What’s Next for the Fed: Rock ‘N Roll!

On July 8, immediately after the dismal employment report, this is what the Wall Street Journal had to say:

After spending funds to fight the crisis, policy makers have few tools left to stimulate the economy.  Mr. Obama is focused on cutting the budget deficit, while the Federal Reserve, which sees unemployment at about 8.0% at the end of 2012, has already cut interest rates close to zero and is reluctant to purchase more government bonds now that inflation is rising. (Luca DiLeo, “Jobs Data Dim Recovery Hopes”)

In addition, in the last week of June, the U.S. 10 year Treasury Note’s interest cost rose 29 basis points from 2.91% (June 23^rd) to 3.20% (July 1^st).   At this writing, we cannot be sure if this move was in response to 1) the “temporary” respite of the Greek debt drama and a reversal of “flight to safety” trades, 2) a noticeable reduction in foreign demand for U.S. debt during the Treasury auctions of the week of June 27^th, or 3) a combination of the two.  Indeed, during the June 27^th week, QE2 was still active, so what happened to interest rates could just be a prelude of what will happen without additional Fed intervention.

In their 2010 working paper, “The future of public debt: prospects and implications” (Bank of International Settlements, March, 2010), authors Cecchetti, Mohanty and Zampoli conclude that since “Most of the projected deficits [for the world’s industrial economies] are structural rather than cyclical in nature … we can expect these deficits to persist even during the cyclical recovery”.  They ask: “When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?”  They conclude that it is a question of “when”, not “if” markets put pressure on the cost of such debt, causing interest rates to rise.  Enter the Fed.

We saw the Fed liquefy the world in ’09 including non-member foreign banks over which they have little influence or authority.  And now we have learned that they secretly loaned huge amounts to the primary dealers in the aftermath of the financial crisis.  Then we saw them intervene again with the late August, 2010 announcement and subsequent June, 2011 completion of QE2.  During the latter intervention, the Fed essentially monetized much of the U.S. budget deficit.

Given the fact that the presidential election cycle has already begun, we strongly suspect that the weakening economy and upward pressure on interest rates due to oversupply will cause further Fed intervention, even if it isn’t called QE3.  At his post-Federal Open Market Committee (FOMC) press briefing, Bernanke indicated that if job growth falls below 80,000 per month, the Fed would likely intervene again.  (Job growth has now been below 80,000 for two consecutive months!)  So, “when” it comes (not “if”), what sort of intervention can we expect?

A look back at then Fed Governor Bernanke’s November 21, 2002 talk before the National Economists Club of Washington, D.C. entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, gives us some clues.  In that talk, he ostensibly outlined all of the tools available to the Fed if the overnight (Fed Funds) rate hit zero.  After all, at the time of the speech, deflation wasn’t expected in the foreseeable future, so he would have no reason not to outline all the tools he could think of.  I have outlined them below:

• #1: Expand the scale of asset purchases;
• #2: Expand the menu of assets the Fed buys.

Both QE1 and QE2 used these tools.  In QE1, the Fed purchased non-traditional assets for its portfolio, including mortgage backed securities (MBS) and derivatives.  In both QE1 and QE2, the “scale” of asset purchases was dramatically increased.

• #3: A commitment to holding the overnight rate at zero for some specified period.

This tool is currently in practice with the Fed’s “extended period” language in the Federal Open Market Committee (FOMC) minutes.

• #4: Announcement of explicit ceilings on longer-maturity Treasury debt.

This isn’t new.  The Fed did this in the 1940s and a version of it again in the 1960s.  During a period of approximately 10 years ending with the Federal Reserve-Treasury Accord of 1951, the Fed “pegged” the long-term Treasury bond yield at 2.5%.  And, during the Kennedy Administration, the Fed sold T-bills and purchased an equal amount of longer dated T-Notes in order to reduce long-term rates.   Bernanke believes that the announced policy of pegging will cause arbitrageurs to keep yields near the announced peg, especially if the Fed intervenes several times to prove its commitment.

• #5: Directly influencing the yields on privately issued securities.

“If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”  Think GM, Chrysler, AIG.

• #6: Purchase foreign government debt.

The Fed would do this, Bernanke explains, to influence the market for foreign exchange, i.e., to weaken the dollar.  He points to the dollar devaluation of 1933-34 as an “effective weapon against deflation”.  “The devaluation and the rapid increase in the money supply it permitted ended the U.S. deflation remarkably quickly … The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market.”  (While this is true, a mere two years later, after the withdrawal of government stimulus, a second severe recession began,  one that would last until the U.S. geared up for World War II.  And the 1937 slump in stocks was one of the largest on record.)

• #7: Tax cuts accommodated by a program of open market purchases.

“A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money”, he said in the speech.  (Hence his nickname – Helicopter Ben.)  The extension of the Bush tax cuts along with the reduction in the social security payroll tax is a recent example of this policy.

These 7 tools are non-traditional, and Bernanke admits that by using them, the Fed “will be operating in less familiar territory” and will “introduce uncertainty in the size and timing of the economy’s response to policy actions”.  Nevertheless, he says, “a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition … A central bank … retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is zero”.  Today, any objective economist will tell you that, despite all of the monetary and fiscal stimulus, aggregate demand and economic activity has been minimally impacted.  At the July post-FOMC press briefing, Bernanke admitted that he has no explanation as to why the economy has remained “soft”.  Nevertheless, as stated above, in an election cycle, the Fed would be expected to do “something”.

Of the 7 available tools, #1 appears to have been taken off the table, and #3 is presently employed.  Tools #5 and #7 have been used, and may be employed again.  #5 was heavily used in the financial crisis (GM, Chrysler, AIG), and #7 requires the cooperation of Congress (tax cuts).  The Fed said that it won’t reduce the size of its balance sheet in the near future, holding it steady like a rock, but will invest or roll any maturities or payoffs back into the market.  Hence, the Fed has already embarked upon a policy of what we will call Rock ‘N Roll.  As part of Rock ‘N Roll, we also expect the Fed to change the composition of its balance sheet to attempt to impact yields on private sector bonds (#5).

Conclusion

Over the past 2 years, Fed actions appear to have had little impact on aggregate demand.  In 2002, when he outlined these non-traditional tools, Bernanke said he had no idea of the magnitude of their effectiveness.  Today, however, we have a couple of years of historical data on which to judge.  Eric Swanson, an economist at the Fed of San Francisco, in a March, 2011 paper entitled “Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2” concluded that the impact of QE2 on the Treasury yield curve was a statistically significant, but moderate 15 basis points.  (That’s not much for $600 billion!)  In addition, Swanson says that the effects “diminish substantially as one moves away from Treasury securities and toward private credit instruments”.

Thus, despite their demonstrated impotence, we expect that the Fed will use tools #4 and #5 in an effort to lower longer-term Treasury rates and simultaneously attempt to reduce private sector rates.  The success of such moves is much in doubt, especially if their balance sheet is constrained.   Tool #6, and other policies to weaken the dollar, however, will continue to be the primary and most effective thrust of Fed policy.  That means inflation will continue to be fostered.

Robert Barone, Ph.D.

Joshua Barone

July 11, 2011