Drama at the Fed meeting?

Drama at the Fed meeting?

August 6, 2010

The forthcoming Fed meeting (August 10) is likely to feature an internal debate. We MAY see some evidence of it in the statement released after the meeting’s conclusion. We will not know the intricate details for years.

The debate is on four levels. The first is, do we do something because deflation risk is rising and the economy is weakening, or do we wait for more “incoming data” before taking any action?

The second issue is, if we do something what should we do? Buy replacement mortgages for those maturing? This could be over $300 billion between now and the end of 2011. Buy more short-term treasury bills? Buy more long-term treasury bonds? Use some other type of special easing program? How large can our balance sheet be?

The third issue is, what do we say to the world about our policy and how do we say it? This language issue has become critical. Financial agents now dissect every word of the Fed’s statements. The term “extended period” seems to mean a length of time of at least four FOMC meetings, or about a half year or longer.

The fourth issue is somewhat technical, but very important. The classic structure for the Fed’s monetary policy construction is to have a corridor of interest rates. The policy rate is in the middle, the penalty rate is the highest, and the interbank trading rate is the lowest. That is the structure applied in most places in the world, as well. In the US, the policy rate is currently defined as zero to 0.25%. The interbank rate is trading below the 0.25%. The penalty rate is well above 0.25% and is little used by the banking system today. One of the reasons that the Fed Funds (interbank) rate is so low is that the GSEs are sellers of Fed Funds and that selling drives the Fed Funds rate lower than it otherwise might be. Banks elect to deposit their excess reserves with the Fed for a 0.25% return rather than sell their excess reserves to each other at a lower rate. This construction influences other market pricing like the swap rates, and that is distorting behavior by financial market agents. The Fed could alter this by lowering the rate they will pay banks for excess reserves, raising the Fed Funds rate to a level above the excess reserve rate, altering the term of the reserve deposit rate, or some combination of actions.

The Fed has not made its policy direction completely clear. Chairman Bernanke has testified about the unusually large “uncertainty” surrounding policy making today. Some FOMC members (Jim Bullard, St. Louis Fed) have enlivened the public debate about Fed policy options. This is a good thing, since it adds to the transparency that market agents see. A secretive Fed is the worst-case scenario, since it heightens risk premia and makes the Fed’s job more difficult.

The coming meeting statement MAY add some clarity. Every word will be scrutinized, as will statements of FOMC members once the blackout period expires. As NY Fed President Bill Dudley noted in a speech at the Philly Fed not that long ago, we are certainly in “interesting times.”

Stay tuned.

David R. Kotok, Chairman and Chief Investment Officer