One Fed To Monetize Them All
A few weeks ago we pointed out that the unfortunate but inevitable conclusion of the Fed's embarking on the second round of QE would be that the total treasury purchases between $1.2 and $1.5 trillion, and possible more, would require nothing less than direct purchases from the Treasury. Today, Morgan Stanley's David Greenlaw has confirmed that QE2, launching in less than one month, will mean outright monetization of US debt, even in its gentle and gradual, $100 million a month format: "This pace of buying would be roughly in line with our estimated budget deficit ($1.15 trillion) for fiscal 2011. So, the Fed would be absorbing virtually all of the net new Treasury issuance as long as they maintained this pace of purchases." What is scarier, is that pretty soon the Fed will be the only holder left of Treasuries with a maturity over 10 years: "There are only about $550 billion of Treasuries outstanding with a remaining maturity of greater than 10 years. So, if the Fed were instead to concentrate their buying in this sector, it could have a powerful impact on long-term yields." The great benefit of monetizing it all, is that the Treasury will be paying all remnant high coupons to the Fed. Which also means that in the future, any retiring individual on fixed income will be forced to buy if not equities in risky companies as a retirement asset, then certainly high yield debt.
But perhaps the scariest thing is that FOMC members are driven more by charts than anything. And during the November 2-3 meeting, the chart that Ben Bernanke will be showing more than any other one will be the following:
Unfortunately, today's news that the Fed has just surpassed Japan as the second top-holder of US debt, will be ignored, and instead the Fed will look at debt holding projections and think that there is capacity not for $1 trillion (which would bring Fed holdings to 20% of total USTs), but for $2 trillion, which would be the previous peak hit back in the mid 1970s. Of course, back then neither China nor Japan were notable holders of USTs, and the other major investor was the US public itself. The problem is that should the Fed indeed venture to purchase $2 or more billion, there is simply not enough debt to satisfy that demand, which we made explicitly clear in a previous post on this topic. Which is why the next step would be a collapse in yields to zero across the entire curve, and the de-reservization of the US dollar, as the Fed's plan to monetize everything in sight become obvious. In other words, the beginning of the end just may begin, perhaps fittingly, on the day the Republicans regain control of the House and Senate.
Full note from David Greenlaw:
We expect the FOMC to restart an asset purchase program at the upcoming FOMC meeting — as highlighted in the US economics note that we published on October 1 (“QE Coming: Slow Rise in Inflation Not Enough to Satisfy the Fed”).
There has been a great deal of Fedspeak in recent days, and the commentary from some of the regional bank presidents regarding asset purchases has been all over the map, highlighting the divergent views that still exist within the FOMC. Importantly, however, three proponents of asset purchases – Dudley, Rosengren and Pianalto – are all currently voting members of the FOMC. Meanwhile, three of the skeptics – Plosser, Fisher and Kocherlakota – do not currently have a vote (but all will in 2011). Obviously, the key decision maker is Chairman Bernanke, and he seems to feel the Fed needs to do something at this point to address deflation tail risk if the incoming data do not show signs of improvement.
So, while it’s not a done deal, it certainly appears that the bar to implementing additional monetary stimulus is quite low. Specifically, to be convinced to stand pat, Bernanke would probably need to see some upside surprises in all three of the key data reports that will be released between now and the November 2-3 FOMC meeting – employment, CPI and GDP. We have scaled back our expectation for the private employment rise in September (to +75,000) in response to today’s disappointing ADP results. Based on a canvass of local media reports, we also remain concerned about the possibility of a sharp decline (50,000 or so) in teaching positions at the start of the new school year. In sum, we believe there is a decent likelihood of another uptick in the unemployment rate (to 9.7%). Moreover, we recently cut our tracking estimate for Q3 GDP by a full percentage point (from +3.1% to +2.1%). This change reflects an accounting quirk in the import category, which we believe will be reversed in Q4, but the Q3 GDP report is especially relevant since it will be released only a few days ahead of the next FOMC meeting. Finally, we do look for a bit of upside in the next CPI figure, but this probably won’t be enough by itself to derail the implementation of an asset purchase campaign at the November FOMC meeting.
What might a new round of asset purchases look like?
Brian Sack, head of the NY Fed's Open Market Desk, delivered an interesting speech earlier this week in which he provided a lot of background information on the structure of the asset purchase programs that have already been implemented and made the case that Fed balance sheet manipulation is a viable policy option. He then moved on to discuss a topic of considerable market importance at present — the design of future asset purchase programs.
Mr. Sack discussed five specific criteria related to a new round of asset purchases. First, he addressed the issue of whether the balance sheet should be adjusted in relatively continuous but smaller steps, or in infrequent but large increments (as with the first round of the LSAP’s). Second, how responsive should the balance sheet be to economic conditions? Third, how persistent should movements in the balance sheet be? Fourth, should the FOMC provide guidance regarding the expected future path of the balance sheet? Fifth, how much flexibility should the FOMC have to change direction? He did not
provide clear answers to each of these questions; indeed, his discussion highlighted the conflicting nature of many of the ideal parameters of an asset purchase program. For example, flexibility is almost always a good thing, but a purchase
program will have a more powerful impact if the market perceives that it is likely to continue for a period of time and the
Fed provides such guidance. So there is a trade-off between flexibility and commitment.
Reading between the lines, we sense that Sack would support a program in which the Fed announced a specific amount of purchases that would be conducted prior to the next FOMC meeting, with some indication of the amount of buying that is
expected over a longer timeframe based on the economic outlook. Sack doesn't make policy — he implements it. But his recommendations are likely to carry a lot of weight at the policymaker level, and we suspect that the program designed by the FOMC will have many, if not all, of the characteristics that seem to be favored by Sack.
In addition to the conflicting parameters of an asset purchase program, we see a more fundamental problem with Sack's
message, since it implies a degree of precision in the link between movements in the size of the Fed's balance sheet and
economic outcomes which may or may not exist. Let's just say we are skeptical. Indeed, economists generally agree that the link between the Fed's main policy tool (short-term interest rates) and the real economy is quite loose and that the
transmission mechanism is highly variable. If this is true for short-term rates, it is even more so for the size of the Fed's balance sheet. Indeed, relying on a "portfolio balance" approach as justification for a new round of asset purchases represents uncharted territory in the field of monetary policymaking.
How much will they buy? A wide range of options appear to be on the table, but based on the signals provided by Sack and other officials, it looks like the Fed is converging on a flexible approach that will involve a specified amount of buying (perhaps $100 billion) that would occur prior to the December FOMC meeting, with the amount scaled up or down from there at future meetings depending on economic and financial market conditions. Indeed, even a policymaker as dovish as
Rosengren appears to favor such a gradualist approach. This pace of buying would be roughly in line with our estimated budget deficit ($1.15 trillion) for fiscal 2011. So, the Fed would be absorbing virtually all of the net new Treasury issuance as long as they maintained this pace of purchases.
Will the Fed continue to buy across the curve or will it focus its purchases at the long end of the market? This is
a major source of uncertainty for the markets. We suspect that the Fed will stick with their current strategy of buying across the curve in order to maintain a 6 to 7 year average maturity of purchases. There are only about $550 billion of Treasuries outstanding with a remaining maturity of greater than 10 years. So, if the Fed were instead to concentrate their buying in this sector, it could have a powerful impact on long-term yields.
What about the 35% rule? The Fed has a self-imposed restriction that prohibits them from owning more than 35% of the outstanding amount of any individual Treasury security. But this rule can be waived at any time and thus does not
represent a significant barrier to concentrated purchases.
Will they buy Treasuries only? Initially, the Fed is likely to stick to buying Treasuries, but over time they could scale into mortgage-backed securities. In particular, we suspect that the Fed may wind up targeting a gross amount of MBS holdings near $1 trillion. When they surpassed this threshold in the first round of asset purchases, it appeared to trigger some significant dislocations in the MBS market.
What is the probability of an intermeeting move? From our standpoint, such action is unlikely but possible. The most obvious potential trigger is Friday’s employment report. If the report is really bad (say, below 0 for private payrolls, for which I would assign about a 20% probability), then we would put the chance of an intermeeting move at about 33%. Combining these probabilities, we see maybe a 5% to 10% chance overall for an intermeeting move. What will be the impact on the markets and the economy? According to our trading desk, the market has already priced in a scenario close to the one we expect. And as we have highlighted previously, the economic impact associated with this type of monetary stimulus is likely to be quite modest. As evidence, we have cited results from a large-scale macroeconometric model maintained by Former Fed Governor Larry Meyer. For the past several decades, economists have recognized that such models are not particularly accurate when it comes to making short-term forecasts, but they are very useful for playing “What if?” games. Meyer’s model is widely used in private and public policymaking circles for such simulations. Meyer estimated that a $2 trillion asset purchase program would 1) lower Treasury yields by 50 bp, 2) increase GDP growth by 0.3 percentage point in 2011 and 0.4 pp in 2012, 3) lower the unemployment rate by 0.3 pp by the end of 2011 and 0.5 pp by the end of 2012. However, Meyer admits that these may be “high-end estimates” because they don’t take into account the unique nature of the current credit environment and the potential blockage of some of the normal transmission channels. Moreover, a relatively high probability of a resumption of asset purchases is already priced into the market, and thus a full 50 bp response in Treasuries seems unlikely. In sum, there is good reason to believe that the pass-through benefits to the economy associated with a modest decline in Treasury yields will be quite limited.
Finally, what will be the long-run impact on inflation?
There are several channels through which asset purchases could ultimately influence inflation. The most obvious would be if we are wrong about the economic impact and the program ultimately proves to be effective in stimulating growth – either in the US or globally – causing the economy to overheat before the Fed can unwind the stimulus. Also, there could be an impact on inflation arising from a significant elevation in inflation expectations. There has been a meaningful rise in market-based measures of inflation expectations in recent weeks as speculation regarding the resumption of Fed asset purchases has become more widespread (see Exhibit 1). The Fed’s actions could stir up some inflation via a decline in the dollar, but the trade-weighted value of the dollar stands about where it did at the start of the year (see Exhibit 2), and many other countries appear to be engaged in policies aimed at achieving a competitive devaluation (or as former Fed and Treasury senior staffer Ted Truman terms it, “a competitive nonappreciation”). So it is hard to see the dollar moving enough to trigger a meaningful impact on domestic inflation.
The financial markets actually seem to be overly focused on what we consider some of the least likely transmission channels — namely, money supply and debt monetization. To date, the so-called money multiplier (the ratio of a monetary aggregate, such as M-2, to the monetary base) has declined by about the same amount that the monetary base has risen, leaving the money supply little changed by the expansion of the Fed’s balance sheet. This reflects the fact that almost all of the excess bank reserves created by the Fed’s balance sheet expansion have wound up being held in bank reserve accounts at the Fed (earning 25 bp; see Exhibit 3). Even a hard-core monetarist should not fear inflationary consequences from this type of balance sheet expansion until the money multiplier begins to normalize. Similarly, the debt monetization channel seems a little hazy. The Fed always monetizes a share of Treasury borrowing, and the current level of monetization is unusually low. Even $1 trillion of buying over the next year would leave the Fed’s holdings of Treasuries within the historical range (see Exhibit 4).