By: Costas Bocelli — September 8, 2010
Former Fed Official: Fed Should 'Do More'
THIS SUMMER’S HEAT WAVE APPEARS TO HAVE INFILTRATED THE FEDERAL RESERVE.
The FOMC (Federal Open Market Committee), which sets monetary policy in the U.S., meets roughly every 5 to 8 weeks.
At the completion of the meetings, which usually last a day or two, the financial markets eagerly anticipate the statements from the committee which may address an update on the health of the economy or announce any policy adjustments, such as a change in interest rates.
With the recovery slowing, recent meetings have become contentious as to how monetary policy can help boost the economy.
The FOMC’s main tool to adjust monetary policy is lowering and raising key interest rates. The problem is that interest rates are near 0%, as the fed funds rate currently sits at 0-.25%. So, the Fed has to reach deeper into its bag of tricks to make any additional impact.
During the height of the recession and credit crisis, the Fed began a quantitative easing program to buy $2 Trillion of mortgage backed securities and other agency debt to drive borrowing rates down, expand liquidity, and ease credit.
Programs like these are supposed to be used for emergencies and should be unwound when normalization returns to the market and economy.
This is where the dissent among members of the policy board is focused. The minutes were released last week from the Aug 10 policy meeting (by the way, the meeting lasted over 5 hours before finally coming to an agreement on policy).
The policy announcement, which was almost unanimously approved, agreed to maintain the level of the Fed balance sheet at $2 Trillion by reinvesting the proceeds from retired and refinanced mortgage debt directly into US Treasury bonds.
BREAKING DOWN THE DECISION
The reason given for maintaining the balance sheet at current levels by additional asset purchases was to inhibit passive tightening in monetary policy by letting the runoff of retired mortgage debt reduce the balance. By taking the proceeds and reinvesting those into Treasuries, they will keep the liquidity level neutral.
These actions signal to the markets a clear policy shift to a loosening bias, and a perceived notion that the Fed may inflate the balance sheet further by purchasing additional mortgage and agency debt if the economy weakens further.
The Fed Chairman, Ben Bernanke, recently made this statement when he addressed the central bank summit in Jackson Hole, Wy: “The committee is prepared to implement additional easing if the economic outlook worsens."
The Committee is comprised of 17 FOMC participants, of whom 10 officially vote in the policy meetings. The minutes that are released transcribe the members' statements and comments; however, they’re not directly identified.
The minutes identified 7 participants who opposed these actions during the meeting. However, the official tally, as I mentioned, showed only one dissenting vote. The lone dissenter came from the inflation hawk, Kansas City Fed President Thomas Hoenig, who not only opposes the quantitative easing measures, but has actually been calling for tightening in interest rate policy.
Hoenig may be the only official dissenter, but the minutes clearly show that the committee is divided, not united, on its actions pertaining to the handling of the balance sheet assets.
The transcripts showed several members were concerned that inappropriate signals could be sent out to the financial markets and investors regarding further purchases of mortgage backed securities.
Other members were concerned that, by not allowing the balance sheet to naturally contract, the Fed will complicate its own exit strategy and adversely affect the economy in the future. The balance sheet is exposed to interest rate risk if rates rise beyond the Fed’s control, which could result in major losses to the portfolio.
Clearly the Fed is in a difficult to position when it comes to how it can further help the economy. The two main worries for the Fed are unemployment and inflation. Many participants feel that additional purchases will not cause a significant improvement in either.
Others also felt that expanding the program of treasury purchases could be very dangerous politically, especially with the mid-term elections approaching. This policy stance could be perceived as accommodative to the Obama Administration's fiscal government policies.
The next FOMC meeting is scheduled later this month, on September 21. It will be very telling to see if the dissenting members increase the pressure of their views or fall back into a more collusive mode.
By the way, Ben Bernanke’s 2nd in charge and long time friend, Donald Kohn, recently retired after a distinguished long career as a public official with the Federal Reserve.
Last week, Kohn was interviewed by the New York Times, and made statements affirming support for Bernanke’s views of maintaining the Fed’s balance sheet level through Treasury purchases.
He went one step further and acknowledged, “The economy is in a slow slog out of a very deep hole and the Fed should consider additional stimulus unless the recovery shows signs of decent progress ... To not trigger something (additional stimulus), I would want to see that there was the prospect of progress in the forecast toward achieving both higher levels of employment and higher inflation close to the 2% target.”
With his exit, will the dissent intensify? That will be something to look for when the minutes are released after this month’s upcoming meeting.
Tinkering around with quantitative easing tools has been causing huge volatility swings in long term interest rates, particularly the 10 and 30 year Treasuries.
If you have an investment opinion on whether the Fed will engage in another round of monetary easing, you can get exposure through the IShares Barclays ETF, Sym: TLT, which tracks long dated treasury prices. TLT is very liquid and trades options.
Below is a chart of TLT...
All eyes will be on the upcoming FOMC meeting later this month. With the summer heat finally breaking, maybe all the committee will need this time around is a handy fan to cool the contentious debate and growing dissent among its members.