Fed Portfolio Manager: Preparing for QE Ad Infinitum -- Don't Expect Any More Big Bang Announcements

Today, Brian Sack, manager of the Fed's System Open Market Account (the SOMA--or, the world's largest hedge fund), remarked on the Fed's resumption of Treasury purchases (so-called QE Lite) and the prospects for full-fledged QE 2.0. Two things to take away:

1) QE Lite purchases will increase slightly to $30 billion per month (up from $27 billion for mid-Sep to mid-Oct). (Don't be surprised for the last two weeks of October before the election to be especially front loaded with risk-market-juicing cash injections.) This is no surprise as mortgage rates continue to break records to the downside and refis continue unabated.

Chart courtesy of Consumer Metrics Institute

2) Reading between the lines, QE 2.0 is virtually guaranteed to be announced at the FOMC's Nov 3 meeting; however, there could be major changes in the FOMC's approach to establishing and communicating future QE policy. Sack proposes five questions for the Committee to consider inasmuch as it is de facto targeting the Fed's balance sheet size similarly to how it (used to) target the Fed Funds rate. From his speech:

Designing a Purchase Program

If the FOMC were to move forward with an expansion of the balance sheet, it would presumably want to take into consideration the perspective gained from the asset purchases conducted from late 2008 to early 2010. The FOMC would have to decide the extent to which a new purchase program would follow the approach from the earlier round of purchases.

An alternative approach would be to design a purchase program that shares more of the features of the FOMC’s adjustment of the federal funds rate in normal times. After all, adjustments to the balance sheet are in many respects a substitute for changes in the federal funds rate. Both instruments attempt to influence broader financial conditions in order to achieve a desired economic outcome. However, the way in which the FOMC implemented asset purchases differed in important ways from the manner in which it has historically adjusted the federal funds rate. With this contrast in mind, I raise a set of policy questions that could be considered in designing a purchase program.

First, should the balance sheet be adjusted in relatively continuous but smaller steps, or in infrequent but large increments? The earlier round of asset purchases involved the latter approach, which caused the market response to be concentrated in several days on which significant announcements were made. That might have been appropriate in circumstances when substantial and front-loaded policy surprises had benefits, but different approaches may be warranted in other circumstances. Indeed, it contrasts with the manner in which the FOMC has historically adjusted the federal funds rate, which has typically involved incremental changes to the policy instrument.

Second, how responsive should the balance sheet be to economic conditions? Historically, the FOMC has determined the federal funds target rate based on the Committee’s assessment of the outlook for economic growth and inflation. If changes in the balance sheet are now acting as a substitute for changes in the federal funds rate, then one might expect balance sheet decisions to also be governed to a large extent by the evolution of the FOMC’s economic forecasts. The earlier purchase program, in contrast, did not demonstrate much responsiveness to changes in economic or financial conditions. Indeed, the execution of the program largely involved confirming the expectations that were put in place by the two early announcements.

Third, how persistent should movements in the balance sheet be? An important feature of traditional monetary policy is that movements in the federal funds rate are not quickly reversed, which makes them more influential on broader financial conditions. A change that was expected to be transitory would instead move conditions very little. For similar reasons, one could argue that movements in the balance sheet should have some persistence in order to be more effective.

Fourth, to what extent should the FOMC communicate about the likely path of the balance sheet? The FOMC often communicates about the path of the federal funds rate or provides other forward-looking information that allows market participants to anticipate that path. This anticipation of policy actions is beneficial, as it brings forward their effects and thus helps to stabilize the economy. For the same reason, providing information about the likely course of the balance sheet could be desirable. In fact, such communication might be particularly important in the current circumstances, because financial market participants have no history from which to judge the FOMC’s approach and anticipate its actions.

Fifth, how much flexibility should the FOMC retain to change its policy approach? The original asset purchase programs specified the amount and distribution of purchases well in advance.9 However, the FOMC would be learning about the costs and benefits of its balance sheet changes as it implemented a new program. This might call for some flexibility to be incorporated into the program, providing some discretion to change course as market conditions evolve and as more is learned about the instrument.

Assuming the FOMC adopts some or all of Sack's suggestions, we can expect balance sheet targeting language to be a regular, rather than punctuating, feature of future FOMC announcements--i.e., the big bang announcements with x trillion multiples may be a thing of the past. With the markets already pricing in $0.5 to $1.0 trillion in the next announcement, there could be some disappointment on November 3.