The Fed Takes Another Big Step to Boost the Economy
As widely expected (and priced into the markets), the Fed decided at its monetary policy committee meeting today that it would increase purchases of Treasury securities to boost the weak economy.
Dust is still settling in the markets as details of the decision are being digested. The purchase amount announced was slightly above consensus. Plus, according to the NY Fed in an accompanying release (the NY Fed does the actual trading), the maturity distribution of the new securities purchases will be more concentrated at the shorter end than anticipated. Traders had expected a greater bias in securities purchases toward maturities over 10 years (particularly the 30 year bond), and may have had to readjust their portfolios after details of the decision were released. There may be some confusion about how much QE2 is really targeted at long-term as opposed to “longer term” (the Fed’s wording) securities.
This marks only the second time ever that the Fed has turned to the extraordinary monetary policy tool known as “quantitative easing”. (This round is known as QE2.) The Fed started the first round when the economy was in extreme distress (many say in free fall) at the end of 2008 and early 2009. Faced with concerns over the weakness of the economy, the Fed has turned again to QE because its normal key tool, the lowering of the federal funds interest rate, would be ineffective since it remains close to zero.
The details. From now until the end of June 2011, the Fed has directed its trading desk to purchase an additional $600 billion in securities (markets had expected closer to $500 billion); and to continue the Fed’s August decision to reinvest principal payments from its holdings of agency and agency mortgage-backed securities into Treasury securities, estimated at around $250-300 billion. (“Agency” refers to Fannie Mae, Freddie Mac and Ginnie Mae.) In total, based on yesterday’s decision, the Fed anticipates buying $850-900 billion over the next eight months, averaging roughly $110 billion a month.
The amount of QE announced today is smaller than QE1 ($850 – 900 billion versus up to $1.75 trillion over a longer period), although it is still a sizeable number compared to the amount of securities that had been normally traded by the Fed. In what seems like a quaint, distant past, only a few years ago the Fed typically managed a $700-800 billion portfolio. Now it holds more than $2 trillion of securities. (See useful background by the head of the NY Fed’s trading desk.)
Observers are concerned that the Fed’s latest move will not be effective under current conditions, although interesting top Fed staff research on QE1 effects suggests that it was more powerful than many realize. While the economy looks a lot better now than it did in late 2008 and early 2009, though, some of the same worries remain, nevertheless. In explaining its decision in terms of its dual mandates, the Fed stated that underlying inflation remains below its target (thought to be around 2%) and that the pace of the recovery in output and employment is “disappointingly slow”. While the word “deflation” was not used in the Fed’s announcement, many think that Fed officials are worried that the risks of deflation have grown and want to head them off.
At the other end of the worry spectrum, observers are concerned that the Fed will not be able to withdraw excess liquidity fast enough when the pace of the economy starts to pick up and that we’d wind up with accelerating inflation. While the Fed would like inflation to pick up a little, it does not want it to pick too much.
Deflation or inflation can be hard to stop past a point.
PS- Is monetary policy the only game in town? And what can we say about the policy mix between fiscal and monetary policy? It’s hard to answer, particularly since the direction of fiscal policy is so uncertain over the next few months – and beyond. For a start, we don't even have a budget - and the fiscal year has already begun.