffer. Government-only funds have increased usage of the Fed’s program as their AUM has soared. The average one-month usage has increase by $150 billion over the last six months. While not a perfect substitute for T-bills, the ON RRP has become a key instrument to manage the inflows. If the Fed’s ON RRP facility were to be capped below current or expected usage, it could cause significant dislocations in the T-bill market.
Another member examined the case for issuing more T-bills because of money market reform. The member noted that even before money market reform, the Treasury had ramped up the issuance of T-bills in order to build a cash buffer in case of operational disruption. The existence of a premium for T-bills and academic research on the desirability of additional T-bills for financial stability reasons were also cited as reasons why Treasury should consider issuing more T-bills.
The member showed that money market reform may have caused an approximately 7.5 basis point increase in the spread between T-bills and OIS at the one month tenor. The member cited academic research that implied a $150 billion increase in T-bill supply would be necessary to reverse that premium. However, the member also emphasized the degree of uncertainty inherent in making such an estimate. The member then showed that Treasury is well positioned to boost T-bill supply in the near term by at least as much as the $150 billion estimate while maintaining steady coupon issuance. For the sake of illustration, using only T-bills to fulfill financing requirements over the next few years would bring the T-bill share of marketable Treasury securities outstanding back in line with its historical average and maintain the average maturity of the total outstanding marketable debt at about 70 months.
The member highlighted that the debt ceiling poses a real risk of disruption in short-term funding markets. The federal government debt limit is set to be reinstated in March 2017. If past actions are a guide, unless legislative action is taken before then, the Treasury will reduce in a few months its cash balance to approximately $23 billion on March 16, 2016, equal to the amount held at the time of the debt ceiling suspension in November 2015.
Under a scenario in which Treasury draws down T-bill supply in order to reduce its cash balance, the member estimated that the T-bill share of marketable debt would shrink appreciably and, using the rule of thumb from the academic research, would suggest a 20 basis point decline in T-bill yields, all else equal. The Fed’s ON RRP facility might cushion the impact somewhat, but probably not in its entirety because the program is an imperfect substitute for T-bills for a variety of institutional and technical reasons. The member stressed that the risks associated with supply disruptions to T-bill issuance could be larger and more uncertain in a post-money market reform environment.
There was a wide-ranging discussion following the members’ presentation of the charge. Several members added that changes in the rules for margining would also increase the demand for HQLA, which has the potential to further widen spreads. In terms of the empirical estimates from the rules of thumb based on the academic literature, a number of members emphasized the need to take the estimates with a grain of salt. It would be desirable to look at a variety of models and a range of estimates of the potential effect of changes in T-bill supply on spreads. Nevertheless, one member noted that the 7.5 basis point wider spreads after money market reform may be a lower bound given the increased supply of T-bills during 2016 and the availability and increased usage of the Fed’s ON RRP facility.
The Committee generally agreed that additional T-bill supply would be beneficial for a number of reasons. In particular, structural changes in the Treasury market in the wake of money market reform are supportive of increasing T-bill issuance over time. Notwithstanding that recommendation, the Committee was unanimous in agreeing that any increase in Treasury bill supply should not be interpreted as changing the Treasury’s debt issuance strategy of extending the weighted average maturity of the debt.
Jason G. Cummins