How will we know if it’s working?
The Federal Reserve surprised no one yesterday when it announced it would purchase $600 billion of long-term Treasuries, concentrated in 2 1/2- to 10-year maturities, by the end of the second quarter of next year. The move was about as well-advertised as it gets.
Now comes the hard part. The Fed’s goal for quantitative easing, part II, is to lower other long-term rates, making it cheaper to buy homes and finance factories. With both ends of the yield curve now under the influence of the central bank, policy makers will lose one of the more important signaling measures they have.
Not that they’re watching or listening. The yield curve, or spread between a Fed-pegged overnight rate and a market- determined long-term rate, succinctly describes the stance of monetary policy. Unlike the Fed’s econometric model, which did such a fine job of anticipating the recession, the inverted yield curve from mid-2006 through January 2008 provided advance warning -- and was widely ignored.
In the same way that printing money risks raising asset prices instead of increasing demand for goods and services, “there’s a danger in depressing a market signal,” says Jim Glassman, senior U.S. economist at JPMorgan Chase & Co.
Other signs of the economy’s health and the effectiveness of the Fed’s efforts -- stock prices, the value of the dollar and credit spreads -- will remain viable, but playing with the yield curve is like trying to fool Mother Nature.
The last time the Fed and Treasury made a serious attempt to manipulate the yield curve was with Operation Twist in 1961. The idea was to lower long-term interest rates to stimulate investment -- John Maynard Keynes was big back then, too -- and prop up short-term rates to prevent capital outflows.
The mechanics involved the Fed buying notes and bonds (previously it had a “bills only” policy) in its open-market operations. At the same time, the Treasury acted like a banker, borrowing short (to finance its spending) and lending long (for its trust accounts).
While Operation Twist was considered a failure at the time, in part because of the reluctant participation of the parties involved, the idea keeps coming back. It was kicked around in the U.S. in the 1970s, 1980s and 1990s. It rears its head periodically in Japan. Last year the Fed bought $1.7 trillion of long-term Treasuries, agency debt and mortgage-backed securities in its first stab at boosting the economy with the benchmark rate near zero.
Mortgage rates did fall, and the spread to Treasuries narrowed, during the Fed’s buying bonanza, but it’s impossible to tease out the Fed effect from weak housing demand. Existing home sales are no higher now than they were when the Fed announced its MBS purchases in November 2008; new home sales are lower.
Which brings me to my idea for the Fed. Instead of another round of Treasury purchases, the Fed missed an opportunity to kill two birds with one stone by using QE2 to buy foreclosed homes.
I was half-kidding when I wrote that sentence. Now I’m not so sure it’s a bad idea, assuming the Fed were empowered to buy houses.
Look at it this way: The Fed stimulates aggregate demand by increasing the quantity of reserves in the hope banks will use them to make loans and buy securities, expanding the money supply even further. From the perspective of quantitative easing, it doesn’t matter what the Fed buys. The reserves impact is the same.
Right now there are more homes than buyers, putting downward pressure on prices. Instead of spending $600 billion to lower long-term rates a tad, the Fed could accumulate a sizeable inventory of foreclosed properties, reducing the supply of homes and stabilizing the housing market.
The Fed could offer its employees in Washington and in the cities where it has district banks free housing. Those employees would presumably spruce up the premises, preventing further erosion in the property and the neighborhood.
Unlike the losses the Fed will incur on its portfolio of Treasuries and MBS when interest rates rise, the homes would probably turn a profit. In a rising market, it’s not hard to unload inventory. The tenants of those homes would have to find new places to live, providing added demand for housing.
OK, so it’s a little unconventional. But isn’t that what the Fed is looking for? Why not be creative?
By purchasing Treasuries, the Fed will miss the turn in the cycle as long rates are artificially depressed. Six months ago policy makers were mulling their exit strategy, only to be side- swiped by the data.
All it took was a hint the U.S. economy was improving to send 10-year note yields soaring to 4 percent in April 2010 from a low of 2 percent in December 2008 in the darkest days of the crisis. Imagine what will happen when the real turn in the economy comes.
The anticipation of QE2 has done more for stock and commodity prices than for bonds. The yield on the 10-year Treasury note is just about where it was when Fed chief Ben Bernanke first teed up additional asset purchases in late August.
If I were a central banker with a $2.3 trillion balance sheet, I would want as many market signals as I could get to nudge me when it’s time to head for the exits. Depressing one of the better ones is, well, depressing in itself.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
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