Now that Chairman Bernanke has inasmuch admitted he has no clue what's going on, but is ready to pull yet another rabbit out of his beard at the next FOMC meeting, it's time to address his monetary manipulation options and just why the most likely one might be illegal. While some might doubt the imminence of the next round of easing, according to the minutes of the last FOMC meeting, released only yesterday, there was a secret meeting by videoconference on August 1 to discuss the debt ceiling and the "possibility" of a ratings downgrade of US debt (which would occur just four days later). The last (and only, according to our search) videoconference was conducted October 15, 2010, just prior to the FOMC meeting that would announce QE2.
Curiously, Bernanke made scant mention of his "tools" Friday at Jackson Hole, perhaps not wanting to tip off the broader bond market on which Treasurys to load-up (though we're sure Larry Meyer is advising his clients). However, his options are basically twofold and come down to targeting either interest rates or the Fed's own balance sheet size.
Really, the Fed has been doing both, as it has continuously targeted the shortest end of the curve in the overnight Federal Funds market at 0-0.25% since late 2008, while its QE1 and QE2 operations aimed at increasing its balance sheet by a total of $2.35 trillion. Arguably, the latter helped facilitate the former. And, in the last FOMC statement, the Fed committed to keeping an exceptionally low Federal Funds rate into mid-2013. This means that even if the market starts demanding higher short term interest rates in the next two years, the Fed has pledged it will step in and flood the markets with liquidity via open market operations (likely temporary repos) to keep rates low. Think about that.
Correct or not, many perceive this massive digital money printing as causing the recent and growing price inflation at the pump and Piggly Wiggly. Recent civil unrest in MENA and (gasp) Londontown are serving as wake up calls. The public, when it perceives itself sufficiently aggrieved, will turn on its government on a shiny, FDR dime. Bernanke knows he needs something different to give himself plausible cover. See here for a variety of possibilities set forth by Goldman.
Today, we'll focus on interest rate targeting further out on the yield curve (so-called Operation Twist 2, or OT2), and why it looks increasingly likely. First hypothesized by David Rosenberg and discussed in detail at ZeroHedge, OT2 would be a quasi repeat of the Kennedy-era Fed operation, whereby it committed to purchasing enough Treasurys at the longer term yields to effectively cap them, in order to strengthen the US Dollar and prevent gold outflows, while simultaneously not putting pressure on short term rates. It was initially judged a moderate success, as indeed the yield curve flattened. While gold convertibility itself is now itself a barbarous relic, the concept of long term interest rate targeting has been revived as an alternative to balance sheet targeting.
The question is what maturity the Fed would target. If, as Rosenberg originally suggested, it is in the longest maturities (10 to 30 years), then we could indeed see higher stock market prices. As TradeWithDave reasoned (prior to Jackson Hole and the last FOMC meeting):
Here’s Dave’s gut instinct. This is a temporary attempt to strengthen the dollar artificially cooling inflation while attempting to coax cash off of corporate balance sheets into mid-term investments by inverting the yield curve and motivating banks to lend to businesses again due to attractive low, long-term rates. What will it actually do? Dave thinks it’s like “cash for clunkers”, but it’s really more just “cash for candy.” It will create the need for increased liquidity and more paper money and it will increase the near-term velocity of cash actually creating a currency shortage.
It will be like a sugar high. Like dropping a Mentos into a bottle of Coke. Wow! Then you’re left with a flat soda and sticky mess. Is anyone foolish enough to sink long-term or even mid-term (say a 7 year term loan for a business) investments when you have such an unstable environment? No. So, what will happen is an increase in liquidations (further drop in real estate prices) in an effort to lock-in short term returns.
In other words, companies will sell the ranch and use the money to chase the higher near-term returns which will allow them to pay stellar dividends which will rocket their stock price all while they destroy their (and our) long-term prospects… but who cares because they’ll make their numbers for the quarter while no one else is, which means they will not only survive, but prosper and further consolidate their leadership positions in the UPS/Fedex, Verizon/AT&T, Apple/Android, Coke/Pepsi duopolistic fantasy of a free market. If the sugar fix was legitimate investment and the dollar was fundamentally strong, then it would destroy the stock prices, spoiling our dinner and the intended wealth effect and we can’t have that now can we.
Since then, we have learned the Fed will target short term rates for two more years (which presumably could include a couple of modest Fed Funds rate hikes up to 0.75%). Accordingly, this might ultimately weigh on the US Dollar. If indeed the Fed ends up targeting longer term yields as well, we might end up with a yield curve that looks something akin to a handlebar mustache. In this scenario, the chase for yield would indeed be in the belly of the curve.
What the Fed might have all along planned is for a two prong interest rate targeting of both ends of the yield curve spectrum, with each leg to be implemented at successive FOMC meetings, sandwiching Jackson Hole for maximal PR value.
Another possibility, raised by Bill Gross of Pimco, is that the Fed will target the 2 to 3 yr maturities. Other than restarting the mortgage option-arm market, we're curious to know what this might accomplish, as the Fed would cede control of the long end. However, we do present it below as a possibility, which is a very rough sketch (we're not bond market wizards):
Why OT2 will not come from QE-Lite
The Fed continues to maintain its balance sheet size by buying Treasury securities as the Agency and Agency MBS securities it also owns mature or are paid off (so-called QE Lite). People pay down mortgages, the servicers pay Fannie and Freddie, who in turn pay the MBS holders, which includes the Fed (holding just under $1 trillion in MBS now). Accordingly, the Fed is still buying Treasurys at about $15 billion per month (down from over $100 billion per month during QE2).
It has been suggested that the Fed could simply target longer maturities with this $15 billion fire power, or actually reshuffle its portfolio to extend its duration. Our view is this puts the Fed in a very precarious position, because once it guides expectations that it will extend duration, the bond market might awaken and demand a full commitment for yield targeting. As many have noted, the Fed cannot target long term rates and its balance sheet size simultaneously. It must be willing to purchase every single bond at a given maturity range.
The legal problem
The oft-cited "dual mandate" of the Federal Reserve for maximum employment and stable prices was enacted in 1977 when Congress modified the Fed's mandate. Curiously, stable prices is always interpreted by the Fed to mean 2% annual inflation dollar devaluation. However, there is actually a third mandate for "moderate long-term interest rates". It's right there in the Federal Reserve Act:
Section 2A. Monetary Policy ObjectivesThe Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Exactly why the third mandate fell down the memory hole is revealed in the footnote of a speech given by none other than Bernanke himself (emphasis ours):
The Employment Act of 1946 established the objectives of "maximum employment, production, and purchasing power" for all federal agencies, whereas the 1977 amendment to the Federal Reserve Act gave the Federal Reserve the specific mandate of promoting "maximum employment, stable prices, and moderate long-term interest rates." Price stability requires that the central bank not attempt to drive employment above its sustainable level, and so in practice the Federal Reserve has interpreted its mandate to include maximum sustainable employment. The goal of moderate long-term interest rates is frequently dropped from statements of the Federal Reserve's mandate not because the goal is unimportant, but because moderate long-term interest rates are generally the byproduct of price stability.
Yet, what if exceptionally low long-term interest rates are the by-product of intentional distortions created by Federal Reserve interest rate targeting? Wouldn't this be an intentional and explicit violation of the Fed's statutory mandate of "moderate" long term interest rates?
What constitutes "moderate" is not explicitly defined, but long term rates are already at historically low levels, and it would be difficult to characterize any further targeted lowering as "moderate". While the 2-3 year range might be considered "middle term", the Fed's most likely option, the 10-30 year, is definitely long term.
All it would take is one Federal lawsuit and a sympathetic judge to serve a temporary restraining order on Brian Sack at the New York Fed to bring the digital money printing wheels to a grinding halt.
Now think about that.
What would be the effect of a hike in short-term rates to 0.75% with IOER held at 0.25%? We'd get some serious fractional reserve lending, no?
ReplyDeleteMaybe I read him wrong but when Bernanke was referring to his "tools" I immediately thought he was referring to either removing IOER altogether or he was thinking of playing interest rate games between FF and IOER.
Per your question, I did not intend that and will correct.
ReplyDeleteIt would be illogical for IOER to be above the FF target range. For instance, if IOER were at 0.50% and FF target were still at 0.00% to 0.25%, banks would be incentivized to arb the spread by borrowing in the Fed Funds market and depositing at the Fed. Demand for Fed Funds would put upward pressure on the FF rate, and the Fed would be forced to engage in liquidity providing repos to bring the FF rate down. It creates a self-defeating feedback loop.
On the other hand, were IOER kept at 0.25% and FF raised to 0.50%, banks would be disincentivized to keep money parked at the Fed as excess reserves. As you note, this could indeed result in a surge in lending since, presumably, the Fed would have waited for a more risk-friendly environment before raising rates. It's also possible that excess reserves would leave the Fed and simply be deployed in the short term funding markets, including FF, in search of higher yield, which would put downward pressure on the FF rate. This might require the Fed to conduct liquidity draining operations to raise the FF rate, which again would be self-defeating.
In short, I think setting IOER and FF at different rates is probably not an effective way to conduct monetary policy. When the FF target is a range, as is now, one could make the case for changing IOER as long as it's in the FF target range. At last year's JH speech, Bernanke expressed concern that lowering IOER to zero could permanently disrupt the FF market, which is credible. Also, given the level of risk aversion, a zero IOER might precipitate a flight into short term T-Bills, which would put upward pressure on short term rates (opposite of intended effect). So, I don't think the FOMC is seriously considering this as a possibility.
I decided not to syndicate this post because a new development leads me to believe something bigger in the works. See here:
http://www.zerohedge.com/contributed/feds-plan-rumors-news
@Bob English,
ReplyDeleteI agree with your assessment. I also think this whole IOER business is going to lead to some funky policy issues for Bernanke if he indeed plans to keep FF and IOER close to parity. By that I mean, in theory, interest rates are going to rise at some point and it'll look strange (and raise more flags among people in general) for the Fed to be paying say 200, 300 or 1000 bps, "risk free", on these excess reserves.
I know Bernanke has stated in the past the he believes he can drain ERs using RRPs but I don't believe the Fed has a sufficient quantity of short duration bills to make this effective in the event reserves start draining in significant quantities. At that point, given the structure of the Fed's balance sheet, he'd have to start offering longer duration securities which are either A) garbage in the case of RMBS and other toxic "assets" or B)Low yielding treasuries. If I'm a Primary Dealer, I don't know if I'm hitting that bid. If the excess reserves are seeping out, then inflation is likely heating up considerably and low yielding treasuries issued over the last 5 years aren't necessarily going to entice me.
Unless, of course, there's some gentleman's agreement between the Fed and the Dealers in which case the latter agreed to accept these bills, notes, bonds or what-have-you when called upon by Bernanke.
@Joe: In a RRP operation, the Fed can pledge any of the securities on its balance sheet. In addition, it has the Term Deposit Facility, which are essentially non-negotiable Fed bills of up to one year maturity (but they can be pledged to the discount window!). So, I don't see lack of collateral as an issue.
ReplyDeleteThe real issues are twofold, one of which you are close to. Indeed, as interest rates rise, the Fed's expenses from IOER, the TDF and any other interest paying facilities will be much greater. It will be remitting much less to Treasury (interest on FR Notes), and this could become a political issue. Worse, what if the Fed's expenses exceed its income earned on its SOMA portfolio? The Fed rewrote its accounting procedures a few years ago such that it cannot go cash flow negative. It simply will print money ex nihlo to pay expenses while creating a negative liability (deferred asset) on its balance sheet.
The other issue is that there is no Fed tool that can deal with a crisis of confidence in the US Dollar. If/when the mindset of the marginal Dollar holder turns from "worrying about having enough Dollars" to "worrying that tomorrow's Dollar will be worth materially less than today's", the end game will be nigh.
When, I said above:
ReplyDelete"a zero IOER might precipitate a flight into short term T-Bills, which would put upward pressure on short term rates"
"upward" should be "downward"