Morgan Stanley's Vincent Reinhart Weighs In On Rate Hiking

Morgan Stanley Chief U.S. Economist Vincent Reinhart released a note Tuesday morning that laid out the firm's view for the mechanics of the Fed exit in light of the fact that those on the current Fed board were not there when "the great experiment of embracing a zero lower bound to the nominal policy rate and expanding the balance sheet began in earnest in 2008."

The size of the Fed's balance sheet makes it the most important player in the market. The coming rate hike will manifest as the Fed manages this massive balance sheet, something that will overshadow any representation of monetary policy the Fed wishes to make through its benchmark Federal Funds Rate.

Speaking to the ability of guidance to offer certainty, Reinhart commented "most likely, the initial guidance on the exit offered later this year will be unsatisfyingly general, and the Fed, along with everyone in markets, will learn by doing thereafter."

The issue at hand is the Fed's ability to manipulate the rates monitored historically, while managing an unprecedented balance sheet size. Reinhart believes that "Anyone in need of an overnight rate in pricing should think hard about the general collateral repo rate" in place of the Federal Funds overnight rate.

Reinhart's view buttresses with a statement Federal Reserve Bank of New York head William Dudley issued six days ago when he supported the view that the repo market still threatens the broader economy, warranting further restrictions from regulators. After Dodd-Frank in 2010 made it more difficult for central banks to backstop bank repo lending, Reinhart's advice to focus on this rate seems reasonable for gauging the impact of the Fed on short-term rates in lieu of its outrageous balance sheet.

The Wall Street Journal said on August 13, "Regulators should consider forcing broker-dealers to bolster their capital levels if they rely too heavily on short-term financing or take other actions, such as limiting the extent to which brokers can use short-term repos ‘to finance long-term assets or high-credit-risk assets,’ [Boston FED President] Rosengren said."

The problem now is that the "prudent planning" the Fed laid out for its exit no longer applies. Reinhart said he central bank has backed away from its calendar-based forward rate guidance, lengthened the maturity of its portfolio and gained confidence in its tools to temporarily drain reserves. The large balance sheet and large reserve balances creates limited precision for which the Fed can control the Federal Funds Rate. This dynamic creates a need for participants to focus on how the central bank will raise short-term interest rates while managing a big balance sheet.

One way the Fed could manage overnight rates would be to raise the interest on excess reserves (IOER), according to Reinhart. Through the removal of market set IOER, the Fed could impact the trading of excess reserves rendering the usefulness of the risk-free overnight rate "under-representative" of the market it is designed to gauge. Losing clarity on this rate may create problems when the Fed tries to manage the volatility of derivatives relying on the Fed Funds Rate.