|The stock market's decline and the resurgence in bond prices since the FOMC's last meeting and the announcement that the FOMC would reinvest proceeds from maturing mortgage-backed securities by expanding its Treasury portfolio should have surprised no one. What we are seeing is the difference between certainty and uncertainty.
By deciding to maintain its portfolio at the current level, the FOMC stopped the slow contraction of liquidity, which had been the first of a series of steps towards an exit strategy. Now that has stopped, we are back to the drawing board in terms of what the FOMC will do and when it will do it. This is not a resumption of quantitative easing, as some have suggested. Stopping a contraction is not the same as expanding the FOMC's portfolio. What this means is that implementation of the FOMC's exit strategy has been pushed down the road and that the "extended period of time" has just been extended even more. That is, the existing liquidity in the system and the potential it represents will remain, and the demand for Treasuries has just gone up, especially in the 2- to 10-year categories where the Fed investments will be concentrated. All of this implies certainty for bond markets in that the generous stock of liquidity will continue to exist, Treasury demand will be strong, and interest rates will be low, with little risk that rates will go up, well into next year or beyond.
At the same time, the FOMC indicated that it had overestimated even the apparent modest strength of the near-term real economy it had noted in June, and thus had pared back its forecasts for real GDP growth, employment, and inflation through the end of the year. While this might imply a further increase in the downside risks to the economy and might call for some significant additional monetary stimulus, the FOMC chose only to hold its portfolio at the current level. This decision puzzled equity markets. We all understand that the FOMC doesn't have a policy dial that it can move one click at a time with predictable and measurable effects on output and employment. But if downside risks have increased then, given the lags in monetary policy, which surely have become very long indeed during this crisis, why not take quick and decisive action now? The likely answer is that the FOMC itself is uncertain as to what the appropriate course of action should be or what impact use of its alternative tools will have. For example, will buying Treasuries have the same impact as buying an equivalent amount of mortgage-backed securities? What is the relationship between quantities purchased and stimulus realized? How quickly will a pick up in quantitative easing have an impact on the economy? Put in economist terms, the FOMC doesn’t know what the impact multipliers of its alternative policy tools are or when those impacts will be felt. Moreover, there is no history to rely upon to answer these questions. All of this translates into uncertainty for equity markets as well, hence the drop in the market and flight to Treasuries.
What this means for investors is that there will be buying opportunities, of course, especially for those very profitable companies whose shares are now underpriced. It also suggests that the volatility we have experienced will continue until the economy strengthens and/or we get more decisive policies on both the fiscal and monetary sides. What we mean by decisive fiscal policy, however, is not more misguided attempts to spend our way out of this recession, but more clear and articulated strategies for dealing with the deficit, for tax policy, for reducing healthcare costs, and for containing regulatory burdens, which are all problems that are currently deterring small businesses from expanding and hiring.