Tuesday, August 10, 2010
The FOMC today announced that it will reinvest principal payments on its mortgage holdings into longer term Treasury securities. What that means is that bank reserves will remain constant: the line on the above chart will not slowly decline as we had been told it would earlier. The Fed will effectively reduce its trillion-plus holdings of mortgage-backed securities over time, but now it will replace them with Treasury holdings instead of allowing principal repayments to reduce the size of its balance sheet. This will result in a lengthening of the maturity and duration of the Fed's security holdings in a manner that could be likened to another "operation twist," in which the Fed attempts to flatten the yield curve by selling shorter-term securities and buying longer-term securities. In fact, it has already had that effect, and it has helped bring down fixed mortgage rates to new all-time lows.
The first of the two charts above reflects the degree to which the Fed's policy intentions have affected the yield curve. The spread between 2-yr and 10-yr Treasuries has narrowed by almost 70 bps since hitting an all-time high earlier this year. The second chart shows that the spread between 10-yr Treasuries and MBS has not changed materially, so the decline in MBS rates is almost entirely due to the decline in 10-yr Treasury yields. By insisting that it will not tighten policy for a long time, and that meanwhile it will make no effort to reduce the size of its balance sheet, the Fed has managed to bring about a significant decline in intermediate interest rates, with the result that borrowing costs for homeowners have been reduced substantially.
We can't know how much stimulus this will provide to the economy (probably very little if any), but it should be a positive on the margin for the housing industry, since the Fed has so far succeeded in lowering mortgage rates, and that has the immediate impact of making current housing prices more affordable for the marginal buyer.
Since the vast majority of the reserves that the Fed created in the latter part of 2008 have been sitting idle on the Fed's books (banks haven't used the reserves to create new money), the Fed's announcement today was almost a non-event. Whether excess reserves (currently about $1 trillion) remain unchanged or decline slowly (as the market previously expected) will not have any practical impact, per se, on the amount of money sloshing around the economy, nor will it make any difference to banks' willingness to lend. But by lowering borrowing costs for homebuyers, the Fed's actions might increase the public's demand for loans (thereby having the effect of reducing the demand for money), and this could increase the inflationary impact of monetary policy. Confirming this, I note that the values of the dollar and gold changed meaningfully on the news (the dollar weakened and gold rose, signaling an effective increase in the supply of dollars relative to the demand for dollars), the spread between Treasury and TIPS yields widened marginally (signaling a modest rise in inflation expectations), and the 10-30 spread has widened to its highest level in history (signaling an increase in long-term inflation risk).
From my supply-side perspective, the FOMC announcement was disappointing. Instead of standing firm in defense of the dollar and in favor of low and stable inflation, the Fed has (once again) bowed to political pressures by giving priority to the economy and attempting to manipulate the yield curve in support of the housing market.
Does this make me less bullish on equities? Yes, but not by much. Today's announcement does not mark any significant change to the way the Fed has been conducting monetary policy over the past 22 months. But it does push forward the day when the Fed eventually moves to tighten policy, and that is a negative for the economy since it reduces confidence in the dollar and inhibits productive investment. Nevertheless, we are only talking about small changes on the margin to the policy outlook; monetary policy has been part of the problem for some time, and now we know it will remain part of the problem for somewhat longer. The bigger problem right now is fiscal policy, and the Fed made no attempt whatsoever to address that, which is unfortunate.
Posted by Scott Grannis at 12:45 PM