On the flip side, the U.S. money supply more than doubled in 2009, and this increase was greater than the increases in our money supply in aggregate over the past 50 years. This massive additional supply will eventually significantly raise inflation. When this occurs, it will impact the timing of the Fed’s response.
The Federal Reserve has addressed the financial market turmoil of the past two years, in part, by greatly expanding its balance sheet and by supplying an unprecedented volume of reserves to the banking system. The Fed’s balance sheet had grown to approximately $2.2 trillion as 2009 ended. Its total portfolio of loans and securities has more than doubled since the beginning of the financial crisis. The Fed’s exit strategy will have profound implications for commercial real estate. In theory, the Fed has four strategies for “exiting” their current, highly accommodative stance.
The first is terminating the current program of asset purchases. The Fed now holds $910.43 billion in mortgage-backed securities and is on its way toward a goal of $1.25 trillion, which was part of the central bank’s efforts to fight the downturn. This program is scheduled to end in March.
The second is draining excess bank reserves through reverse repos and/or term-deposit facilities. The Fed is already testing this strategy of reverse repurchase agreements, in which the central bank sells securities from its portfolio with an agreement to buy them back later. Under this arrangement, the buyers move cash from banks to the Fed, removing reserves from the system. Term deposits are roughly analogous to the certificates of deposit that banks offer to their customers. Under this strategy, the Fed would issue term deposits to banks, potentially at several maturities up to one year. This would encourage banks to park reserves at the Fed rather than lending them out. This removal of money from the lending stream has obvious implications for commercial real estate.
The third strategy is hiking short-term interest rates via parallel increases in the federal-funds rate and the interest rate on reserves. This is the most commonly used monetary policy lever utilized by the Fed.
The fourth is simply the outright selling of assets.
The Fed has indicated that the testing of, and discussion about, these strategies has no implications for monetary policy decisions in the near term. This year, the main form of exit is likely to be an end to asset purchases. Fed officials will likely drain some excess reserves, mainly to prove to market participants that the Fed is capable of doing so. When it decides to tighten in earnest, it would probably use the term-deposits program ahead of or in conjunction with its traditional policy tool, the target for the federal-funds rate at which banks lend to each other overnight.
Draining reserves from the system has clear implications for the commercial real estate debt market, as the cash available for mortgages will shrink, further constraining an already dry market. Additionally, the cost of real estate debt available will likely increase as the federal-funds rate increases. This will be a key mechanism to watch when tightening occurs.
How will lenders react when their borrowing rates are increased? Present monetary policy is allowing for the recapitalization of the banking industry, as banks are borrowing at close to zero and are lending or investing at rates significantly higher. The Fed’s accommodative policy is actually reducing incentives for banks to lend, as they can invest borrowed money in risk-free treasuries, making substantial spreads (profits), rather than make risky loans. An increase in the federal-funds rate might, therefore, actually increase the supply of dollars available to the debt market.
