The Federal Reserve reports that Minutes of the Federal Open Market Committee Meeting on June 24-25, 2003.
(Here is the link to the material covered during meeting)
(emphasis mine) [my comment]
Minutes of the Federal Open Market Committee Meeting on June 24-25, 2003
CHAIRMAN GREENSPAN. … Would somebody like to move approval of the minutes of the May 6 meeting?
MR. GUYNN. So move.
CHAIRMAN GREENSPAN. Without objection they are approved. We turn now to Mr. Reinhart and Mr. Kos.
MR. REINHART. Thank you, Mr. Chairman. I' ll be referring to the material called “Conducting Monetary Policy at Very Low Short-term Interest Rates” which was on the table when you came in. It' s the same as the material I sent to you electronically last week. …
Although I have spoken about these policies in relatively abstract terms, they are part of our history, as shown in exhibit 7. The Federal Reserve has always appreciated the importance of correctly aligning market expectations about the economy. In that regard, and as shown in the top left, one of the more sizable reactions in financial markets in the past few years to an FOMC decision followed the decision on May 6 not to change the overnight rate. The System has also been willing to put its balance sheet at risk to encourage appropriate expectations about interest rates or to calm fears about funds availability. As plotted at the top right, the Desk sold options on RPs for the weeks around the century date change that totaled nearly $0.5 trillion of notional value. Given that the Desk already operates in all segments of the Treasury market, we wouldn' t have to move up a learning curve if instructed to increase purchases of longer-dated issues. …
The alternative approaches that would involve changes to how the Desk operates are summarized in exhibit 4. The alternatives that could be adopted while changing only the composition of the balance sheet are listed in the top panel. These include (1) extending the average maturity of the outright holdings in the SOMA, (2) setting explicit ceilings on longer-term Treasury yields, and (3) using derivative instruments. Because only the composition of the balance sheet changes, excess reserves can be kept at low levels and under the Desk' s control, allowing the Desk to continue targeting a positive funds rate. …
… There is another weapon in the Board' s arsenal: It could cut reserve requirements. True, the available base is narrow (transactions deposits) and the amount limited by law (at most from the current 10 percent to the 8 percent floor), but such an action would signal a willingness of the Federal Reserve to use all means at its disposal to revive the economy. Finally, the Federal Reserve could coordinate its policy with the Administration and the Congress to encourage, say, tax cuts that would be directly financed by money creation. You can see why I put this list last. These options would change how we are viewed in financial markets, involve credit judgments of a form we are not used to, perhaps smack of desperation, and pull us into a tighter relationship with other parts of the government. But they are available if you felt the other, more traditional forms of monetary stimulus would be inadequate to the situation
The Committee could sanction the use of various derivative instruments on conventional Desk operations as a way to influence longer-term yields, which is outlined in exhibit 8. Options of some form are a possibility, as are forward operations. For example, we could sell a sequence of options on term RPs, covering interlocking time segments that collectively extend as far into the future as desired. In this way, longer-term yields could be influenced and a visible signal of the Fed' s desired path of interest rates could be demonstrated. Forward operations in term RPs could be structured in a similar fashion. Alternatively, we could sell put options on longer-term Treasury securities at strike prices associated with desired longer-term yields. Of course, the operating objectives set for the sale of derivative instruments would determine their proper structure and should be carefully formulated first. I' ll come back to this subject after going through some of the logistical issues. I' m also going to focus primarily on options for RPs specifically, as these have certain advantages over forward operations for the kinds of policy purposes under consideration.
The sale of any options, or forwards for that matter, would not affect the domestic portfolio immediately and, in the case of options, may never do so. Auctioning derivatives is something we already have experience doing. In the event that options were ever exercised, the impact on the portfolio would be profound, assuming that more than just a symbolic amount of contracts were sold. Simultaneously controlling the funds rate means that any reserve effect would need to be immediately sterilized. The volume of options sold might be limited because of this concern. Alternatively, options contracts might be configured to make a net cash payout if exercised, perhaps by structuring them as interest rate caplets or pairing them with offsetting trades with the Desk at then-current market prices. This would insulate the size and composition of the balance sheet, but the payouts would appear very visibly as losses on the income statement.
Of course, a successful program would be one in which any options sold would never be exercised. Achieving this result, just as with interest rate ceilings, would depend on how well the characteristics of the options—the strike price and the expiration dates—corresponded to market expectations for future rates. In this regard, options on RPs with the Desk have a strong advantage over, say, options on Treasury yields because the policy rate over which the Committee has direct influence could be more directly linked to shorter term RPs than to longer-term Treasury yields. For these same reasons, options on Desk RPs could be structured to correspond directly with a policy commitment on the path of future short-term rates, and they could be effective through one of several channels. First, even a relatively small program would undoubtedly add symbolic weight. Second, they would represent a monetary cost to the Federal Reserve of deviating from the implied path of future short-term rates, which might be seen as further binding the Committee to that path. For this effect, the more options sold the better. Third, a large volume of options sold could reduce risk premiums embedded in longer-term rates, independent of the level of credibility about any policy commitment. Here too, the more sold the more effective. As with interest rate ceilings, the question could be asked how effective the sale of options, either on Desk RPs or Treasury securities, would by itself be in reducing longer-term yields. No doubt, an initial impact would be felt. But ultimate success would hinge on the quantity of options sold—that is, how big a bet the Federal Reserve were willing to make. The more options sold, the greater the chance they would have the desired effect on longer-term rates even if not associated with any policy commitment, either by raising the costs to the Fed associated with options being exercised, or by lowering risk premiums on longer-term rates. But of course the risks to the portfolio, to reserve levels, and of capital losses would rise in equal measure. And an exit strategy for options may not be as straightforward as it seems, even apart from the possibility of their being exercised. Of course, the Desk could stop auctioning new options at any time. But a decision to stop selling more options or not to issue new contracts with later expiration dates as time passes likely would be interpreted in the market as a statement about future policy intentions. The resulting rush to unwind market positions would likely be very disruptive and send yields sharply higher.
I' ll conclude by making a few summary observations, which are outlined in exhibit 11. In terms of our being able to achieve the narrow operating objectives that might be set for us, there seems little doubt that we could be successful, with the possible exception of explicit ceilings on longer-term Treasury yields. But many of these alternative approaches would have as an implicit intermediate objective a reduction in longer-term Treasury yields; and in the case of rate ceilings, this would be the explicit operating target. While our ability to change the composition and size of our domestic portfolio measured in absolute terms is undoubtedly huge, it is still questionable how sizable and durable an effect Desk operations alone would have on relative market-determined rates. As Vincent noted, however, changes in market expectations about future short-term policy rates can have a profound effect on longer-term yields without any adjustment to the central bank' s balance sheet. Such changes could be induced by a communications strategy to shape interest rate expectations. The tactical approaches I have described could very effectively reinforce some form of communication about the future stance of policy. For purposes of shaping market expectations about future short-term rates, however, it is unlikely that the adoption of any of these alternative operating approaches by themselves would be an adequate substitute for some clear communication coming from the Committee. Finally, all the approaches that I have described raise issues about exit strategies, coordination with Treasury debt management, and potential for capital losses, some of which I have mentioned. But in general, it seems that concerns associated with these issues would be greater if we were relying on changes in the composition and size of SOMA holdings to be the primary channel through which we were trying to influence longer-term yields. Thank you.
MR. REINHART. At this point, the staff is seeking guidance from the Committee on how to proceed. In particular, we will be listening especially intently to your discussion this afternoon for answers to the four questions highlighted in exhibit 9, the very last chart in my package. First, are there any alternatives that the Committee particularly favors for additional study? Second, are there any alternatives that should be dropped immediately from consideration? Third, how does the Committee assess the costs of very low nominal overnight interest rates, and are they such that an alternative policy should be put in place at a funds rate above zero? Finally, how should the Committee' s assessment of these policy alternatives be conveyed to the public in the months ahead?
CHAIRMAN GREENSPAN. Let me just say first that, combined with the supplemental memorandums you gentlemen have given us, you have covered the ground in an exceptionally comprehensive way. We have to be careful, though, not to try to lock in any particular strategy, largely because we don' t know how events will transpire under a number of different scenarios. If these become the types of policies that we must implement, I think we' re going to find that we will have to do a significant amount of decision making as we go along. …
The New York Fed reports on its website that the Federal Reserve does not engage in derivative transactions.
U.S. Foreign Exchange Intervention
In recent years, the Federal Reserve and the Treasury have made their interventions more transparent. Thus, the New York Fed often deals directly with many large interbank dealers simultaneously to buy and sell currencies in the spot exchange rate market. The Fed historically has not engaged in forward or other derivative transactions [This is a lie!]. The Treasury Secretary typically confirms U.S. intervention while the Fed is conducting the operation or shortly thereafter. Often, statements that reflect the official U.S. stance on its exchange rate policy accompany the Treasury's confirmation of intervention activity.
My reaction: I stumbled on this Fed transcript last night. I can' t believe the Federal Reserve published something so damning to itself!
1) The Federal Reserve sold options on repos in 1999 that totaled nearly $0.5 trillion of notional value.
2) According to the Federal Reserve' s website: The Fed historically has not engaged in forward or other derivative transactions. The Fed is lying!
3) Auctioning derivatives is something the Federal Reserve' s Trading Desk in 2003 already had experience doing.
4) In June 2003, The Federal Reserve was contemplating selling massive quantity of options sold to reduce risk premiums embedded in longer-term interest rates.
5) If the Federal Reserve did sell those options (and they probably did), the unwinding of the Fed' s derivative positions will likely be very disruptive and send yields sharply higher.
Conclusion: This is proof positive that the Federal Reserve has been abusing derivatives on a dangerous scale since at least 1999.