The Federal Reserve’s Open Market Committee met in secret by videoconference on October 15th to hash out policy issues ahead of the official November 2-3. The most extraordinary development at that meeting was discussion around whether the Federal Reserve should target long-term interest rates with an unlimited supply of liquidity. Eventually, the committee settled for the less spectacular sum of $600 billion.
The Fed released the minutes of those two meetings yesterday. There were a number of surprising admissions in the minutes. But first, here is what the Fed said regarding the October 15th discussion:
The Committee met by videoconference on October 15 to discuss issues associated with its monetary policy framework, including alternative ways to express and communicate the Committee’s objectives, possibilities for supplementing the Committee’s communication about its policy decisions, the merits of smaller and more frequent adjustments in the Federal Reserve’s intended securities holdings versus larger and less frequent adjustments, and the potential costs and benefits of targeting a term interest rate. The agenda did not contemplate any policy decisions and none were taken.
So the Fed was not meeting to conduct policy but rather to coordinate future policy action. This dovetails with what I had been saying about the Fed’s desire not to make any decisions until after the US midterm elections. However, the discussion of future policy decisions was significant. Writing for Bloomberg News, former Bank of England policymaker David Blanchflower had broached the concept of the Fed’s targeting municipal bonds during a second round of QE. However, there is no indication that this was discussed. What was discussed was whether to create a specific target for long-term interest rates. That is the first surprising admission.
Finally, participants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce longer-term interest rates and thus provide additional stimulus to the economy. But participants also noted potentially large risks, including the risk that the Federal Reserve might find itself buying undesirably large amounts of the relevant security in order to keep its yield close to the target level.
This is significant. This paragraph at once demonstrates that the Federal Reserve understands it could have done more but is actually only committed to QE-lite as I have called this round of QE. Likely, political constraints or internal dissent explains why the Fed took this route. Here is what the Fed could have done:
- Buy municipal bonds. Blanchflower had said "they are also allowed to buy short-term municipal bonds, and given the difficulties faced by state and local governments, this may well be the route they choose, at least for some of the quantitative easing."
- Set an interest-rate target. As authors here have indicated (see here), the Fed has absolute control over the full spectrum of rates if it is willing to offer unlimited supply of liquidity to target those rates. This is what is meant when the Fed says "participants also noted potentially large risks, including the risk that the Federal Reserve might find itself buying undesirably large amounts."
- Buy only the longest duration Treasury assets. he Fed could have targeted long-lived assets like 10- and 30-year paper. This would have had the largest impact on mortgage rates. Instead, it has chosen to target the middle of the yield curve.
Again, you have to remember that its about price i.e. interest rate not quantity. If the Fed is to be effective, it has to alter the interest rate. Randall Wray said it well last week:
All of those who are focusing on quantities, such as the $2 trillion of excess reserves the Fed created plus the additional $600 billion of excess reserves the Fed plans to create just do not get it. It is about price (rates) not quantity
We now have confirmation that the Federal Reserve knows this. So why have they chosen to focus on quantity instead of price? I think it is because they do understand that QE is controversial. My view has been that the Fed feels politically constrained and will only act in small measure. For example, last month I wrote:
Here’s the thing: The Federal Reserve Board is located in Washington, DC and Washington is a political town. As such, the Fed must mind its manners or it will find its mandate diminished. You may recall that the Fed has already taken a lot of unconventional measures in lending to AIG, in setting up the TALF, and in its program of credit easing (what I called qualitative easing) by focusing on the asset side of the Fed’s balance sheet in printing money during the credit crisis. I see all of this in a dubious light, as do many others like former Fed Chair Paul Volcker and Fed stalker Ron Paul…
I suspect the Fed can begin and may well have already begun some QE type stuff. They won’t announce it until later and I don’t believe they will have done so in a big way. But, if they announce on Nov 3 that they already are doing QE, this could be beneficial to asset prices – because I think that’s what they’re concerned about.
And so we have seen the reaction in asset markets. The effect is now waning, however. As to depreciating the currency, this too was seen as potential collateral damage by the Fed. The minutes say:
Most participants judged that a program of purchasing additional longer-term securities would put downward pressure on longer-term interest rates and boost asset prices; some observed that it could also lead to a reduction in the foreign exchange value of the dollar.
As with asset markets, we saw the initial reaction after the Fed’s announcement. However, the effect has waned and we are back to where we started. Buy the rumour, sell the news.
The first round of QE was somewhat defensible as a measure to provide lender of last resort liquidity. This round is different. I do not advocate more QE. Nevertheless, my view is that QE will be ineffective in large part because the Fed has not taken any of the three more draconian measures I highlighted above. Moreover, QE has been that much more destructive because it has damaged America’s negotiating position abroad and made the Fed a lightening rod of criticism. Meanwhile, Ben Bernanke continues to argue that QE will create jobs when all indications are that it will not – unless they are willing to target interest rates lower with an unlimited supply of liquidity. Then, and only then, would we have to worry about inflation from the huge amounts of money sloshing around the system. Marshall’s post Amateur Hour at the Federal Reserve looks even more on target today than when he wrote it.
Source: Minutes of the Federal Open Market Committee, October and November 2010