Duke on QE2

In the span of a few days, many major players from inside the Fed have offered their insights on the current state of the economy and the mechanisms through which the fed plans to pull out of this recession. The following are interesting excerpts from Elizabeth Duke's speech regarding current economic conditions and monetary policy:

"My outlook for the housing market and for commercial real estate is more cautious. A sustained recovery in income and jobs will be an important prerequisite for a recovery in the housing industry. But until the overhang of vacant homes is reduced significantly and home values begin to firm, new residential construction is likely to remain at low levels. Similarly, time will be required to absorb the currently large amount of vacant office and commercial space before construction in that sector begins to turn up noticeably." 

First, it is very clear that the Fed is very worried about the continued high rate of unemployment and sustained weakness in the housing market.

"One notable exception to my forecast for gradual improvement in financial markets is my expectation that residential mortgage markets could take a number of years to repair as policymakers and market participants grapple with the role of government in housing finance, adapt to changing regulation, and look for ways to better manage and price the risks associated with mortgage lending and servicing. Whatever the structure of housing finance is to become, the large overhang of problem loans and weak housing markets will necessitate a gradual transition." 

I find this point to be very interesting. If residential mortgage markets do not recover significantly in the near future, it could mean that the Fed will continue to hold its Mortgage Backed Assets for an extended period of time until those respective financial markets stabilize.

"...between December 2008 and March 2010, the FOMC elected to purchase large amounts of longer-term Treasury, agency, and agency mortgage-backed securities (MBS). Those purchases put downward pressure on longer-term interest rates generally and helped normalize the spread between mortgage rates and long-term Treasury rates, which had widened during the financial crisis. Reducing longer-term rates influences the economy in much the same way as lowering the expected path of short-term rates. For instance, the decline in longer-term rates lowers the cost and increases the availability of capital and credit, which in turn encourages business expansion. In the most recent episode, another important result of lower rates has been a reduction in debt service burdens from existing debt. Households in particular have significantly reduced mortgage payments through refinancing. And numerous small business owners have told me that they could not have survived the downturn without low rates.

Economic activity picked up in early 2010, but by the time the FOMC met in August, the rate of growth seemed to be slowing and inflation continued to drift lower. In addition, lower mortgage rates were resulting in faster prepayment of mortgages underlying the agency MBS held by the Federal Reserve. To avoid the modest monetary tightening that would result from the Fed's gradually shrinking portfolio of agency MBS, the FOMC voted to reinvest all principal payments from agency debt and agency MBS in longer-term Treasury securities. The Committee also began a discussion about the strength of the recovery, the amount of slack in the economy, the likely path of inflation, and the appropriate action to provide additional monetary accommodation should such action be deemed necessary. In November, the FOMC judged that additional monetary policy stimulus was needed to support the economic recovery and help ensure that inflation, over time, returned to desired levels. To implement that stimulus, the Committee decided to expand its holdings of securities by purchasing an additional $600 billion in longer-term Treasury securities by the end of the second quarter of 2011.

After considering the costs and benefits of the action and recognizing that taking no action would have its own risks, I believe that the expansion of securities holdings was worth implementing to support the economy and make the recovery more durable. I don't want to overpromise. This action is not a panacea. While it is still premature to judge the overall efficacy of the program, I believe that by exerting downward pressure on longer-term interest rates, it has provided and will continue to provide support for a vulnerable recovery. At the same time, I believe the risks associated with this action are manageable, that we have the safeguards in place to monitor evolving conditions, and, most importantly, that we have the conviction to act when necessary.

Based on our own research and that of others, evidence is accumulating that purchases of longer-term assets have been successful in exerting downward pressure on longer-term rates.¹Consistent with research on the effects of asset purchases, between August, when Chairman Bernanke in a speech first publicly suggested the Federal Reserve might take additional action, and November, when the action was taken, longer-term Treasury rates fell as market participants priced in additional Fed purchases.² However, since the announcement of the decision to purchase longer-term Treasury securities, longer-term rates have actually increased. It might seem that the recent increase in rates contradicts the view that Fed asset purchases put downward pressure on rates. However, the logic behind this view works in both directions. If the market expects the Fed to respond to weak economic conditions by buying more assets, investors bid up the assets and rates fall. Conversely, if the market expects the economy to strengthen, investors ratchet back expectations for Fed purchases and reduce their bid for the assets, and rates rise. I believe that the current rise in rates is due to exactly this latter circumstance--a strengthening in market participants' outlook for the economy and a corresponding decrease in the market's expectation for future accommodation."  

This section explains the Fed's rationale for quantitative easing, which have been pretty well established before. However, one point draws my attention. Duke claims that partly due to recovery, home owners have been paying back mortgages at an increasing rate, decreasing modestly the profile of the Fed's balance sheet in mortgage backed securities. This would have, at least on some level, provided a contractionary effect in financial markets. This is a point that I have not heard anyone make yet.

"The monetary policy objective of asset purchases is to foster downward pressure on interest rates. But assets are "paid for" by crediting the reserve balances of banks, generating higher levels of reserve balances in the banking system. Reserves are relevant to the growth of the money supply because banks are required to hold a percentage of some types of deposits as reserves with the Federal Reserve. Thus, the total amount of reserves in the banking system acts to cap maximum reservable deposits. It is important to note that it is deposits, not reserve balances, that are included in the monetary aggregates used to measure the money supply. For example, M1 is made up of currency, traveler's checks, demand deposits, and other checkable deposits, while M2 is made up of M1 plus savings, small time deposits, and retail money market mutual funds.

Moreover, the linkage between the level of reserve balances and the monetary aggregates in the current environment is quite weak. You were probably taught, as I was, that the broad monetary aggregates increase when reserve balances increase because the larger volume of reserves supports increased lending, which in turn leads to a larger volume of reservable deposits. While that argument might hold in normal circumstances, in the current environment excess reserves are many multiples of required reserves, and adding reserves is unlikely to spark a further increase in the volume of deposits. As a result, the textbook linkage between reserve balances, bank loans, and transaction deposits just is not operative at present. Fundamentally, the levels of M1 and M2 are determined by the strength of the economy and the preferences of businesses and consumers for money, which depend on the yields on monetary instruments and competing assets.

Recent experience has again illustrated the difficulty in identifying a reliable relationship between reserve balances and the monetary aggregates. Even though Federal Reserve actions to fight the financial crisis and support the economic recovery added roughly $1 trillion to a base of about $43 billion in aggregate bank reserves, M1 and M2 rose at relatively moderate rates over the same period.

Going one step further, I should note that the linkage between the monetary aggregates and either real economic activity or inflation has been very weak over recent decades. The lack of a reliable relationship between the monetary aggregates and the economy led the Federal Reserve to abandon M1 as a key policy instrument in the early 1980s and then to reduce the role of M2 as a policy instrument in the late 1980s and early 1990s. Indeed, in a 2006 speech about the historic use of monetary aggregates in setting Federal Reserve policy, Chairman Bernanke pointed out that, "in practice, the difficulty has been that, in the United States, deregulation, financial innovation, and other factors have led to recurrent instability in the relationships between various monetary aggregates and other nominal variables."³ Still, my colleagues and I will be monitoring a wide range of financial and economic developments very closely--including the growth of the money supply, inflation, and many other financial and nonfinancial variables--and, based on a full assessment of those developments, the FOMC will withdraw monetary accommodation at the appropriate time. My view is that the elevated reserve balances would be inflationary only if they prevented the FOMC from effectively removing monetary accommodation by raising interest rates when the time comes to remove such accommodation, and I am convinced that that will not be the case.

The FOMC has a number of tools at its disposal for raising interest rates. When appropriate, the Federal Reserve can put upward pressure on interest rates by raising the rate it pays on reserve balances. Moreover, we have developed new tools that will allow us to drain reserves if necessary. In particular, we can drain large volumes of reserves by replacing them with repurchase agreements and term deposits. Finally, we can always sell the securities we purchased. Such sales would not only drain reserves but would also put direct upward pressure on longer-term rates."

Once again, we have a very high profile member of the Fed vouching for the use of interest on reserves a policy tool in preventing inflation from getting out of hand. Over the past year, many agents from the Fed have begun to put an increasingly large amount of emphasis on this tool. The tool was originally conceived to serve as a floor on market interest rates (just as the discount window serves as a ceiling). However, Bernanke in a speech last year claimed that the Fed was looking into an alternative interest rate of some sort. I am beginning to wonder if this new interest on reserves tool will be made into the new standard for interest rates.