Fed Mulls New Bond Approach
By Jon Hilsenrath
September 28 (Wall Street Journal)
Federal Reserve officials are considering new tactics for the purchase of long-term U.S. Treasury securities to bolster a disappointingly slow recovery.
Rather than announce massive bond purchases with a finite end, as they did in 2009 to shock the U.S. financial system back to life, Fed officials are weighing a more open-ended, smaller-scale program that they could adjust as the recovery unfolds.
The Fed hasn't yet committed to stepping up its bond purchases, and members haven't settled on an approach. After its meeting last week, the Fed's policy committee said it was "prepared" to take new steps if needed.
A decision on whether to buy more bonds depends on incoming data about economic growth and inflation; if the economy picks up steam, officials might decide no action is needed.
The Fed's internal debate about a bond-buying strategy is emblematic of the challenging position in which it finds itself. In normal times, it simply raises or lowers short-term interest rates to guide the economy.
But having pushed short-term rates to near zero, it now has to devise new, untested approaches at almost every turn. A misstep could lead to unintended consequences, one factor that makes officials wary and investors jittery about its every move.
In theory, buying long-term bonds pushes other interest rates down because it reduces the supply of debt available to investors, pushing up the price of this debt and the yield down.
In March 2009, the Fed said it would buy $1.7 trillion worth of Treasury and mortgage-backed securities over a six to nine month period—known inside the Fed as the "shock and awe" approach.
Most Fed officials believe that helped to drive down long-term interest rates and spurred the economy.
Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.
Most economists at the Fed and outside, though not all, believe that the Fed's decision to embark on what's known as "quantitative easing"—buying bonds—after cutting its target for short-term interest rates to near zero helped prevent an even deeper recession.
A move to resume the purchases would be a big step for the Fed, which just a few months ago was talking about how to reduce its portfolio.
In deciding how to resume its large-scale purchases, if it opts to do so, the Fed is considering both the potential benefits of pushing down already-low long-term interest rates and the potential risks, particularly to its credibility in financial markets about its ability and willingness to reverse course if the economy rebounds or inflation accelerates.
Fed officials have done little to dissuade investors that they might do more.
Fed Chairman Ben Bernanke last week reiterated his dissatisfaction with the recovery, saying the economy has failed to grow "with sufficient vigor to significantly reduce the high level of unemployment."
Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at least another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.
A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path.
"The shock and awe approach is rarely the optimal way to conduct monetary policy," he says. "I really do not think it is the right way to go except in really exceptional circumstances."
In the heat of the crisis it made sense to jar frozen markets back to life with a big attention-grabbing program, he says. Announcing another big program with a finite end date now, he says, would lock the Fed into a policy that might not prove appropriate several months from now.
Moreover, a large commitment could destabilize markets by unhinging the dollar or creating fears of a big inflation uptick, he says.
Under a small-scale approach, Mr. Bullard says, the Fed might announce some still-undecided target for bond buying—say $100 billion or less per month. It would then make a judgment at each meeting whether continued action was needed, he says, based on whether "we're making progress toward our mandate of maximum sustainable employment and inflation at our implicit inflation target."
There are many open questions. One is size. Mr. Bullard says doing more than $1 trillion of purchases per year would give him "pause" because that's how much net debt the Treasury will issue this year, meaning the Fed would be financing it all. There is also a question of whether the Fed might tie further action to movements in the unemployment rate, inflation or other metrics.
Mr. Bullard currently is among 12 regional Fed bank presidents with a vote on monetary policy, along with the four current Fed governors in Washington. He has been arguing for this kind of approach to Fed policy for several months, but only began to get traction with other officials as the economy slowed down this summer.
The Fed is not of one mind on the issue, though. Some officials are reluctant to resume bond buying to, as they put it, "fine tune" the economy. Others are more inclined to be bold to resuscitate the recovery.
A small-scale approach could be a path to compromise among officials.
"Given the disagreement about the need for additional easing within the FOMC, retaining some flexibility might be critical to the adoption" of more quantitative easing, Goldman Sachs analysts said recently.
The Goldman economists estimate that an open-ended, small-scale approach would have less impact on bond markets than a large one-time approach, because investors wouldn't be certain about whether such a program would continue.
"The more you commit to large amount of purchases up front, the bigger effect you're going to get," says Jan Hatzius, Goldman's chief economist.
The Fed concluded its $1.7 trillion purchases of mortgage and Treasury bonds in March. Researchers at the Federal Reserve Bank of New York estimate that the program reduced long-term interest rates by between 0.3 percentage point and 1 full percentage point.
The Fed took a step toward new purchases in August. It said it would begin replacing maturing mortgage bonds by purchasing Treasury debt to keep the overall level of its securities holdings constant.
Rather than announce massive bond purchases with a finite end, as they did in 2009 to shock the U.S. financial system back to life, Fed officials are weighing a more open-ended, smaller-scale program that they could adjust as the recovery unfolds.
The Fed hasn't yet committed to stepping up its bond purchases, and members haven't settled on an approach. After its meeting last week, the Fed's policy committee said it was "prepared" to take new steps if needed.
A decision on whether to buy more bonds depends on incoming data about economic growth and inflation; if the economy picks up steam, officials might decide no action is needed.
The Fed's internal debate about a bond-buying strategy is emblematic of the challenging position in which it finds itself. In normal times, it simply raises or lowers short-term interest rates to guide the economy.
But having pushed short-term rates to near zero, it now has to devise new, untested approaches at almost every turn. A misstep could lead to unintended consequences, one factor that makes officials wary and investors jittery about its every move.
In theory, buying long-term bonds pushes other interest rates down because it reduces the supply of debt available to investors, pushing up the price of this debt and the yield down.
In March 2009, the Fed said it would buy $1.7 trillion worth of Treasury and mortgage-backed securities over a six to nine month period—known inside the Fed as the "shock and awe" approach.
Most Fed officials believe that helped to drive down long-term interest rates and spurred the economy.
Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.
Most economists at the Fed and outside, though not all, believe that the Fed's decision to embark on what's known as "quantitative easing"—buying bonds—after cutting its target for short-term interest rates to near zero helped prevent an even deeper recession.
A move to resume the purchases would be a big step for the Fed, which just a few months ago was talking about how to reduce its portfolio.
In deciding how to resume its large-scale purchases, if it opts to do so, the Fed is considering both the potential benefits of pushing down already-low long-term interest rates and the potential risks, particularly to its credibility in financial markets about its ability and willingness to reverse course if the economy rebounds or inflation accelerates.
Fed officials have done little to dissuade investors that they might do more.
Fed Chairman Ben Bernanke last week reiterated his dissatisfaction with the recovery, saying the economy has failed to grow "with sufficient vigor to significantly reduce the high level of unemployment."
Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at least another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.
A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path.
"The shock and awe approach is rarely the optimal way to conduct monetary policy," he says. "I really do not think it is the right way to go except in really exceptional circumstances."
In the heat of the crisis it made sense to jar frozen markets back to life with a big attention-grabbing program, he says. Announcing another big program with a finite end date now, he says, would lock the Fed into a policy that might not prove appropriate several months from now.
Moreover, a large commitment could destabilize markets by unhinging the dollar or creating fears of a big inflation uptick, he says.
Under a small-scale approach, Mr. Bullard says, the Fed might announce some still-undecided target for bond buying—say $100 billion or less per month. It would then make a judgment at each meeting whether continued action was needed, he says, based on whether "we're making progress toward our mandate of maximum sustainable employment and inflation at our implicit inflation target."
There are many open questions. One is size. Mr. Bullard says doing more than $1 trillion of purchases per year would give him "pause" because that's how much net debt the Treasury will issue this year, meaning the Fed would be financing it all. There is also a question of whether the Fed might tie further action to movements in the unemployment rate, inflation or other metrics.
Mr. Bullard currently is among 12 regional Fed bank presidents with a vote on monetary policy, along with the four current Fed governors in Washington. He has been arguing for this kind of approach to Fed policy for several months, but only began to get traction with other officials as the economy slowed down this summer.
The Fed is not of one mind on the issue, though. Some officials are reluctant to resume bond buying to, as they put it, "fine tune" the economy. Others are more inclined to be bold to resuscitate the recovery.
A small-scale approach could be a path to compromise among officials.
"Given the disagreement about the need for additional easing within the FOMC, retaining some flexibility might be critical to the adoption" of more quantitative easing, Goldman Sachs analysts said recently.
The Goldman economists estimate that an open-ended, small-scale approach would have less impact on bond markets than a large one-time approach, because investors wouldn't be certain about whether such a program would continue.
"The more you commit to large amount of purchases up front, the bigger effect you're going to get," says Jan Hatzius, Goldman's chief economist.
The Fed concluded its $1.7 trillion purchases of mortgage and Treasury bonds in March. Researchers at the Federal Reserve Bank of New York estimate that the program reduced long-term interest rates by between 0.3 percentage point and 1 full percentage point.
The Fed took a step toward new purchases in August. It said it would begin replacing maturing mortgage bonds by purchasing Treasury debt to keep the overall level of its securities holdings constant.