Atlanta, GA 7/17/12 (StreetBeat) -- I think the Fed wants to do something more that will stimulate the economy. Bernanke has probably seen enough to be convinced that aggregate demand is too slack to help the labor market. He will therefore want to do something to increase demand because he thinks that will in turn spur hiring. Inflation is trending down and the Fed’s favored measure of inflation, the PCE deflator, is below its target level, so concern on prices is not a deterrent to acting. If Bernanke is ready to move once again he will carry the day at the FOMC. If this assumption is correct, what will the Fed do next? The Fed funds are up against the zero bound, so they can’t go any further with that. But that numerical limit has not put a lid on their monetary policy creativity. Even as the Fed considers additional stimulus there are three ongoing programs in play. One is the guidance that the funds rate will be exceptionally low at least through late 2014. Also, at the most recent meeting in June the FOMC decided to continue Operation Twist through the end of the year and finally they are still reinvesting the principal payments from the housing related securities holdings back into new investments in that sort of paper.
Bernanke heads up to Capitol Hill this week in order to deliver the Fed’s semi-annual testimony on monetary policy and the economy. The chairman will not usurp the Committee when he speaks to Congress, so there will not be anything explicit in regards to future activity from the FOMC. But there is a good chance that he will describe the policy buffet table from which the policymakers will choose, should they decide they need to do more. He’s done this before and it’s worth noting the order in which he presents them, because that seems to matter.
Last July during this testimony Bernanke listed three items on the stimulus menu: 1) the Fed could “provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels.” 2) “initiate more securities purchases or to increase the average maturity of our holdings.” 3)”reduce the 25 basis point rate of interest it pays to banks on their reserves.”
Bernanke made these points on July 13, 2011. The FOMC next met on August 9; at which time they first offered the specific guidance on the funds rate, they would remain “exceptionally low” at least through mid-2013. Menu item number one was enacted at the first opportunity. The Fed met again on September 21. It was at this meeting that they initiated the so-called Operation Twist, the program that increases the average maturity of their Treasury position. And with that, menu item number two was served. It was a similar pattern the year before. When Bernanke spoke in late August 2010 at Jackson Hole, Wyoming he listed three items on the Fed’s tasting menu. First on that list was “conducting additional purchases of longer-term securities”; and sure enough QE2 was announced in November of that year. When it comes to the policy buffet table, the order in which the menu items are presented matters.
There is some thought that the Fed will once again include on the menu a reduction in the “interest on excess reserves”, the IOER. Bernanke mentioned this option in his Jackson Hole speech referenced above and in last summer’s semi-annual testimony; but each time it was the third option. He was somewhat dismissive of this strategy in his Jackson Hole speech for a variety of reasons including the possibility that it would disrupt the money and repo markets. He is not alone in his concern for the potential of unintended consequences from cutting IOER to zero. “Cutting interest on excess reserves is a hugely risky option for the Fed, and could do more damage than good (leading even to major systemic issues)” wrote FT Alphaville last September. “We’ve said as much, and now RBC Capital Markets makes the same argument too. But much more eloquently (dare we say). The main reason, of course, is that cutting IOER could wreak untold havoc in the money and repo markets. It’s all inter-related to things like the Treasury fail penalty brought in May 2009 and the FDIC fee, which brought in April 2011 (about the same time Bill Gross of Pimco started talking down and ‘shorting’ US Treasuries, a fact which eased repo market stresses—an interesting coincidence). As RBC Capital Market’s Michael Cloherty and Dan Grubert explain, all of these factors have led to a situation where Treasuries can now trade at a negative rate. Something not apparent for other markets (yet) because of there being no penalty systems in place there. In other markets if you come close to zero, you just fail instead,” says the FT blog. But the RBC team says, “There is a 0% floor on repo for everything except Treasuries, because the effective cost of failing to deliver a security is equivalent to borrowing that security a 0%. The floor on Treasury repo is -3% due to a 300bp fee for failing to deliver a Treasury. The repo floor puts a limit on how special specific securities (ex-Treasuries) can trade when general collateral rates fall: when GC is at 20 bps a security can trade up to 20 bps special, but if GC fall to 5 bps that issue can only trade a maximum of 5 bps special.” So, if the reduction in “IOER causes GC rate for non-Treasury repo to fall too low, then we are likely to see enough bondholders pull back on their lending to cause very large systemic fails,” says RBC. More fails, more counterparty risk, the more likely there is a hording of short-term Treasuries, possibly leading to negative yields. There is more to it than that, but that’s the gist of it. In any case it seems the equivalent of playing with fire.
Bernanke could also suggest another round of quantitative easing. He and others at the Fed have consistently mentioned this as a possibility when musing about what else they could do if something else was deemed to be necessary. If so then it would be a QE focused on the long-end; hard to see the logic for QE to buy the short end paper that Operation Twist is selling.
Besides it is the long-end that is the key to these programs anyway, that was the message delivered by NY Fed VP Brian Sack when he spoke to primary dealers last October 24. Sack was describing the purpose of Operation Twist and the importance of the 10 Year maturity in this strategy. “As has been discussed on many occasions, the effects of the asset purchase programs are thought to arise from the amount of duration risk that they remove from the portfolios of private investors. By removing duration risk, the Federal Reserve puts downward pressure on longer-term real interest rates, which in turn pulls down private borrowing costs and makes broader financial conditions more supportive of growth. The MEP (Maturity Extension Program, or Operation Twist) was intended to have the same effects, only under a program that did not involve an expansion of the Federal Reserve’s balance sheet. Duration risk can be measured in a variety of ways, but one common measure of a securities portfolio is ten-year equivalents, or the amount of 10-year Treasury notes that an investor would have to buy to be exposed to the same amount of duration risk contained in the portfolio. Some of the staff work that calibrates the economic impact of the Federal Reserve’s balance sheet policies assumes that the effects on yields and financial conditions are driven by the amount of ten-year equivalents that the Fed takes into its portfolio,” explained Sack, “By that metric, the effect of the Maturity Extension Program is about equal in size to that of the large-scale asset purchases program that ended in June of this year (what we have referred to as LSAP2). This fact was highlighted in a recent post to the Liberty Street Economics blog. In both cases, the effect of the program was to remove about $400 billion of 10-year equivalents from the market.”
The Liberty Street blog post from October 19, 2011 presented the purpose of the plan; “Under the portfolio balance view of these interventions, what matters is the amount of duration risk removed from the market. Duration can be thought of as a measure of the change in price of a security when interest rates change. When interest rates change, securities with higher duration, which also tend to have longer maturity, are subject to larger capital gains or losses than securities with less duration. Investors seek the additional return associated with duration risk for a variety of reasons. With the Federal Reserve buying longer-term securities and thus reducing the amount of duration risk available to the market, investors obtain duration risk by purchasing other securities. These portfolio adjustments should keep interest rates lower than they would otherwise be, not just on the securities being purchased, but also on other assets.”
Given that the purpose of these asset purchase plans is to reduce the duration risk at the 10-year horizon then it could be that at some point Bernanke suggests that the Fed utilize a strategy that he once called “a more direct method, which I personally prefer.” In his famous “Deflation” speech of November 21, 2002 Bernanke said he championed the idea that the Fed could “begin announcing explicit ceilings for yields on longer-maturity Treasury debt.” A commitment the Fed could enforce by committing to make unlimited purchases of the suggested maturity. Back then it was the two-year that he suggested, but with the current focus on the 10-year equivalents then maybe this would be the contemporary maturity of choice. This strategy may need a more urgent deflation fear than currently exists in order to be chosen, but at some point the Fed, specifically the chairman, will want to pursue a plan in which there is the most confidence; which I assume is why someone would describe it as the one “I personally prefer.” Theoretically the cap on the 10-year could actually be set above the current rate, say a two percent ceiling. That’s because it would seem that the important point is the amount of time that the cap would exist at a low rate rather than the rate itself. Maybe the Fed would keep the cap in place for as long as their commitment on the funds rate remains in place.
None of this sounds any good, but maybe there will be a tastier option when Bernanke displays the menu.
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