Fed should focus on mortgage buys, sell Treasuries: study
The Federal Reserve should concentrate its unconventional monetary stimulus on mortgage asset purchases, according to a new study released on Friday, ditching Treasury bond buys which the authors say have not had much of an effect.
Presented at the Kansas City Fed's annual Jackson Hole conference, the paper argues rather controversially that the central bank should begin its exit strategy by selling Treasuries, something that is hard to conceive given the recent speedy selloff in government bonds.
The authors of the study say that the absence of concrete guidance as to the goal of asset purchases—vaguely defined as aimed toward substantial improvement in the outlook for the labor market—neutralizes their impact and complicates an eventual exit. The paper's authors are Arvind Krishnamurthy of Northwestern University and Annette Vissing-Jorgensen of University of California, Berkeley.
"Without such a framework, investors do not know the conditions under which (asset buys) will occur or be unwound, which undercuts the efficacy of policy targeted at long-term asset values," the authors write.
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Minutes from the Fed's July meeting, released on Wednesday, suggested policymakers had already considered such a step but, for now, decided against it.
"The Committee also considered whether to add more information concerning the contingent outlook for asset purchases to the policy statement, but judged that doing so might prompt an unwarranted shift in market expectations regarding asset purchases," the minutes said.
The authors of the study say the effects of the U.S. central bank's asset purchases, which began after the Fed had already brought official interest rates down in late 2008, are much narrower than policymakers' had foreseen.
Predictably, current and former Fed officials took issue with the findings. James Bullard, president of the St. Louis Fed, said the authors' focus on market impact immediately following policy announcements was misleading.
"I just wanted to push back against this conclusion that you get an effect in one single market and then there's not that much (impact) over a variety of assets," Bullard said.
Donald Kohn, former Fed Vice Chair, was also skeptical.
"The findings do not comport very well with the experience of the last couple of months," said Kohn.
Another former Fed vice chair, Alan Blinder, was even more blunt regarding the idea that Treasury sales would not have a major market impact: "You don't want to retract that given what happened recently?"
U.S. Treasury 10-year note yields have risen sharply in the last two months to two-year highs above 2.80 percent following hints from the central bank that it may begin winding down its asset-buying stimulus program, also known as quantitative easing.
In particular, Fed Chairman Ben Bernanke and others have argued that asset purchases work by taking safe assets out of the market and therefore forcing cautious investors to take more risk. In official parlance, this is known as the "portfolio balance effect," affecting rates in markets well beyond those targeted by the Fed.
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The impact of asset buying is a lot narrower than Fed officials contend, according to the authors of the paper.
"It does not, as the Fed proposes, work through broad channels such as affecting the term premium on all long-term bonds," the paper finds.
Instead, mortgage-buying has been more effective because, by targeting a specific sector that was under duress, Fed officials have been able to create scarcity of supply in the mortgage market, leading prices—and therefore credit availability—to rise.
"We find that (mortgage purchases) are more economically beneficial than Treasury (buying)," the authors write.
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Recently, Fed officials have worried that excess risk-taking may have gone a step too far, potentially leading to dangerous asset bubbles—hence all the talk of a 'tapering' in quantitative easing.
In response to the worst recession in generations, the Fed has left official rates effectively at zero for over four years, and is on track to buy over $3 trillion in assets in an effort to support still-weak growth.
The U.S. economy expanded at an annualized 1.7 percent rate in the second quarter, while the jobless rate remains at an elevated 7.4 percent.