Aug 28. Fed out of bullets?

A couple of thoughts about Bernanke’s Jackson Hole 2010 speech.  He talks about the transmission mechanism of central bank purchases of assets bringing down rates, but candidly admits that quantification is somewhat difficult.  Then later he says if the economy weakens and long term rates are falling as a result, mortgage refi’s may cause significant pre-payment on MBS in the Fed’s portfolio, causing its balance sheet to shrink just as the economy might need further support. 
 
Here are a couple of passages:
 
        I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.
 
    Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed’s balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening–a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments of principal on agency securities into longer-term Treasury securities.
 
     One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions.
 
     Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. (Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit.) To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. Indeed, by providing maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy stance–and thereby helping to anchor inflation expectations–the Committee increases its own flexibility to use securities purchases to provide additional accommodation, should conditions warrant.
 
In some ways this seems circular: Bernanke credits the Fed with bringing down long term rates, but also says a weaker economy can do the same thing.  So it is pretty clear they can’t exactly quantify how much of the drop is due to the Fed.  And he pretty much admits that.  He also highlights the risk that large increases in the Fed’s balance sheet could cause a crisis in confidence.  So if, as the Fed Chairman, you are conveying the idea that lowering rates along the curve is your PRIMARY WEAPON, but that a weaker economy probably accomplishes the same thing and we’re already near zero, then the public could easily draw the conclusion from this line of reasoning that the Fed really IS out of ammo.   
 
The more I focus on these aspects of the speech the more fearful I am that the Fed might not be able to handle the situation over the medium term, and you can bet the farm they’re not getting any help from Congress.
 
On the positive side, he mentions that flow of credit to smaller businesses and efforts to spur smaller bank loans is a large goal of the Fed.  I think he should have emphasized those programs much more.
 
What he neglects to mention is that consumption as a percentage of GDP just became too large due to overuse of leverage, and that it takes a while to work through the changes.  At this point policy makers should just be trying to cushion the fall and smooth out rough spots.  It is pretty clear from interviews with business leaders and even according to Bernanke himself that uncertainty is a major factor holding down the economy, whether due to regulation/tax changes or the larger macro picture.  A return to political gridlock after the November elections is probably the best outcome we can hope for.

Posted on August 28, 2010 at 2:31 pm by alexmanzara · Permalink
In: Eurodollar Options

Leave a Reply