Ramble on the FOMC

Oxford, MS 9/21/2011 (PennyPayDay) – Most observers figure that on Wednesday the FOMC will announce that they are going to utilize additional tools to further ease monetary policy. The most popular assumption appears to be a modern version of the sixties classic “Operation Twist”; the program that has a number one with a bullet name, but likely no better than B-side prospects. This involves selling shorter-term debt out of the Fed portfolio and using the proceeds to buy the long end. There is also some thought that the Fed will lower the interest they pay the banks on the excess reserves held at the Fed, in order to encourage the banks to loan more of the money that the Fed has already made available. Since the Fed extended this week’s meeting by a day solely to discuss the cost and benefits of the various potential tools that could be useful, it is likely they will do something. What is also likely is that not everyone on the policy Committee will walk away happy.

At their August policy meeting the FOMC pre-committed on the future path of the Fed funds rate. Their post meeting statement said that economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” That strategy was just one of many that they discussed, the others, in the order they were mentioned in the meeting minutes, included: “additional asset purchases”; “increasing the average maturity of the System’s portfolio” by following a method used in operation twist so as not to increase the Fed balance sheet; and reducing the interest paid on excess reserves. The pre-commitment was the only new strategy wrinkle, but that appeared to be a compromise. A few members wanted to do even more stimulus at the August meeting because the economy was deteriorating but three other members thought that the pre-commitment was too much because additional stimulus risked inflation without assuring it would help output or employment. So they decided to take extra time at the next meeting to figure out their next move.

Both sides of the argument were provided additional ammunition in the interim. For instance, the employment situation looks to have worsened, but the latest inflation data was hotter than expected. But the first among equals on the Committee, Chairman Bernanke, did not sound as though he thinks the Fed is done tinkering when he spoke a couple of weeks ago in Minnesota. Not only did he reiterate that the recovery stinks (I paraphrase) and the risks to the outlook are on the downside, but that inflation is likely to moderate in coming quarters. He also stressed the “unusual weakness in household spending” and that “even taking into account the many financial pressures they face, households seem exceptionally cautious.” The September report on consumer sentiment from the University of Michigan, which came out a few days after that speech, was a slight improvement from August for the headline index. But the report reinforced Bernanke’s perception of the consumer when it said, “when asked about prospects for the year ahead, just 17% expected their finances to improve in early September, the lowest figure ever recorded” in the sixty year history of the survey. Add to this the heightened potential for financial system contagion emanating from Europe and it is unlikely that Bernanke will not deliver something on Wednesday.

So what will be the result of the meeting? It seems as though no matter what they do the Fed will have to sell the sizzle because neither of the anticipated options appear to be a prime cut of steak.

If the Fed cuts the interest they pay on the excess reserves, will that be enough to get the banks to loan out more money? There seems to be as much of a problem with demand as there is with the banks being too restrictive, so the chances of this move being a game changer are slim. Additionally, there is the some thought that the huge pile of excess reserves is acting as a “rainy day fund” for the banking system that they may not be ready to give up and also the Fed may not want for them to be caught unprepared should something hit the fan in Athens or Rome. Back in February, before the US economy took a turn for the worse and European debt still seemed like a problem that could be pushed down a multi-year road, the St. Louis Fed economist Silvio Contessi wrote in Monetary Trends about the security blanket aspect to the excess reserves. “Analysis of the cross-sectional data suggests that some banks may be maintaining such large reserve positions as a precautionary hedge in an uncertain environment. Many banks, especially smaller ones, likely recall the autumn of 2008 when repurchase agreement (repo) markets closed and, absent Federal Reserve actions, liquidity was unavailable at any price. As long as the strength of the recovery remains uncertain, there are few other investment opportunities, after adjusting for risk and taxes, with anticipated returns greater than the near-zero interest the Federal Reserve pays on deposits.” Last week the ECB, in conjunction with other central banks, enhanced the dollar liquidity facility that was originally conceived of during the stressful time that Contessi referred to; although last week’s move was intended to ease the strain in funding markets, the fact that it was necessary may make the Fed think twice about changing the status quo of excess reserves at this time.

So the idea behind Bernanke’s Operation Twist (OT) is that very low long-term interest rates will inspire investment in ways that he imagined would be the case with QE2, the basis of which he expressed in the Washington Post last November. As a matter of fact, OT is sort of QE on the cheap; the Fed pays for long-end paper by selling the short stuff they already have on their books; don’t even need the change in the sofa cushion to accomplish the task. San Francisco Fed researchers compared the 1961 version of OT to the QE2 program in an Economic Letter in April. “In many respects, Operation Twist was similar to the Federal Reserve’s recently announced program of Treasury purchases, dubbed ‘QE2’ by the financial press. First, both programs aimed to lower longer-term interest rates without lowering short-term rates. In the case of Operation Twist, the program sought to prevent further gold outflows. In the case of QE2, lowering short-term rates was not an option because the federal funds rate had already been reduced to its lower bound of essentially zero. Second, both programs involved purchasing large quantities of longer-term Treasury securities. And third, both programs financed those purchases by selling or issuing short-term government liabilities. During Operation Twist, the Fed sold off some of its holdings of short-term Treasury bills. During QE2, it issued bank reserves, which are nearly identical to Treasury bills in that both are short-term liabilities of government agencies—the Federal Reserve in the case of bank reserves and the Treasury in the case of Treasury bills.”

Hmmm. The best that can be said of QE2 is that the economy may have been worse off had it not existed; that may be true, but that’s a bit tricky to prove. What we can say is that the GDP growth was below one percent during the quarters that QE2 was underway, the labor market did not find its footing and is again deteriorating, housing is still in a depression and, although the stock market rallied during the process, the SP 500 is now trading exactly where it was when the program began early last November. Therefore, it seems to me that by pursuing OT Bernanke is hoping for a different outcome from a similar strategy that he tried last year, that has not turned the economy onto a consistent growth trajectory. The debt overhang is likely to thwart any Fed policy from real success, but that will not prevent Bernanke from doing all that he can to help with the recovery process; but does he really want to circle the same block again only to end up where he started, again.

With that in mind it could be that Bernanke will feel the need to enhance OT so that its effect will not be as fleeting as was QE2, at least in his judgment. It could be that he will attach a duration component to OT in the same manner that he pre-committed to the future path of the funds rate. In other words saying that the Fed will be the bid in the long-end of the Treasury market for the next year or so, given certain, but unspecified economic data thresholds; maybe creating an unofficial, but evident, ceiling on long-end yields. In his famous deflation speech of November 2002 he said there were “at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination.” The first approach was the pre-commitment on the fed funds rate, which the Fed instituted in August. The second part of the combo, which he said was his preference, was to announce an explicit ceiling for yields on longer-maturity Treasury debt. This is something that could be done, or at least intended to be done, by pursuing an OT strategy that has a time component attached to it. Fed Vice Chairperson Yellen is on board with the idea that communicating a forward commitment on policy duration is an important component of monetary policy. In a speech she gave in February she noted, “In particular, financial conditions depend on market expectations not only concerning the amount of the FOMC’s purchases but also concerning the anticipated timing and pace of the eventual unwinding of those holdings.”

In a nut shell, I think it is possible that if the Fed goes to OT today they will attach to it some sort of duration component, in coordination with the pre-commitment on the Fed funds rate that they put in place at their last meeting.

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