Tuesday, March 19, 2013

FOMC Report
March 19-20, 2013
Martin McGuire

There is an interesting dynamic in play providing sufficient fodder for argument on both sides, for and against, continued large scale asset purchases (LSAP).  While I expect little, if any, change to the FOMC statement from January and similarly on changes to SEP (Summary of Economic Projections) from December, there is rightly room for forceful and even meaningful discussion during the FOMC meeting on the efficacy and cost of continued LSAP. 
While researching this note, I chanced to look up to the wall monitor and spy President Obama, nominating Tom Perez as the new labor secretary.  The sound was off and no script showed, but I have little doubt recent employment gains (+236,000 in February) and improvement in the unemployment rate to 7.7% were humbly acceptance as indication of appropriate prior executive branch decisions.  There may be enough bragging right in those numbers to be enjoyed also by the FOMC. 
Therefore the progress to date, while squarely short of what the Fed says is needed, can be laid out as a testament to the efficacy of monetary policy including the current LSAP program. This progress would be one part of that dynamic.  
Were it only for the strengthening employment and housing statistics, a stronger voice might be heard in demanding an elimination of supportive LSAP as early as mid-2013.  However, part two of the dynamic earlier mentioned is expected to come more strongly into play at just about that mid-year time.  The sequestration as is called the somewhat arbitrary budget cuts assigned as default measure against grown boys and girls unable to agree to long-standing fiscal problem resolution is the headwind against which recent economic traction must lean into. 
Just as massive accommodative monetary policy measures were seemingly set to ushered in a sustained economic advance, headwinds from the fiscal drag of sequestration are ready to take hold, slowing the pace of real GDP growth by about 1 ½ percentage points this year, relative to what it would otherwise have been (by CBO estimate(1)).  Therefore even while these fiscal headwinds are only beginning to blow, the committee will be mindful of their implications when they discuss potential policy action.
Some additional information relative to the potential for adjustment to the level of LSAP might be noted in the upcoming FOMC statement with the intent of giving greater clarity to the existing reaction function.  I expect however there will not be a discernable change in the current stance outside earlier referenced guidance.  There appeared to have been some heated discussion about the language used to describe the ongoing nature of LSAP at the last meeting as it was noted in the minutes; ‘In light of this discussion, the staff was asked for additional analysis ahead of future meetings to support the Committee's ongoing assessment of the asset purchase program.’(2)  
Later again in the same minutes and before the committee could agree on the wording of the post-meeting statement to be released it was noted; ‘Similarly, one member raised a question about whether the statement language adequately captured the importance of the Committee's assessment of the likely efficacy and costs in its asset purchase decisions, but the Committee decided to maintain the current language pending a review, planned for the March meeting, of its asset purchases.’
Clearly the LSAP will be a hot topic for its remaining life.  What is apparent to me at this juncture is that there shall be no meaningful change in the administration or description of the programs intent in this meetings statement.  At some point, possibly as early as June, the Committee will recognize a need to decrease the size of the ongoing LSAP program and will at that time also decide, quite likely favorably, on committing to the maintenance of the portfolio, or some large portion thereof for an ‘extended period’. 

How Long Will Fed Hold SOMA
Several economist friends pointed me to the data concerning the average maturity of the SOMA (System Open Market Account)(3) currently roughly 10.5 years.  I was interested in this figure because it is my long standing view that the Fed will hold onto much of their portfolio for a long, long time, quite possibly allowing a majority of the portfolio to mature. 
In remarks by Janet Yellen (Challenges Confronting Monetary Policy - March 4th )(4), the Fed Vice Chair who is on the top of many lists as a candidate to be the next Fed Chairperson, shared a sequencing of tools available to withdraw accommodation that is consistent with what Fed officials have shown before; ‘Further, I've argued previously, and still judge, that the FOMC has the tools it needs to withdraw accommodation, even if the balance sheet at that time is large. These tools include a new one, approved by the Congress during the financial crisis, which allows the Federal Reserve to pay banks interest on their reserves. A suite of supporting tools, such as reverse repurchase agreements with a wide range of counterparties and the Term Deposit Facility, are routinely tested to make sure that the Federal Reserve is prepared to use them and that they will work as planned.’  
I would attach some level of importance to the sequencing of these tools and recognize earlier mentioned as having elevated status in the application of accommodation removal.  Interestingly, there was no mention therein or thereafter about the prospects for selling assets as a ‘tool’ to be used to withdraw accommodation.  Rather later in an effort to address the prospects for returning Fed net interest remittances to the Treasury to former pre-crisis levels Ms. Yellen notes; ‘Once the Federal Reserve's portfolio is normalized, however, earnings are projected to return to their long-run trend. The study supports the conclusion that the Federal Reserve's purchase programs will very likely prove to have been a net plus for cumulative income and remittances to the Treasury over the period from 2008 through 2025, by which time it is assumed that the balance sheet has been normalized.’ (5) 
The year 2025 is used in reference to an assumed date for the Feds balance sheet to have become normal.  While this is not the point of the Board study, 2025 is within 1 year from the widely expected mid-2013/early-2014 LSAP end date plus 10.5 years average maturity of the SOMA portfolio.  The study further notes; ‘Under the assumption of an additional $1 trillion in asset purchases in 2013, the portfolio returns to a more normal size in early 2019.’  2019 is a very aggressive assumption for the normalization of the Feds portfolio in my opinion and would require extraordinary levels of economic growth and employment so as to encourage tactical use of the portfolio to combat excessive leverage in the system.  While many have come to believe the Fed will hold their portfolio for longer than earlier imagined, there is still some room for a larger majority to expect little selling from the portfolio for many years after the completion of LSAP.  As this is priced, so too might be the expectation that fed funds policy rate will be required to do most of the heavy lifting of accommodative policy reduction.   

If Not Asset Sales
One of the most striking visuals I’ve enjoyed for some time was afforded when I read Fed Governor Jeremy Stein’s, ‘Overheating in Credit Markets: Origins, Measurements, and Policy Responses’.(6)  In it he indicated; ‘I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability.’  Of the ‘Three observations in support of this perspective’, I most thoroughly enjoyed the following; ‘Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot.’  Indeed, as blunt an instrument as is fed funds, it can be used to counter ill-advised and potentially systemically threatening excess leverage in ways that regulations and supervision cannot timely address.

Transparency and the Attainment of Policy Mandate
The Fed now has a rather lengthy history of varying levels of transparency used as a monetary policy tool.  More meaningful and purposeful application of these measures dates to 2003, but examples of guidance go much further back and the process of unveiling intent has arguably become less convoluted through time.  Lost in much of the description of the evolution of the lead-up to the ‘Great Recession’ as it has come to be called is the recognition that transparency of monetary policy intent was a prime contributor to the excess of leverage leading to mal-investment and ‘bubble’ mentality prior to the credit crunch of late 2007.  Without rehashing too much of my work from 2005-2007, the Fed provided a road map for monetary policy intent (transparency on steroids) in its use of ‘measured pace’ (16 times) which left no question as to the succession of hurdle rates investment schemes needed to clear on their way toward increasing levels of mal-investment.     
We shall need to study and reference this period more fully in time if we are to make more sure-footed progress along the hope-for path we tread toward economic and financial market repair.  There is clearly a time for transparency, but that time is not always and everywhere – at least not when used in extremes.  While it may appear to sound manipulative, decreasing the level of transparency may have a rightful place in a restrictive monetary policy regime.  Transparency generally speaking lends itself to greater visibility and thus increases levels of certainty and conviction.  While sometimes these ‘certainties’ and ‘convictions’ turn out to be ill-conceived, they have a wonderful tendency of promoting economic growth.  Nothing arrests ‘animal spirits’ quite like uncertainty. 
Fed Chairman Bernanke earlier this month addressed a conference in San Francisco(7).   Here in discussing the prospects for ‘How Are Long-Term Rates Likely to Evolve?’, he noted quite frankly;However, it is now a bedrock principle of central banking that transparency about the likely path of policy, in general, and interest rates, in particular, can increase the effectiveness of policy.’  As a ‘generality’ I can completely agree.  What we might more specifically recognize is that greater and lesser levels of transparency should be used during different monetary policy directive. Just as higher and lower policy rates affect the level of economic activity and greater levels of LSAP have thus far been found to promote economic repair, so too does greater levels of transparency support economic growth in the midst of uncertain times. 
One of the great challenges for central banking over the coming years will be the application of requisite levels of transparency needed to adjust visibility in ways to either increase economic growth or discourage mal-investment. 

Parting thought: The level of innovation at the early stages of economic expansion is attributable more to the state of ‘animal spirits’ than available funding.      
(2) Minutes of the Federal Open Market Committee; January 29-30, 2013; http://www.federalreserve.gov/monetarypolicy/fomcminutes20130130.htm 
(4) Vice Chair Janet L. Yellen; At the 2013 National Association for Business Economics Policy Conference, Washington, D.C.; March 4, 2013; Challenges Confronting Monetary Policy
Also (footnote #28): The extent of realized capital losses on sales of Federal Reserve assets depends on the precise securities sales policy that the Committee eventually decides to undertake. An increase in longer-term interest rates would lower the market value of the securities in the System Open Market Account (SOMA) portfolio. But the Federal Reserve would continue to receive interest income on those securities for as long as they remained in the SOMA portfolio, and securities held to maturity could roll off the portfolio without the Federal Reserve realizing losses on them. While the authors of the Board staff study used particular assumptions about future securities sales that are consistent with the exit strategy principles outlined by the Committee in June 2011, other strategies for sales that are equally consistent might lead to different results.

(5) Finance and Economics Discussion Series; Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C.; The Federal Reserve’s Balance Sheet and Earnings: A primer and
Projections; Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, Daniel W. Quinn, and Alexander H. Boote
(6)  Governor Jeremy C. Stein; At the "Restoring Household Financial Stability after the Great Recession: Why Household Balance Sheets Matter" research symposium sponsored by the Federal Reserve Bank of St. Louis, St. Louis, Missouri; February 7, 2013; http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm
Also; Borio and Drehmann (2009), who write: "But in sophisticated and open financial systems, in which the scope for regulatory arbitrage is high, the interest rate has the merit of setting the universal price of leverage. It reaches parts that other instruments cannot reach."

(7) Chairman Ben S. Bernanke; At the Annual Monetary/Macroeconomics Conference: The Past and Future of Monetary Policy, sponsored by Federal Reserve Bank of San Francisco, San Francisco, California March 1, 2013; Long-Term Interest Rates

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