E-piphany

Many Fed watchers and other assorted punditry have focused recently on how the Fed is exiting from the temporary liquidity facilities and how it is going to go about draining liquidity from the system when it is time to do so. For example, there has been much attention focused on the Desk’s testing of large-scale reverse repos and the question of whether this indicates a hike in rates (or otherwise tightening of monetary policy) is near. This is well and good, but it seems less attention has been paid, at least from the point of view of public statements from the Fed, to the market effects of the unwind of the Fed’s massive balance sheet position.

I want to bring to your attention several excerpts from a very important recent speech by Brian Sack, who manages the System Open Market Account (SOMA) at the NY Fed (in market parlance, he ‘heads the Desk’ with a capital “D”). Ordinarily, I need to significantly annotate speeches from Fed officials in order to mark-them-to-market with respect to reality. With Mr. Sack’s speech, I don’t really need to do that very much and it is a delight.

As an aside, I think Sack is a big upgrade over the prior manager of SOMA, Bill Dudley, who now runs the whole NY Fed. He is more of a theoretician, and I initially had concerns that he may not be as adroit a manager of markets as is required, but he has done a great job during a time when Desk operations were being conducted in totally new ways. I don’t applaud many public servants, and Mr. Sack and I have disagreed in the past on some economic questions of importance, but he deserves laurels for his work to date.

So without further detour, here are some choice quotes from Mr. Sack’s December 2, 2009 speech at the Money Marketeers club of NYU, entitled “The Fed’s Expanded Balance Sheet” and available in full here.

He begins by talking about the Fed’s program of purchasing $300bln of Treasuries, $175bln of agency debt securities, and $1.25 trillion of MBS, and discusses some of the side effects:

“With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.”

It is fantastic to see a Fed official actually understand and admit that they are somewhat responsible for bidding up equities, even when they’re not bidding on equities. And his explanation of why it happens is clear and concise. Bravo!

“One key issue in this regard is whether the market effects mentioned before arise from stock or flow effects. The portfolio balance effects discussed earlier would presumably be associated with changes in the expected stock of assets held by the public. Under this view, even an abrupt end to the Fed’s purchases, if fully anticipated, would not cause an adverse market response, as it would not represent a discrete jump in the outstanding stock of securities held by the public. However, we want to allow for the possibility that the flow of asset purchases, or the ongoing presence of the Fed as a significant buyer, may also be relevant for market pricing. In that case, the end of the Fed’s purchases could cause an increase in longer-term interest rates, at least temporarily until the market has had more of an opportunity to adjust to the Fed’s absence.”

When have you even seen any other Fed official make such an important distinction, and raise such an important question?

“Related to this discussion, it is useful to note that exiting from LSAPs can involve a tension that is absent in the Fed’s liquidity facilities discussed earlier. The liquidity facilities were established in response to considerable market strains that had caused the price of term liquidity to skyrocket. In responding, the Fed could be confident that it was pushing market rates toward levels that would be considered normal over the intermediate term. LSAPs, in contrast, could in practice push risk premiums below the levels that would be sustainable over the medium term. Doing so could still be an optimal approach, in terms of achieving macroeconomic outcomes, even if it requires that market pricing will eventually have to reverse.”

Better yet, when have you heard a Fed official note that what they are doing might actually have a deleterious effect if taken too far?

I am clearly taking snippets from throughout the speech, so I apologize if they don’t segue well. He next starts talking about tools under consideration, in particular the paying of interest on reserves.

“In that regard, it is useful to consider what these tools can achieve and what they cannot. As noted earlier, draining reserves with these tools could help to improve our control of short-term interest rates, which is the critical issue for ensuring that policymakers can tighten financial conditions when necessary. However, draining reserves with these tools does not undo the portfolio balance effects of the LSAPs. These operations would basically substitute one short-term, risk-free asset for another—replacing what is in effect an overnight loan to the Federal Reserve (reserves) with another short-term loan to the Fed (a reverse repo or term deposit). It is hard to believe that the willingness of an investor to hold risky assets or of a bank to make risky loans would be affected in any meaningful way by this substitution between such similar assets.

“A key issue here is whether reserves have some special importance for the availability of credit. Some market observers have a very reserve-focused perspective on the transmission mechanism of monetary policy, arguing that high reserve balances inevitably lead to rapid credit expansion. Under that view, the large-scale asset purchases provide stimulus to the economy primarily by supplying reserves to the banking system, in which case the stimulative effects could be unwound by draining the reserves using any of the tools available. My own perspective differs. In my view, the effects of the asset purchases arise primarily from the removal of duration and prepayment risk from the markets, based on the portfolio-balance effects discussed earlier. Those effects would not be unwound by draining reserves with reverse repos or term deposits.”

I have a modest issue here. If the Fed can push markets up by buying lots of risky securities and then essentially immunize it by paying interest on balances at the Fed or doing reverse repos with no effect on the portfolio balance effects, then why shouldn’t they do that constantly? It seems like a free lunch. Of course, it’s not – by buying risky assets, and not selling them out, the Fed (and by extension, taxpayers via the budget) is collectivizing the risk. I would have liked to see a nod in this direction, or some indication that merely holding these risky assets at the Fed in run-off mode creates other imbalances.

“An alternative approach would be to reverse a portion of the portfolio-balance effects through asset sales. Asset sales would put the portfolio risk back into the market at a faster pace than redemptions alone, forcing risk premiums to adjust more quickly in order to entice investors to hold that risk. The result would be to put upward pressure on Treasury yields and MBS rates independent of any changes in the expected path of short-term interest rates, so that less of the burden of financial tightening would fall on the short-term interest rate.”

Also, I would add, it should reverse earlier effects and cause other risk assets to fall. But it is the result that gets the Fed back to where it began most effectively, and gets risk back in the market where it is supposed to be more quickly. By not selling the assets, the Fed is creating a market shortage of risky assets and driving up the price of risky assets above where it would be if all risks had a market price. Mr. Sack mentions this earlier, but neglects to mention that this statement defines the word “bubble.” The Fed is, in no uncertain terms, helping to inflate another bubble. The only way to avoid this is to sell the assets into the market as soon as is practicable. But they have to choose between pain now and deferred pain from a later bursting of this next bubble. Since Volcker, no Fed and no Administration has chosen current pain and I am not convinced they will have the guts to do so.

But these are excellent questions and an excellent discussion of them by Mr. Sack. As readers will know, I have been a critic of the Federal Reserve for a long time, in particular its Chairmen (see the tab at the top of this page? Buy my book! Buy my book!). And I think the very structure of the Fed and its conflicting mandates makes its usefulness as an institution not a completely slam-dunk case. But I will give credit where credit is due. I figured the Fed would miss some of the really important big-picture issues about the way the end game of this crisis should be played. This seems reasonable, since they missed some of the important big-picture issues about the way it began. I still believe they will be late in tightening and that we will have some measure of inflation before they can rein it in, just because there are lots of reasons to be slow and few reasons to be fast (not to mention, I doubt they are looking at inflation ex-Shelter). But I am less concerned today that they will completely lose control of the situation, and it is because of guys like Brian Sack.

At the end of the day, inflation is partly a global process and effective central banking at the Fed can’t prevent other central banks from screwing up. Additionally, the part of inflation that is idiosyncratic to the US and comes as a result of dollar depreciation isn’t the Fed’s fault, but will eventually be laid at the door of the people trying to finance the huge deficits. But, while I am no fan of Ben Bernanke, I will say that this Fed is definitely improving its marks this semester.