Cashin's Cliff Notes Of Bernanke's Playbook
Earlier in the week, UBS' Art Cashin noted that some traders were re-reading Bernanke’s speech of November 21, 2002 on countering inflation. Prior re-readings had given clues on things like QE1 and even Operation Twist.
The primary theme of the speech was - what can the Fed do to fight deflation (and stimulate the economy) if the Fed Funds rate fell to zero (aah, those simple golden years). Here’s how Mr. B. set that phase up in 2002:
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.
There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
So, here we see the precursors of at least two subsequent Fed operations. Remember the pledge to hold rates flat into 2014? And, the other suggests quantitative easing with a slight hint of “Operation Twist”. But, hold it, let’s look at the next paragraph:
Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).
That’s a real Operation Twist and a hint of mortgage buying.
But these weren’t the only arrows in Bernanke quiver. He talked of pegging rates to a specific rate in longer years, citing Fed success before Fed-Treasury Accord of 1951. He suggested that the Fed might get money to private companies (currently barred) by changing acceptable or qualified collateral from the banks. Mr. B. noted that the Fed might influence the currency, though that is not its normal venue. There is even the possibility that the Fed could widen its tolerance bands for inflation.
Most of the operations, however, tend to be means to make money available or easy. With nearly $2 trillion in excess free reserves that doesn’t seem to be the problem. Inducing spending is the problem. Of all the suggestions, the wider inflation tolerance may be the only one that may do that.