What Will The Fed Do?
Senior Editor, CNBC.com
The disappointing jobs numbers Friday were quickly met with a consensus view on Wall Street that it is very likely that the Federal Reserve will take some action intended to boost the economy. But it’s far from clear what that action would be. (Read more: Payrolls Rose Only 96,000 in August, Rate Hits 8.1%)
Last autumn, it seemed clear to many that the Fed was laying the groundwork for a new round of quantitative easing—QE3—that would see the Fed buying mortgage-backed securities. That could still be in the cards, although improvements in the housing market may make it less likely.
The Fed actually has a number of policy options it could pursue apart from buying mortgages or any other bonds. It could, for instance, make a stronger commitment to keeping rates low for a longer period than the market expects, hoping that would spur increased economic activity. (Read more: Probability of Fed Easing Above 50%: Hatzius)
The Federal Reserve believes that what it calls the “zero lower bound on nominal interest rates” limits its ability to reduce short-term interest rates. What that means is that since the Fed has already brought interest rates to near-zero on overnight borrowings in the Fed funds market, it cannot stimulate the economy by further lowering short-term rates.
Along with several other major central banks, including the Bank of England and the Bank of Japan, the Fed has developed “non-traditional” policy tools in an effort to provide stimulus, despite zero-interest-rate policies. These have included large scale asset purchases as well as the now familiar strategy of promising to keep rates low for an “extended period.”
The idea behind both these tactics—asset purchases and communicating Fed intentions—is to lower longer-term rates. It’s thought that the real economy typically is responsive to changes in long-term rates, so that lower long-term rates will result in easier financial conditions, stimulating economic activity and combating disinflation.
Last Friday in Jackson Hole, Wyoming, Fed Chairman Ben Bernanke gave a speech touting the effectiveness of “large scale asset purchases,” or LSAPs in FedSpeak. While noting that it is hard to “obtain precise estimates” about the effects of the Fed’s earlier rounds of quantitative easing, Bernanke said that there is “substantial evidence the Federal Reserve's asset purchases have lowered longer-term yields and eased broader financial conditions.”
According to Bernanke, the asset purchases work in two ways.
The Fed’s buying of longer-term Treasury bonds and agency-backed mortgage bonds lowers the supply of these instruments available to private investors. This pushes their prices up, lowering their yields. Bernanke says there is evidence that movements of the bonds that the Fed buys ripple out to the rest of the market, pushing corporate bond yields lower and stock prices higher. The former makes financing new business activity through debt less expensive. The latter may create a wealth effect—investors see themselves as better off—that triggers new consumption and encourages further investment. (Read more: Market Sees 'Helicopter Ben' Coming to the Rescue)
That sounds like a pretty ringing endorsement of asset purchases.
But this doesn’t mean we should rush to the conclusion that the Fed will definitely launch a new round of large-scale asset purchases.
There are good reasons to suspect that the Fed may try something different this time.
When the Fed first announced that it would buy agency debt (that is, debt issued by Fannie Mae and Freddie Mac) and agency mortgage-backed securities in November 2008, the rate on the 30-year fixed-rate mortgage was 6.69 percent. Last year, when the Fed started hinting at another round of buying mortgages, the rate was above 4 percent.
Today, the 30-year is down to 3.55 percent. Meanwhile, home prices in a majority of major U.S. markets are rising once again. This may mean that the effectiveness of a Fed mortgage-buying program could be quite limited. Rates likely won’t fall too much further and home prices don’t seem to need the stimulus they once did.
What’s more, the Fed already owns a tremendous portion of the mortgage market. Credit Suisse analysts pointed this out in a note last fall:
“The Fed currently owns roughly 15% of all Agency MBS, and just over 20% of fixed-rate conventional pass-throughs. If the Fed were to buy $500B of MBS as part of QE3, the numbers would jump to 25% and 34%, respectively,” Credit Suisse wrote.
The Fed is worried that owning too much of the agency mortgage market could create distortions and liquidity problems. Especially in an era when capital adequacy requirements on risk assets at banks are rising, having the Fed’s position grow too large could create unintended strains.
“Conceivably, if the Federal Reserve became too dominant a buyer in certain segments of these markets, trading among private agents could dry up, degrading liquidity and price discovery,” Bernanke noted in his Jackson Hole speech.
Another possible tactic the Fed could pursue, perhaps alongside a mortgage bond program, would be an extension of what’s known as Operation Twist but is officially called the “Maturity Extension Program.” Under this program, the Fed bought $400 billion of long-term Treasury bonds and sold the equivalent amount of short term bonds.
Operation Twist, launched about a year ago, was originally supposed to end this June but was later extended until the end of this year. The Fed could announce that the program will continue for an even longer period. Bernanke has described the effects of the Twist as “economically meaningful.”
Not everyone agrees that Operation Twist has had that great an effect. The program doesn’t expand the Fed’s balance sheet—it just adjusts the maturity of its holdings and therefore of the private sector's holdings. It is a form of credit easing but not really a quantitative easing—the quantities of securities or dollars both at the Fed and in the private sector don’t change.
Twisting again also would run into obstacles similar to those the Fed faces in the mortgage channel. Interest rates are already at 50 year lows, with the 10-year now yielding just about 1.5 percent. And increased Fed ownership of long-term Treasury bonds could create liquidity problems.
But even if the direct effects would be limited, the Fed could announce a program to buy mortgages or an extension of Twist as part of a communication strategy. The purchases could be used as a way of showing the market that the Fed is very serious about aiding the economy and willing to expand its balance sheet in pursuit of economic stimulus.
In his speech in Jackson Hole, Bernanke noted that LSAPs “can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors' expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms.”
Columbia University professor Michael Woodford delivered a mammoth 97 page paper at the Jackson Hole conference arguing that the Fed should focus on communication strategy directly. His paper, which many folks think may influence Fed policy makers, argued that the Fed should commit to keeping short-term interest rates low for an extended period—even if inflation and other indicators might otherwise call for raising rates. One way to do this would be for the Fed to announce that it was targeting nominal gross domestic product growth and would keep interest rates low until the economy is performing at its full potential.
“The point of a nominal GDP target to Mike [Prof. Woodford] is this: When and if inflation breaks out (which raises nominal GDP) or (let's hope) real GDP starts growing again, the Fed, following the usual Taylor rule linking interest rates to GDP growth or inflation, would normally raise rates. If the Fed instead changes to a nominal GDP target, then the Fed will not raise rates, until the cumulative inflation or real growth brings us back to the dashed line. Then, and only then, will the Fed raise rates,” according to University of Chicago Booth School of Business professor John Cochrane. (Cochrane says he agrees with 99 percent of the paper.)
The main obstacle to this approach is one of credibility. The Fed has spent decades building its reputation as an inflation fighter. It's not at all clear that markets will believe that the Fed would tolerate unexpectedly high inflation shocks—regardless of what the Fed says about its policy. What’s more, the political pressure brought to bear on a Fed that announced it was going to ignore inflation could be enormous—and perhaps even result in a challenge to the Fed’s independence.
At the very least, we’d be in unknown territory. Historical models predicting Fed actions would forecast one thing, while untested models based on the Fed’s statements would say another. Politicians worried about the Fed “debasing the dollar” would be hoisting pitchforks on Capitol Hill. This uncertainty alone could undermine the intended effects of NGDP targeting.
Woodford’s paper argues that NGDP targeting would work best—if at all—if coordinated with fiscal policy. That is, the Treasury would have to borrow money, Congress would have to spend it, and the Fed would buy the debt. That kind of coordination seems—at least, prior to Election Day—very unlikely. Certainly that’s not what we’ll hear about when the Fed meets next.
So the Fed’s options include providing stronger forward guidance about the direction of policy rates, extending the MEP-Twist well into next year, and buying mortgage-backed securities. Since the latter two options will likely have limited direct effect, I suspect we’ll see some combination of all three programs aimed at effectively communicating a Fed commitment to stimulating the economy.
by CNBC.com senior editor John Carney
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