Major Policy Shift
The Fed Open Market Committee voted today to roll its holdings of maturing Fannie and Freddie debt into longer term Treasurys. This represents a significant change in Fed policy and it appears that the anti-deflationist wing of the Fed, led by James Bullard, president of the St. Louis Fed, won over the anti-inflationists led by Thomas Hoenig, president of the Kansas City Fed.
As I reported last week, there is a significant movement in the Fed, led by James Bullard, to increase its Open Market Operations purchases of Treasurys in order to prevent deflation. They see that money supply is decreasing and that zero interest rate policy (ZIRP) has been ineffective. In a groundbreaking paper just published by Bullard, he advocates the purchase of Treasury debt which is, in effect, a monetization of U.S. debt. They believe that such purchases, called “quantitative easing” is the only effective tool the Fed presently has to increase money supply.
This reveals that the Fed is very worried about deflation.
The Fed noted in its press release that:
Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.
They announced their policy change as follows:
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.
Presently (as of August 4) the Fed holds a total of $2.054 trillion of debt. Commencing last year and continuing through April of this year, the Fed bought $1.25 trillion of GSE debt (MBS of the government sponsored entities, Fannie Mae and Freddie Mac) and the balance consists of Treasury paper. They intend to keep their holdings at this level. According to a subsequent release today by the NY Fed, which carries out the Fed’s Open Market Operations, Treasury paper purchases will be “in the 2- to 10-year sectors of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS yield curves.”
They voted to keep the present ZIRP, something Bullard advocated against since he felt it was ineffective and actually contributes to deflationary expectations.
The impact of this new policy on the MBS market is not known, but it would seem that it would weaken the market for GSE debt. Another factor is the rollover rate of the GSE paper was not revealed in this statement, so it is not known how long the markets would take to be impacted by this policy. I can imagine that Treasurys will continue to rise.
While the initial impact of this new policy on the economy will be modest, it sets a precedent for the Fed to substantially increase its attempts to inflate the money supply as the economy declines. Like everyone else they will be watching unemployment numbers and money supply. If unemployment fails to improve, and especially if it grows, then the Fed will pull out the monetary stops through more quantitative easing.
This policy is exactly what I anticipated in my article last week:
Bullard released this paper for a reason and that is to frame the debate about what they are all really concerned about: a sinking economy that will keep unemployment high. Continued high unemployment is not politically acceptable to Congress and the Administration, and the Fed will face tremendous pressure in the next several months as negative data continues to come in.
Most Fed presidents fear unemployment more than they do deflation. I believe they will keep ZIRP for the foreseeable future and that they will also engage in more “quantitative easing.”
Monetizing debt has been a taboo among central bankers because it is a one-way ticket to high inflation. But, Dr. Bullard thinks that is what the Fed should do. That is why I believe we are eventually headed for stagflation.