LSAP 2: A Question for the Chairman

by Annaly Capital Management

We attended Chairman Bernanke’s lecture last Friday at Princeton University, primarily because there was going to be open Q&A. As it turns out, despite our eagerly raised hand we were not called, the questions that were asked were beside the point, and in any event his talk steered far away from monetary policy. (His speech evaluated the study and practice of economics in light of the overall failure by the economic community to predict the nature, timing or severity of the financial crisis.) So we didn’t learn anything that we didn’t already know.

Unfortunately, what we don’t know is worth knowing. Our interest is in the newly-opened door to another round of Large Scale Asset Purchases (LSAPs). The first round increased the Federal Reserve’s balance sheet to over $2 trillion, and the Fed had started to float trial balloons about possible exit strategies. But the weakening of the economy, the Fed’s announced policy of reinvesting principal payments from its portfolio of Agency MBS and the FOMC’s pledge to “provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate,” have brought back the focus back to LSAPs as the main tool to go after long-term rates. Let’s focus on one passage from his Jackson Hole speech in this regard:  “[T]he evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets.” This is true. Research from the New York Fed called “Large-Scale Asset Purchases by the Federal Reserve:Did They Work?”found that the reduction in the term premium on 10-year Treasurys as a result of the announcements and execution of the first LSAP was between 30 and 100 basis points. The graph below from the paper, written by Joseph Gagnon, Matthew Raskin, Julie Remache and Brian Sack, shows the cumulative effect of one-day responses in basis points for a number of markets to the baseline announcements regarding the first LSAP (the initial announcement, Bernanke’s 12/1/08 speech and certain FOMC statements), the baseline announcements plus all FOMC statements and minutes over the period, and the same baseline events using cumulative two-day measurements.

Bernanke continued his Jackson Hole speech, and said he believed “additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions.” This brings us to the question we would have asked Chairman Bernanke. “Mr. Chairman, the problem in the United States is not rate or financial conditions. Corporations are borrowing in the credit markets at advantageous rates—for example, IBM at 1% and Microsoft at 7/8% for three years—and the funding markets are liquid. What does the Fed do if it expands its balance sheet to $4 trillion or $6 trillion, drives the 10-year yield down to 2% or less, but unemployment still stands around 10%?” The reason we would ask is the first slug of quantitative easing has not been successful in improving the unemployment rate, as the graph below shows. Moreover, there is the risk of diminishing returns for each round of LSAPs.

If we had gotten a chance to ask the question, we believe he would have given one of the following three answers:

1. “The counterfactual is that the unemployment rate would be much higher had we not executed our balance sheet with our first $2 trillion of large scale asset purchases.”

2. “Do more.”

3. “Like I said at Jackson Hole, central bankers alone can’t solve the world’s economic problems.”