Insight - Fed’s SLR decision may start countdown to tapering

It seems unlikely the SLR will simply revert back to its pre-pandemic calculation and stay that way forever.

AFTER investors spent weeks brushing up on the specifics of the Federal Reserve’s (Fed) Covid-19 era changes to the supplementary leverage ratio (SLR), the central bank ultimately decided it was best to just let those exemptions expire as intended on March 31.

The Fed and other regulators announced Friday that they wouldn’t extend an emergency move that temporarily allowed banks to exclude US Treasuries and reserves at the central bank from the SLR denominator.

All else equal, this reduces banks’ capacity to own Treasuries because they would have to put up more capital to do so, given the SLR doesn’t factor in the risk level of assets. “The Treasury market has stabilised, ” the central bank said in its own statement. “

However, because of recent growth in the supply of central bank reserves and the issuance of Treasury securities, the board may need to address the current design and calibration of the SLR over time to prevent strains from developing that could both constrain economic growth and undermine financial stability.”

When comparing the two statements, it seems as if the Fed wasn’t quite pleased with the decision, which was politically fraught.

It seems unlikely the SLR will simply revert back to its pre-pandemic calculation and stay that way forever.

But at least in the immediate future, banks can expect to be required to once again maintain a minimum level of capital against all of their assets, even deposits at the Fed, which the central bank itself is forcibly increasing by purchasing US$80bil (RM33bil) of Treasuries and US$40bil of mortgage-backed securities each month.

As I noted in a column this month, the SLR debate trapped the Fed between its role as a regulator and the nation’s monetary policy authority.

Now that it’s pulling back this capital break as a regulator, it’s only natural to wonder if it will soon start to prepare the markets for a tapering of its bond purchases, which would slow the huge growth in bank reserves.

After all, it’s not exactly a healthy development for the financial system when JPMorgan Chase & Co, the largest US bank, warns about having to turn away deposits without SLR relief.

Now, Fed chair Jerome Powell offered an emphatic “not yet!” during his press conference on Wednesday when he was asked about whether it was time to start contemplating tapering.

He and his colleagues have said it would require “substantial further progress” toward their goals of maximum employment and inflation that reached 2% and was on track to exceed it for some time before they would reduce the current pace of asset purchases.

They have also said they’d provide guidance well in advance of such a move.

Bond traders

Still, bond traders have seen just how much can change over three months. Fed officials raised their growth estimates for this year to 6.5% this week from 4.2% in December. What might happen come June?

Rick Rieder, BlackRock Inc’s chief investment officer of global fixed income, says the central bank may communicate plans to taper its asset purchases as soon as its June meeting, with the actual process potentially starting before the end of the year.

In his view, the Fed could begin by slowing its buying of shorter-dated Treasuries while maintaining support for the longer-end of the yield curve.

This kind of timeline is hardly radical.

The Fed is already bracing for some huge inflation numbers in the coming months because of comparison with figures from the same period a year ago.

The movement in the central bank’s “dot plot” this week suggests that by June enough policy makers will see a rate increase by 2023 to lift the median estimate for the fed funds rate above the current 0% to 0.25% range.

Rate hike

Already, four officials are forecasting a rate hike in 2022.

Given that the Fed has made clear that tapering will come before moving away from the zero lower bound, it certainly seems as if that group is on the same page as Rieder.

Meanwhile, other Fed officials who are more in line with Powell will wait to see actual data before changing anything about their monetary policy stance.

Powell is optimistic, writing in an op-ed for The Wall Street Journal on Friday that “today the situation is much improved” and “I truly believe that we will emerge from this crisis stronger and better.”

But belief is no longer enough for the Fed – it now requires proof that the economy has indeed made “substantial further progress.”

At the same time, the entire SLR debate has served as a crucial reminder that the unprecedented monetary and fiscal support for the country during the pandemic isn’t without consequences.

Much to do

For one, the Fed still has much work to do when it comes to shoring up the resiliency of the Treasury and repo markets during periods of stress. It’s not clear exactly what changes it might propose to the SLR that it couldn’t have put in place now.

Most likely, it simply didn’t have buy-in from the Federal Deposit Insurance Corp and the the office of the comptroller of the currency.

Either way, without the SLR exemption in place, which by some estimates allowed banks to take on as much as US$600bil in extra reserves and Treasuries, the Fed’s current pace of bond buying is only going to strain the financial system.

There may yet be a more permanent solution. But starting to “think about thinking about” tapering might also have to be part of the equation.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. The views expressed here are the writer’s own.

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