The above well-known line captures much of the discussion about quantitative easing that has plagued recent newsletters and media reports, and has even spawned the new Liesman survey on expectations for additional quantitative easing by the Fed. The third quarter ends with great uncertainty about what the Fed will do, when it will do it, and how much it will do in terms of possibly adding more securities to its portfolio. This commentary tries to lay out for the benefit of our clients and other readers what we believe the current policy is and how to think about the policy issues facing the FOMC going forward. It considers the issues, both short- and long-term, that the Fed must wrestle with in deciding whether further asset purchases are needed or desired. It is important to emphasize that we are not attempting to suggest what the FOMC should do. From an investment perspective, what is being done and what will be done are the important factors.
Briefly, current policy can be described in terms of the FOMC’s most recent statement following its September meeting and what it has been doing with its asset portfolio. The FOMC has concluded that simply allowing its holdings of mortgage-backed securities to run off would constitute a passive tightening of monetary policy, and it views this as being inconsistent with supporting a meager recovery and the shortfall in employment gains. As a result, the Open Market Desk is reinvesting the maturing proceeds in additional purchases of Treasuries and confining those purchases to the 2- to 10-year-maturity spectrum. In the meanwhile the FOMC is weighing the costs and benefits of embarking on further quantitative easing, fully aware that the efficacy of such additional easing is uncertain.
Let us consider why so much market uncertainty now exists. First, the Fed itself has contributed mightily to the current uncertainty. In the last week of September, several FOMC participants, including reserve bank Presidents Dudley, Bullard, Rosengrin, Plosser, Pianalto, Lockhart, Fisher, and Kocherlakota have all in their own ways sought to provide interpretations of what the FOMC meant in its last statement. Careful reading of these speeches reveals a wide range of views, differing concerns about inflation versus employment, and differing views on the possible costs versus the benefits of additional quantitative easing. One gets the impression that committee members – at least those who have spoken out – are themselves uncertain about what to do, and some are more so than others. Particularly noteworthy is the speech given by President Dudley on October 1, since he is both the vice chairman of the FOMC and the only reserve bank president who is a permanent voting member of the FOMC. A careful reading of his speech suggests that he would support additional quantitative easing, and probably relatively soon. His logic and analysis backing up that position, however, are indeed curious and nonconventional, especially when he discusses the relationship between inflation, inflation expectations, and real interest rates. Other members, such as Presidents Hoenig, Fisher, and Plosser, are clearly in the camp that seriously questions the wisdom of additional quantitative easing at this time.
Given these divergent views, the FOMC has opted, a least for the short term, to simply ride it out. Those who read the FOMC’s statement as a preamble to further action may be engaged more in wishful thinking and a desire for additional certainty that such might not be delivered. However, the recent confirmation of President Yellen as vice chairman of the Board of Governors elevates her from being a non-voting FOMC member in her former capacity as president of the San Francisco Fed to a voting member as a governor. She likely would be supportive of further quantitative easing and would join the growing coalition that would support additional policy easing, should Chairman Bernanke decide to go down that road.
Despite the differing views on the need for further policy action, there are two areas where it is possible to identify agreement among those who have spoken out so far. First, all feel that the economy is growing slower than they would like to see and that the rebound in employment is too slow. However, besides President Dudley, Presidents Plosser and Fisher ( who are doubtful about more quantitative easing) have provided views as to whether monetary policy can significantly affect or speed up the recovery at this point. Second, there seems to be a growing consensus that the FOMC has modified its inflation objective from the 1% to 2% range for PCE expressed by the Greenspan FOMC to a point-estimate target of 2%. This evolution, which has received relatively little attention in the press, helps to explain why the FOMC could now say in its last statement that “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” In several of the speeches by the above-mentioned presidents, there is clear evidence that 2% is now the point of reference.
So what are the pros and cons or the possible costs and benefits of further quantitative easing that the FOMC is mulling over at this point? There are three main arguments for further quantitative easing. The first is the view that more asset purchases will send a message to markets that the FOMC intends to keep rates low for a long period of time, thereby reducing policy uncertainty. Second, more asset purchases will further reduce long-term nominal interest rates, which should stimulate investment and employment. Third, even if there is no immediate impact form further quantitative easing, a tipping point will be reached where the opportunity cost of holding idle reserve balances by banks or cash assets by firms will be sufficiently high that the banks will begin lending and firms will begin investing and hiring.
There are four main cons to further quantitative easing. First, it is not clear what the impact of further quantitative easing will be on interest rates. For example, private-sector estimates, those estimated by Federal Reserve staff at the Open Market Desk in New York, and those put forward by some federal reserve bank presidents, cover a wide range, from as low as 20 basis points for an additional trillion dollars of purchases to as high as 50-80 basis points. Chairman Bernanke himself revealed uncertainty about what the impacts would be in his Jackson Hole speech. One of the problems with even the most sophisticated econometric estimates of the impacts of quantitative easing on interest rates is that they rely upon data which don’t include experience such as we have endured in recent years. That is, they are out-of-sample estimates for which we have no reliable measures of the errors associated with those estimates.
Second, there is great disagreement as to how much quantitative easing is needed to have the desired impact upon long-term rates, for example to reduce long-term rates by, say, 10 basis points. Some have expressed the view that it will take a large amount of asset purchases to have the desired rate impacts, and increasing amounts to have the desired impact, the more purchases that are made. Interestingly, President Dudley suggested that $500 billion more in quantitative easing would be equivalent to a 50- to 75-basis-point cut in the Federal Funds rate. In contrast, others – including myself – are concerned that the relationship between purchases and rates may be nonlinear and would require fewer and fewer purchases the larger the Fed’s portfolio becomes relative to the rest of the market. The argument is that as the Fed absorbs more and more of the outstanding supply of Treasuries in the hands of the public, it will have to bid higher and higher prices to have the same desired impact on rates for a given amount of purchases. One of the reasons for this nonlinear effect is that as the public gives up its holdings of Treasuries, more and more of the outstanding supply will be held by foreigners, including governments and investment funds who may be more reluctant to give up the liquidity that those holdings imply.
Third, some have expressed the concern that the purchases and lower rates will not spur domestic investment and job creation, but rather will simply encourage firms to borrow and expand abroad, where returns are likely to be higher. This would clearly defeat the intent of the policy.
Finally, there is the risk that more asset purchases will simply add to excess reserve holdings by banks, which will increase both the monetary base and potential for expansion of the money supply, should banks suddenly begin lending again; and this would generate an abrupt change in inflation, inflation expectations, and nominal interest rates. The larger the amount of excess reserves, the greater is this risk, the more complicated the Fed’s exit strategy becomes as it begins to reverse policy, and the more likely the FOMC is to be too late to act and find itself behind the policy curve. One reason for this belief is that more and more investors are moving into bonds bearing low interest rates. Others are sitting on huge bond portfolios with embedded capital gains. Should there even be a hint of a policy change in the FOMC’s statements, in speeches, or in a change in the pattern of its purchases, rational bond holders and managers will run for the door to avoid getting caught. This raises the specter of a large rate shock that could trigger panic bond sales and spawn the next financial crisis. These are the kinds of concerns that are behind the cautious statements from some of the federal reserve bank presidents about the likely costs of additional quantitative easing and the continuing dissent by President Hoenig.
So, where does that leave the FOMC? Clearly, there is an active debate on these issues that is not yet resolved. There are differing assessments over the relative importance of the Fed’s output versus inflation mandates. There is also great uncertainty about the efficacy of the tools that it has at hand to deal with the problem. The FOMC doesn’t know what to do, how much to do, or when to do it. Additionally, the FOMC continues to struggle with its communications policy, and so far all it has succeeded in doing is to increase market uncertainty. We expect to see more leaks and trial balloons on possible strategies, which this writer believes is unbecoming of the central bank. Under such circumstances, when you have dug yourself into a hole, the best plan is to stop digging. This is what the FOMC essentially has done in the hopes that the recovery will continue, albeit at a halting rate. We also expect rates to remain low, and the data will dictate what the FOMC does next.