Yesterday, when discussing what QE3 could look like, I highlighted the 2002 remarks by then Federal Reserve Board Governor Ben Bernanke before the National Economists Club in Washington, D.C.. Bernanke was outlining what the Fed could do in a zero interest rate environment to promote economic activity. I indicated that the FOMC has already considered offering unlimited quantitative easing to target specific interest rates during the second round of quantitative easing. I believe the Fed will do this in QE3, and apparently Bill Gross and David Rosenberg do as well. While a QE3 is still a way’s off – probably not until 2012 – it makes sense to think about how it will be conducted.
The crucial passage pertaining to quantitative easing in a zero interest rate environment is below. Bernanke stated:
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
Today, Pimco offered up the same thinking on Twitter:
- Gross: QE3 likely to take form of “extended period” language or interest rate caps on 2-3 year Treasuries.
- Gross: Next week’s Fed statement will likely stress “extended period of time” language or even a period of interest rate caps.
My understanding about what Gross believes is that the Fed could see QE3 "guaranteeing" a 2 year or 3 year yield at a certain level—say 50 basis points. Moreover, the Fed would not necessarily have to buy any Treasuries to defend this target. Gross understands that the private sector “would do it” for the Fed via the language and confidence in the "guarantee". In fact, I was tipped off last night that “it worked on long bonds in the 40s as his speech indicates.” The same individual also tipped me off that “the helicopter speech has been reemphasized as recently a 8/2010 at Jackson Hole”. So it is clear that Bernanke will do this if the economy is near or in recession.
I think this point about not having to buy any securities despite offering to defend the rate with an unlimited supply of liquidity is significant. We have mentioned this in passing before regarding the Fed’s defense of the Fed Funds rate.
Scott Fullwiler wrote me:
The Fed and other central banks actually don’t change the qty of rbs when they want to change the interest rate target. Under pre-Lehmann operating procedures (that set the target rate above the rate paid on rbs) the demand for rbs is VERY interest inelastic at the qty banks desire to hold to settle payments and meet rr. The Fed essentially just announces a new target, and stands ready to "defend" the target via repos/reverse repos if the mkt doesn’t move to the new rate.
The same approach can be taken anywhere on the Treasury curve. As I said in the term-structure post:
I think this is significant when thinking about bond market vigilantes and the like. But the key takeaway from the Japanese experience is the one I just outlined: sovereign central banks control short-term rates in the currency they issue and through the term structure, they also have some control over longer-term rates. When there is slack in the economy, there is only so far the bond market vigilantes can go. I’m not saying rates can’t rise. I’m saying that that rise is capped if an economy is in a balance sheet recession.
Despite the talk of financial repression, savvy market participants like Bill Gross know the Fed has this power to ‘artificially’ suppress rates. I would argue it is the knowledge that the Fed is able to do so that has people talking about financial repression. Of course, savers don’t have a ‘right’ to a specific rate of return. But, rates are going to be held below what the market would dictate. if you are a fixed income investor in the United States, the only reason to invest in Treasuries then is to benefit from the price appreciation associated with yield suppression that interest rate caps would involve. A better bet is to find yield elsewhere – in high quality, high dividend shares, in corporate bonds or in government bonds in economies that offer a better yield and macroeconomic backdrop. And this is exactly why Gross is looking elsewhere to get bond yield.
Will this policy be a ‘free lunch’? Raghuram Rajan says no and I agree. Savers are the first casualty. But, more importantly, so are consumer balance sheets. Releveraging is exactly what is desired by these kinds of policies both on the monetary and fiscal side. Larry Summers said it well when he quipped:
that the central objective of national economic policy until sustained recovery is firmly established must be increasing… borrowing and lending
If the rate of return is artificially suppressed, you are probably going to get an underinvestment in capital in the sectors where you want it because marginal debtors and marginal projects will be favoured. That leads to malinvestment and longer-term economic underperformance. We have seen over the past generation that the distributional effects of monetary policy are much larger than mainstream economists estimate and ultimately end up in crisis.
My take: the US savings rate will remain low because of the skew in favour of debtors. With private sector debt levels still high, that means future US recessions will be events of extreme levels of private sector deleveraging and public sector deficits
There is certainly nothing preventing the Fed from targeting the 10-year Treasury-note any more than the Fed funds rate. But the funds rate is already near zero and as such there is no incremental move there that can benefit the economy. But targeting the 10-year note in much the same fashion is probably worth a try and if there is anything else we know about Ben Bernanke. It is that…
(i) he will be late, not early. So, by the time this comes the economy may well be back in recession, which in balance sheet cycles tend to occur every three years, so mark 2012 down in your calendar;
(ii) he is willing to be very aggressive when the time comes — he has certainly proven that. Back in 2007 or 2008 for that matter, who believed that short rates were going to vanish entirely and that the Fed would be buying assets by early 2009?
Now it is doubtful that the Fed would ever target the long bond. In fact, the Fed may even want it to be higher in yield to ease the pressure on radically underfunded pension funds. While the Fed can either target its balance sheet, which it has been doing with these QE measures, or target interest rates, it cannot do both at the same time. So the next ‘QE’ will not be called ‘QE’ but rather something else — maybe Operation Twist 2 (072 — you heard it here first).
My sense is that this will not be called quantitative easing or credit easing or anything like that. Those terms are dead because they are now politically radioactive. But operationally, the policy will be the same. This time the Fed will target price instead of quantity.
P.S. – The Fed is likely to soft peddle this policy change because of comments from people like former Atlanta Fed President William Ford questioning Can the Fed Go Bankrupt? The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Eventually people will be forced to accept this – and the term structure will flatten further and further out the curve. That’s how Japan got to a 1% 10-year yield because expectations of zero rate policy continued to lengthen in time.
Peter Diamond, the Nobel prize winner who withdrew his nomination for the Fed, would probably have supported this, judging from his prior statements. In a recess appointment to fill his post, we will probably get a like-minded official. So there is a great likelihood that we are going to see an increasing number of people at the Fed in favour of these policies going forward and fewer people like Plosser or Hoenig.
In my view, the only thing that can force the hand of a central bank is persistent and embedded inflation. Look at the BoE with a headline rate of inflation of 4.5% and a policy rate of 0.5%. If you are a British retiree living on fixed income, you are extremely unhappy. But low rates will continue like this for a good clip (5-10 years at least). Welcome to the new normal.