As Federal Reserve policy makers consider a world without quantitative easing, they are dusting off an idea similar to one proposed by Ben S. Bernanke a decade ago to ward off deflation.
Policy makers discussed creating a program to buy short-term Treasury securities to keep yields in line with their policy intentions, according to minutes of their Oct. 29-30 meeting released this week.
Such a tool could help reinforce the Fed’s commitment to keep the benchmark overnight lending rate near zero even after it starts to reduce its $85 billion in monthly bond purchases. Fed officials are concerned that tapering those purchases, which focus on mortgage securities and Treasuries between four and 30 years, could cause a sudden increase in yields that would threaten the expansion.
“If you say ‘I’m going to commit to keeping rates at zero for three years’ but the market doesn’t believe you, then you could just buy up three-year notes until they do,” said Michael Feroli, the chief U.S. economist at JPMorgan Chase & Co. “It’s a way of backing up their words with deeds.”
The idea resembles a proposal from a 2002 speech by Chairman Bernanke, who was then a Fed governor, titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” said Feroli, a former Fed economist. The speech laid the groundwork for many of the Fed’s actions during the financial crisis and its aftermath.
Fed officials are considering additional tools because they don’t want to continue indefinitely with the monthly bond purchase program, known as quantitative easing. They say the longer QE continues, the greater the risk to financial stability and market functioning and the harder it becomes to exit the policy.
Creative and unprecedented use of the Fed’s legal authority has been a hallmark of Bernanke’s eight-year tenure as chairman. Under his leadership, the Fed found ways to provide loans to companies from Goldman Sachs Group Inc. to McDonald’s Corp., held its target interest rate near zero since December 2008 and enlarged its balance sheet with securities purchases to a record $3.9 trillion.
Fed officials meeting last month considered “a standing purchase facility for shorter-term Treasury securities or the provision of term funding through repurchase agreements,” according to the minutes, which didn’t provide other details or define what maturities officials had in mind.
In repurchase agreements, the Fed swaps securities for cash with financial institutions such as banks or money-market funds. By setting the terms of the deals, the Fed would attempt to fix yields at a certain level. The central bank has traditionally used repurchase agreements to help control the overnight Fed funds rate, and under a new facility could try that approach with longer-maturity securities.
It’s far from clear the ideas discussed in October will be adopted. Policy makers “expressed a range of concerns,” saying the new tools would “remove valuable sources of market information” and “might be difficult to explain to the public.” Still, officials said such operations were “worthy of further study or saw them as potentially helpful in some circumstances.”
Either of the tools discussed could help stave off an unwanted increase in short-term interest rates, such as occurred over the summer, when the yield on the two-year Treasury note climbed as high as 0.52 percent in September from 0.2 percent in early May after Fed officials began considering winding down purchases.
Quantitative easing is one of two tools Fed officials have deployed to stimulate the economy. The other is so-called forward guidance about the future path of the Fed’s target rate for overnight lending among banks, known as the federal funds rate.
“One lesson they learned is that forward guidance is perfectly believable as long as there was QE to back it up,” said Roberto Perli, a partner at Cornerstone Macro LP in Washington and a former Fed economist. “The moment they started talking about phasing out QE, people started questioning the forward guidance.”
The central bank has said since December that it will hold the benchmark interest rate near zero at least as long as unemployment remains above 6.5 percent and the outlook for inflation is no more than 2.5 percent.
At last month’s meeting, Fed officials signaled they may taper their bond buying “in coming months” if the economy improves as anticipated, according to the minutes. In a speech this week, Bernanke sought to assure investors that tapering doesn’t mean an increase in the benchmark rate is any closer.
“The target for the federal funds rate is likely to remain near zero for a considerable time after the asset purchases end, perhaps well after” unemployment falls below the 6.5 percent threshold, Bernanke said.
The facility to buy shorter-term Treasury debt, perhaps only a few years in maturity, would be a way to “back up your promise of low rates with something concrete,” Perli said.
In 2002, when Bernanke was a newly-minted Fed governor under Chairman Alan Greenspan, monetary economists were debating strategies to end deflation and spur growth in Japan, which had held its target interest rate below 1 percent since 1995. Many central bankers were concerned that the U.S. economy might sink into the same trap after the 2001 recession.
“A commitment to keep short-term rates at zero for some time, if it were credible, would induce a decline in longer-term rates” to support growth, Bernanke said in 2002. “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings” for two-year bond yields.
“The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields,” Bernanke said.
The program would be a departure from the current QE that has a defined size of $85 billion in purchases a month. Instead, the Fed could buy whatever was needed to hold interest rates at their target. The potentially “unlimited” nature of the purchases may make the program a non-starter for Fed officials seeking to end quantitative easing on concern the Fed’s balance sheet is growing too large.
Still, the experience of the European Central Bank suggests it may be manageable, said former Federal Reserve Vice Chairman Alan Blinder. Under an as-yet-unused Outright Monetary Policy program, announced in September 2012, the ECB said it would buy unlimited amounts of government bonds maturing in one to three years from nations that met certain criteria related to their debt. Its creation is credited with easing the euro area’s debt crisis.
ECB President Mario Draghi “hasn’t spent a single euro doing that and the spreads have come in a lot -- the market didn’t want to fight the ECB,” said Blinder, a professor at Princeton University. That shows the Fed “might in fact not have to blow up your balance sheet a titanic amount” if it pursued a plan to peg interest rates.
Even so, JPMorgan’s Feroli said he thinks such a strategy “will stay in the ‘in case of emergency’ box,” at the Fed. “Trying to play around with the yield curve, and Bernanke has said this, is something we don’t have any experience with.”
Fed officials are “still in the brainstorming phase,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut, and a former Richmond Fed researcher. “Everything they’ve come up with has pros and cons.”
A decision to adopt the strategy may fall to Bernanke’s successor, Fed Vice Chairman Janet Yellen, whose nomination was approved yesterday by the Senate Banking Committee. Her nomination now moves to the full senate where only one of the 55 Senators allied with Democrats has signaled opposition to her candidacy.
“In principle these ideas may have some merit,” said Perli. “Why not keep thinking about it?”