April 2014 Letter to the Secretary
Dear Mr. Secretary:
Since the Committee last met in early February, the pace of the expansion has slowed following the 3.4% annual pace of growth of real GDP growth registered in the second half of 2013. Several temporary factors likely weighed on growth in the first quarter, but the most recent data indicate that momentum has picked up in the tail end of the quarter. Unseasonably cold weather, an inventory overhang from late last year, and the restraint on disposable income from the expiration of extended unemployment benefits all likely exerted some temporary restraint on the pace of activity growth. Nonetheless, consumer spending accelerated in March and labor market indicators have generally remained firm, supporting an expectation among most forecasters that the economy will soon return to above-trend growth.
Retail spending by consumers slowed abruptly in December and January, but more recently appears to have shown signs of better growth. Through this soft patch total consumer spending has been supported by two other factors. The unseasonably cold weather – while it may have pushed back the timing of spending on certain discretionary items – lifted spending on utilities. In addition, as part of the implementation of the Affordable Care Act, the expansion of Medicaid in January boosted real consumption of health care services. The fading of these two temporary supports should be replaced by a resumption of discretionary outlays. In particular, a bounce in retail sales in March appears to have contributed to a 0.4% increase in real consumption last month. Looking forward, data from the NY Fed’s Survey of Consumer Expectations indicates that households are increasingly expecting wage gains to pick up in the future, which should provide important support to households’ willingness to spend.
Real business fixed investment spending accelerated to a modestly above-trend 5.7% annual pace of expansion in the fourth quarter of 2013, led by a solid 10.9% rate of growth in real equipment outlays. Thus far, it appears that the growth of capital outlays may have moderated in the first quarter: a slowing in outlays for capital equipment has been only partly offset by increased spending for oil and gas mining structures. More generally, looking through the quarterly volatility, over the last two years real business investment spending growth has fluctuated around the mid-single digits and that trend appears intact in the first quarter. Business inventory investment was quite robust in the second half of last year; the moderation to a more sustainable pace of inventory investment appears to have occurred in the first quarter – a process which exerted temporary restraint on the pace of industrial production growth.
Housing has been a disappointment. Real residential investment contracted at a 7.9% annual rate in the fourth quarter, and appears on track for another modest decline in the first quarter. While some slowing was to be expected following the back-up in mortgage rates last spring, the duration of the slowdown has been surprising. Even so, most house price indicators continue to point to continued robust gains.
Employment in the state and local government sector increased by 6,000 in the first quarter, the fourth consecutive quarterly increase in that measure. Federal government activity, however, continues to contract, though the degree of austerity should lessen in coming quarters.
Gross exports appear to have contracted in the first quarter, though the weakness is expected to be transitory. The eurozone economy has shown encouraging signs of acceleration; the conflict in Ukraine poses a downside tail risk. It remains to be seen the degree to which the rise in consumption taxes will restrain Japan’s economy, but it appears to have come to that point with solid momentum. Concerns remain about the strength of the Chinese economy, however downside tail risks associated with the shadow banking sector appear to have diminished, at least for the near term.
The labor market has continued to create jobs at a steady clip, increasing employment by an average of 178,000 jobs per month in the first three months of the year. The unemployment rate stood at 6.7% in the most recent reading in March, unchanged from the end of last year. Even so, the labor force participation rate has firmed to 63.2% in March, up 0.4%-point from the end of last year. Average hourly earnings increased at a 2.3% annual rate in the first quarter, a historically anemic pace, but nonetheless the second-fastest quarter in the expansion, raising hopes that wage gains could firm further in coming quarters.
Inflation has remained subdued. The deflator for personal consumption expenditures (PCE) increased only 0.9% in the twelve months ending in February. The ex-food and energy core PCE measure has posted only slightly stronger gains, up 1.1% over the same period. The consumer price index (CPI) report for March hints at modestly firmer inflation, with both the headline and core measure up 0.2% in that month. Even so, PCE inflation is generally expected to remain well below the Federal Reserve’s 2% goal for this measure.
With inflation subdued and unemployment still high, the Fed has signaled continued easy monetary policy. The pace of asset purchases has been reduced by $10 billion per month at each FOMC meeting since December and are expected to continue at upcoming meetings. The interest rate forecasts presented at the March FOMC meeting featured a steeper path of the funds rate than did the projections released following the December meeting. Even so, the Fed Chair has indicated that this should not be interpreted as a shift in the stance of policy. Markets continue to anticipate a first rate hike at some point in 2015.
The Committee’s first charge was to provide its view on ways that the Treasury can effectively manage potential risks associated with the Treasury portfolio, including mitigating cash flow timing mismatches between revenues and expenditures (debt maturities, coupon payments, and outlays.) The Treasury asked for the Committee’s view on the effectiveness and practicality of the following: 1) using buybacks to smooth the maturity profile, manage cash balances and provide cost savings to the tax payer; 2) modifying the current auction schedule, particularly for 10- and 30-year securities, as a means of more evenly distributing Treasury’s maturity profile; and 3) optimizing the cash balance as a means of reducing operational and market access risk.
One member reviewed the attached presentation to address these questions. The Treasury’s non-uniform debt profile evolved, in part, due to intra-year variation in the primary deficit (revenues less expenditures, excluding interest payments), resulting in a seasonal variation in gross financing needs on a month to month basis. Driven by the existing maturity structure, this variation is projected to worsen over the coming years and private funding needs would be amplified were the Fed to cease reinvestments of maturing Treasuries. Typically this seasonal variation has been absorbed by adjusting bill issuance, which has not appeared to adversely impact Treasury’s funding costs over time. However, there is evidence that the bid-to-cover ratios for bill auctions drift moderately lower when gross issuance sizes are large. In addition, cash management bills are generally more expensive for Treasury to issue. Lumpy maturities of coupon securities and bills leaves the Treasury vulnerable to operational risk in the event of an extended market shutdown, exposing the Treasury to the remote risk of a technical default. Indeed the Treasury lost market access for 3 days following the September 11, 2001 attacks, 1.5 days following Superstorm Sandy in October 2012, and one day during a Treasury Auction system IT issue in December 2013.
Potential solutions proposed by one member and debated by the Committee were: 1) structurally increasing the size of the Treasury’s operating cash; 2) modifying the quarterly 10-year note and 30-year bond auction schedule to monthly new issues; 3) shifting the 3-year issuance to non-refunding months; and 4) making use of other debt management tools, such as switches and buybacks, to manage seasonal variation in financing needs.
After a robust discussion, the committee recommended that the Treasury consider increasing structural cash balances to mitigate situations where normal access to funding markets may be disrupted or delayed. One member highlighted that other debt management offices globally have a higher structural level of cash as part of their debt management practice. In addition, the committee recommended that the Treasury further study the efficacy of using additional debt management tools to smooth its debt profile. While the committee was open to shifting the 3-year notes to maturities in March, June, September and December (with two reopenings in the following months) to reduce peak refunding needs, it was concerned about the recommendation to modify the 10-year and 30-year auctions to monthly new issues due to potential reductions to the liquidity of the on-the-run issues.
Distinct from the prior Treasury risk management discussion, the Committee’s second charge was to examine whether adjustments to the debt issuance schedule were warranted in light of current funding needs. Current deficit and borrowing projections indicate the Treasury is likely to be overfunded in Fiscal year (FY) 2014 and 2015 if it keeps the current calendar and size of coupon auctions unchanged and leave the projected $1.45 trillion of Treasury bills outstanding. Given expectations for stronger economic growth and increased tax receipts, the Treasury Marketable Borrowing announcement states that the Treasury will be overfunded by $115 billion for FY 2014 and the CBO projects that the Treasury will be overfunded by $166 billion for FY 2015. However, projections for FY 2016 and beyond show underfunding. The committee continued to recommend a gradual lengthening of the weighted-average maturity of the debt and maintaining flexibility in auction sizes given uncertainty in the rate of economic growth and the level of tax receipts.
To inform this discussion, the committee reviewed the attached Financing Outlook presentation. After consideration of the first charge and in light of the expected overfunding in the FY 2014 and FY 2015, the committee recommended cutting 2-year coupon issuance by $1 billion per month from the current level of $32 billion to $28 billion by August 2014, maintaining the issuance size at $28 billion until September 2015, and then gradually increasing issuance size from $28 billion to $32 billion from September 2015 to January 2016. In addition, the committee recommended cutting the 3-year auction size by $1 billion per month from $30 billion to $26 billion from April 2014 to August 2014, maintaining the level at $26 billion from August 2014 to September 2015 and then gradually increasing the auction size from $26 billion to $30 billion from September 2015 to January 2016. These changes would result in an expected cumulative reduction of $128 billion in coupon issuance over this time period. Given the prior recommendation for the Treasury to consider structurally increasing its cash balance, the Committee recommended that bill issuance remain at current levels rather than reducing issuance to reduce excess funding. These recommended reductions to coupon issuance are consistent with past reductions as well as with the Treasury’s commitment to extending the Weighted Average Maturity of the outstanding marketable debt which, under this recommendation, is projected to reach 70 months by the end of FY 2016.
Dana M. Emery
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