The topic of quantitative easing has been beaten to death. Speculation has raged about how much large the Fed’s purchases will be. What the duration of those purchases will be. What the impact on yields will be. Will they be 3 basis points or 30 basis points? Pseudo-econometric analysis has been done attempting to justify whatever predictions are made. As we have written before, these estimates are subject to wide confidence bands, are developed from data that don’t include scenarios like we are currently experiencing, and are based essentially upon output-gap/Phillips-curve models that have been discredited.
Putting all that aside, the market seems to be providing fairly surprising answers with potentially important implications for the FOMC. First, it now appears that the decision to engage in more quantitative easing, which seems to have been made before the upcoming FOMC meeting, has been more successful in affecting the inflation outlook than might have been expected – for both good and bad – in an extremely condensed period of time. Markets quickly digested the news and responded by raising both equity and bond prices. However, this initial reaction is now being reversed. Most notable were the results of the TIPs auction, which suggested a huge upward shift in inflation expectations, greater than the nominal yields on 5-year Treasuries. Rates across the spectrum seem to be drifting up a bit, also consistent with the acceleration in inflation expectations. Note that none of the rhetoric coming from the Fed talked about interest-rate increases that would accompany more quantitative easing. But in the last couple of days, things seem to be backtracking as more and more uncertainty creeps into those initial market reactions, equities pull back, and skepticism grows that the huge volume of purchases that some commentators argued for have begun to seem less and less likely.
Everyone has run ahead of the FOMC, but now find themselves less and less sure because of the lack of specifics. All of this means that the Fed can’t simply sit pat and let the market do its work for it. The FOMC not only has to deliver but must do so with sufficient specifics that markets gain more certainty about the future course of policy. This, however, is where the “bargain with the devil” that Kansas City Fed President Tom Hoenig so strongly warned about comes into play. Failing to deliver on expectations will be more damaging than to actually deliver, but delivering will simply signal that the worst (that is a return to higher interest rates) is yet to come. When that will happen, no one knows. Surely, it will be some time yet before an unwinding is perceived as necessary, especially with the fixation of the current FOMC on employment rather than inflation risks.
Just to suggest how deep the hole is that the FOMC has dug for itself, consider the portfolio implications of more quantitative easing that can be derived from the CUMB-E index that we have been publishing for some time on our website. That index is an attempt to estimate how much flexibility the FOMC has to raise interest rates before the capital losses incurred exhaust its equity capital. The following table uses estimates of the duration of the Fed’s portfolio to calculate how many basis points the term structure can rise before the economic value of the Fed’s portfolio goes to zero, given alternative volumes of purchases and where along the term structure those purchases occur. The analysis makes no attempt to take into account price or market effects that such purchases may have.
The results are quite striking since, even prior to a purchase of $500 billion, the estimate was that the policy margin was already thin at 67 basis points. That margin is cut by 50% if only $500 billion in purchases are concentrated in the over-ten-year maturity class. There is virtually no cushion if the larger amounts that some have urged are kept on the table.
With such uncertainty and the exit costs so high, one wonders why the FOMC is going down this road, when it isn’t even clear that they will or can have a measurable impact upon employment.