Exit Strategy, Part One: ZIRP

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By Perry G. Mehrling, Professor of Economics at Barnard. Originally published at his website

The Fed has announced plans to raise rates in the imminent future, but the market does not believe it.  Why not?  Conventional wisdom appears to be that the Fed will chicken out, just as it did during the so-called Taper Tantrum.  The Fed has signaled its appreciation that “liftoff” will involve increased volatility, and has stated its resolve this time simply to let that volatility happen, but markets don’t believe it.

I want to suggest a slightly different source of disconnect, concerning expectations about what exactly will happen in the monetary plumbing when the Fed raises rates.  Case in point is the recent Credit Suisse memo, apparently the first of a series, that forecasts “a much larger RRP facility–think north of a trillion” whereas the FOMC itself “expects that it will be appropriate to reduce the capacity of the [RRP] facility soon after it commences policy firming”.  That’s a pretty big disconnect.

Pozsar and Sweeney (authors of the CS memo) think about the exit from ZIRP (Zero Interest Rate Policy) from the perspective of wholesale money demand, which they insist is “a structural feature of the system” and “the dominant source of funding in the US money market”.  Before the crisis, that money demand was funding the shadow banking system, largely through the intermediation of repo dealer balance sheets.  Now, it is funding the Fed’s balance sheet, largely through the intermediation of prime money funds and US bank balance sheets, both of which issue money-like liabilities and invest the proceeds in excess reserves held at the Fed.

The big problem that now looms is that neither prime money funds nor banks want that business any more.  Capital regulations have made the bank side of the business unprofitable, and looming requirements that prime money funds mark to market (so-called floating NAV rather than constant NAV) will force them out of the business as well.  Where is that money demand going to go?  Pozsar and Sweeney say it will go directly to the Fed, causing the swelling of the Reverse Repo Facility pari passu with the shrinking of excess reserves.  The mechanism will be a shift from prime money funds and bank deposits into government-only money funds, which will absorb the flow by accumulating RRP.

In other words, the Fed will not be able to shrink its balance sheet as part of this first stage of exit from quantitative easing.  It will only be able to shift the way that balance sheet is funded–much less excess reserves held by banks, much more RRP held by government-only money funds.  Nevertheless, because this shift will allow the Fed to regain control over the Fed Funds rate, it will accept that consequence.  Exit from ZIRP comes before exit from QE.

Are you with me so far?  If not, I urge you to have a look at Exhibits 1, 3, and 6 in the P&S memo.  All I have done is to translate them into English.

I have some quibbles with details of the memo, but they do not concern the central point up to this point.  One difference however is important for what comes next.  Unlike P&S, I would not describe the shift from pre-crisis to post-crisis as involving shrinking the shadow banking system and growing the traditional banking system, as they do on p. 3.  I would rather point out that the Fed itself took a sizeable chunk of the shadow banking system onto its own balance sheet.  Reserve liability funding of RMBS lending=money market funding of capital market lending, which is my definition of shadow banking, as also theirs.  Why does this matter?

Suppose everything happens just as they anticipate.  What then?  What then is that there will be two policy rates in the system, not one.  The Fed Funds rate is the rate for the traditional banking system, and the RRP rate is the rate for the market-based credit system, at least for that fraction of the market-based credit system that sits on the balance sheet of the Fed.  From this standpoint, what would eventual exit look like?  Eventual exit would involve the Fed shedding its own shadow bank-like exposures.

How can that happen?  Maybe first the Fed steps back from being money dealer of first resort and serves only as money dealer of last resort.  In practical terms that means that it makes the outside spread, not the inside spread.  And that means that it must offer an RRP rate that is below private wholesale money rates, indeed far enough below that wholesale money demand will shift over to funding private issue.  Only than can the Fed take the second step, terming out its own funding or, more reasonably, packaging its long term assets into a special facility that is funded separately.  Only then could RRP shrink, and with it the size of the entire balance sheet.

This seems to me a plausible road to exit (with one pretty big but not insurmountable obstacle, namely capital losses on the assets).  Is that maybe what the Fed has in mind?

This way of thinking may shed light also on the disconnect between the Fed interest forecast and the market interest forecast that we mentioned at the top.  Possibly that difference is not so much about market expectations that the Fed will chicken out, and more about an expected increasing divergence between IOER and other money market rates.  P&S Exhibit 4 shows plainly that the Fed’s RRP rate has provided a floor while IOER has provided a ceiling; Fed Funds effective has been in the middle.   The market thinks that IOER can go up with no consequences for other money market rates.  Even worse, the market thinks that there are trillions of money funding about to be released from bank deposits and prime money funds, which if anything will be driving wholesale money rates down, not up.

For me, the money quote from P&S is the following, from p.2:

“The untold story behind the changes in the money market since 2008 is policymakers’ struggle to find a permanent home for the money demand of cash pools in a financially stable manner that is also consistent with control over short-term interest rates.”


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      1. Demeter


        I fail to see how any of this financial engineering will be an improvement…it’s a game of Hot Potato, the loser is burnt while the swift get out of the way.

    1. financial matters


      “What are the overnight reverse repurchase agreements (ON RRPs) conducted by the Desk?

      The Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York (New York Fed) is responsible for conducting open market operations under the authorization and direction of the Federal Open Market Committee (FOMC). A reverse repurchase agreement, also called a “reverse repo” or “RRP,” is an open market operation in which the Desk sells a security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the cash invested by the RRP counterparty.”


      This is a safe way for the Fed to fund money market funds rather than having these funds participate in tri-party repo/shadow banking.

      1. washunate

        Interesting usage of the word safe!

        What is the policy justification for why the public should be responsible for funding private accounts of affluent investors?

        1. MyLessThanPrimeBeef

          Maybe we can bundle individual money market funds (up to some limits for each) for the Fed to purchase?

        2. financial matters

          I was thinking of safe in terms of trying to prevent the money market run we had after Reserve Primary Fund broke the buck in 2008 due to tri-party repo involving Lehman.

          This would allow small savers, anyone who had a few hundred dollars set aside for example, from being exposed (exploited) by this activity.

          I think it would be useful to have a safe saving system for anyone who wants to save as opposed to invest.

          1. washunate

            I guess I’m not following what helping small savers has to do with money market funds? I’m not opposed to helping out small savers.

            If you have a few hundred dollars saved up and your primary interest is preservation of capital while maintaining liquidity, that’s what an FDIC insured demand deposit account at your local banking institution is for. Or if you don’t need guaranteed liquidity, open an online savings account. For example:


    2. Chauncey Gardiner

      If you’re so inclined, you can track the Fed’s Reverse Repo (RRP) rate and outstanding total balance daily here:

      I am following the rise in long-term rates that has been underway since early February while the RRP rate has been held steady as a rock at 5bp. Will be interesting to see if they’re just padding the banksters’ net interest margin, or if the Yellen Fed has the political courage to break the long term trend resistance line that has been in place since Volcker passed the reins to Greenspan in 1987.

  1. financial matters

    I like the idea of the Fed using its ‘money printing’ power to fund money market funds. By funding I mean giving these savers (I don’t think people who park their money in money market funds should be considered investors) a guaranteed interest rate of around 3%.

    Right now money market funds participate in the myriad shadow banking system. I think its good that this funding is proving more difficult than just giving money market savers 0.5% interest. This funding should seek out investors who are compensated for their risk.

      1. MyLessThanPrimeBeef

        By guaranteeing 3% money market funds (perhaps up to a certain limits), so that money doesn’t participate in shadow banking system, and the broad public can benefit from this, is something worth thinking about and to be weighed versus, that as you say, the idea that it is privatizing gains and socializing losses, Do we get a net plus?

  2. washunate

    The very concept of an exit strategy is intriguing. We have been approaching ZIRP for decades; not in a straight line of course, but rather over time. An exit implies this isn’t being done on purpose, as if policy makers desire some state other than the long, slow, methodical looting process of stagflation.

  3. RN

    I think the only possible exit strategy is to shift to fiscal policy. I think at least one of the two presidential contenders will be forced to commit at least 750 B / year “additional” deficit on “public infrastructure” spending. FIscal stimulus is the only way big buisnesses can now increase their profitability. So tea partiers and aust(e)rians will be forced to tow the line. I will not be surprised, even if the republican nominee supports additional fiscal stimulus.

    1. washunate

      Isn’t that what we’ve been doing? In just the 21st century, we have net deficit spent some $12 trillion. That’s an average annual increase of about $860 billion. Both parties have occupied the Presidency, the House, and the Senate during that time period. Plus we’ve taken on completely new future liabilities, like the housing bailouts that transferred private debt to the public sector.

    2. MyLessThanPrimeBeef

      Tea partiers will be against the only way big business can now increase their profitability? Are we for big business to increase their profitability?

      Is shifting military/surveillance spending to infrastructure spending, in equal amounts, not fiscally stimulating? Is that merely fiscally neutral?

      Should we spend more on infrastructure than we reduce military spending – that’s one way. More likely, we will keep the same or increase military spending while we hope for/fight for more infrastructure/social spending. That will be fiscally stimulating. That also ignores the global nature of our money and our military spending fiscally. as many abroad say of Americans.

      Until we demonstrate we can take on the Military Industrial Complex, we should be prudent about more fiscal spending.

      As a first step, let’s try something fiscally neutral, like simply shifting drone spending to, say, social security.

  4. Christer Kamb

    It is really telling that market-actors views the consequences differently. During the built-up of the excess-reserves in the crises 2008-09 FED wasn´t sure how to set the i.e IOER(yes FED were behind the short-end). I guess it´s even harder today when raising rates. It´s seems easier to lower than raising rates when not being in full control. Well, that´s always the case isn´t it! Also easier to expand credit(especially during disinflation) than deleverage. In normal credit-cycles money-demand/supply(M2) increase pretty fast after a recession. This time things go slower(larger cycle-level!). Much slower and debts were much higher going into next business-cycle. A cycle that now seems to have reached a top again since 2007?

    In Europe centralbanks have negative deposit-rates(i.e bringing government bonds towards zero-rates and below). If inflation is coming back or if a normalization is wanted I guess raising repo-rates would not raise reserves “again” since “IOER” rates are far lower than “FF/repo-rates” in Europe. Normally this is not wanted if they want to curb lending. But that´s probably not the case in the latter situation. It´s a little different in the US were the IOER is higher than FF/RRP. If FED wants to curb lending they(must also)normally raise the IOER. But today this is not the case as I understand. On the contrary(except maybe i.e subprimes in students/autos). Instead new capital-rules(Basel) means shrinking banks balance-sheets(and reserves). Not to mention a new recession around the corner.

    The market always have to park money somewhere. It is said there is a lack of liquidy in some money- and capitalmarkets(velocity shrinking). But on the other hand too much hiding on CB balance-sheets/excess-reserves, other “risk-free” assets and real estate. It is not a surprise we have a transmission-problem at hand. I agree CB have to postpone QE-exits.

    Some people say government bond-yields will shoot up dramatically(all durations) due to coming defaults worldwide and too low yields (c.p). That means more excess-liquidy have to be parked! Not to mention capital-inflows from abroad by the same reasons and dollar debt-deleverage(dollar safehaven). Private paper have to pick up the slack and a risk of a stockmarket bubble(bubble-transmission) like the late 1920´s putting FED in situation pressed to prick the bubble through rate increases? Another dilemma coming for the FED? Forced to expand it´s balance-sheet further? I think the FED won´t raise rates as a step towards normalization or because of inflation-expectations anytime soon. Hope I am wrong though.

    ps! I don´t understand why FED abolished M3 against MZM. How to follow, as an market outsider, the biggest money-(repo-)market and the large institutional money(volume and velocity)?

  5. Peter Pan

    I suspect that ZIRPxit and/or QExit will have the proverbial malarkey hitting the wind machine. Either the Fed will blink and reverse course or there will be another fiscal bailout. I find it difficult to envision an exit without a huge cost to financial assets and/or over-valuation of the $USD that harms US export trade. Either way, say goodbye to US jobs with or without the TPP (although I suspect the TPP would amplify the consequences).

  6. Older & Wiser


    That’s not the (perceived) problem because the strategy is to kill the tiger while riding it…

    The problem is that, as much as the Fed wants to kill the bloody tiger (of their own making, mind you) the instant it takes one of its hands off to grab its 9 mm, instantly you are 100% right and the Fed finds itself belly up with the tiger on top… and the world’s monetary and financial system blows up in small pieces.

    In this analogy, one of the possible 9 mm guns is banning cash for good.
    Think it through my friend.

    At any rate Tom, I agree with you in that this MONSTER experiment will necessarily end very very very badly.
    “This is not good, this is not good”…

  7. phichibe


    Interesting post. I’m going to have to re-read this a couple of times to get the ramifications. Thanks for calling it to our attention.

    This may be unrelated, but I’ve been hoping to get your thoughts on some remarks by Richard Koo, who gave a presentation in 2014 that maintained the Fed would have a very difficult time unwinding QE due to poor choices made in how it was implemented. Here’s the YT link


    Koo says that there are going to BIG problems. I’m not qualified to assess his claims but he’s been credited by many as one of the few economists to predict/understand the “balance-sheet” recession we seem to be stuck in. Cause for worry or not?



    1. Older & Wiser

      An important part of the (supposed) “balance-sheet” recession can be found outside the US.
      Actually, it’s an arch-famous debt-deflation-liquidity trap, both inside and outside the US.
      But, unfortunately, analysis is mostly US-centric, for good reasons.
      The first one being the (perceived) ‘American exceptionalism’ which, mind you, has gotten us where we are.
      The Fed should not be in charge of monetary policy, establish the price of “money”, etc.
      Well, here we go again: it’s not even “money” as dollars have no store of value per se.
      Dollars are just legal units of account and means of payment, i.e., currency (not ‘money’).
      Dollars are just IOU’s against future US GDP, nothing worthwhile for a world reserve ‘currency’.
      Since the 70s-80s Made in USA products can be seen practically nowhere outside the US.
      So dollars should be good only for transactions within US borders, not anywhere else (or for paying US taxes…)
      But the US takes chronic trade and fiscal deficits as ‘business as usual’.
      Well, they should not be.
      The rest of the world also has its enormus debts to service, which will go sour as soon as rates rise.
      These debts are arithmetically unpayable at anything above 1% p.a.
      So, rates can’t rise, can they ?
      So what’s the solution to this MONSTER experiment ?
      How can this HUGE MESS be unwound ?
      Ron Paul has had the solution long ago: “End The Fed”

  8. Gaylord

    Exhibit 4 looks like a hospital ICU display scope with the patient in critical condition.

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