David R. Kotok
Chairman and Chief Investment Officer
What the Fed gets for $100 billion
September 15, 2010
Silly rumors swirl about the Fed. One circulating has the Fed increasing the size of its balance sheet by as much as $1 trillion.
The FOMC meets on September 21. They have not decided what they are going to do, so any rumor about the outcome is purely speculative. The likely outcome is that the Fed will do nothing for the next several meetings. There is one exception. The Fed will continue to purchase US Treasury obligations to maintain the size of their balance sheet as their mortgage holdings pay off.
Fed speakers will offer various views of the economic recovery outcome and risks attached to it. A minority of hawks, like Kansas City Fed president Tom Hoenig, will want to tighten policy now. Remember, tightening can be passive, in that doing nothing reduces the balance sheet size and therefore shrinks the monetary base. Chairman Bernanke has made it clear he does NOT want passive tightening. Bernanke’s speeches suggest that the Fed is committed to keeping the balance sheet at its present size for at least a year.
Others on the FOMC will keep the policy door open for additional easing. Bernanke leaves that door open as well. No one calls for immediate additional easing by balance sheet expansion. St. Louis Fed president Jim Bullard wants the decision about purchasing treasuries to be made at each meeting.
The Fed never says it is influenced by politics in the timing of a decision. Fed members deny it, as they must do. However, the members of the FOMC know well that their institution is subject to continuous congressional scrutiny. They see Chairman Bernanke testify regularly and they know that congressional inquires are always answered. The Fed is a creature of Congress. It has recently seen its role changed by Congress. Therefore, it is very unlikely that any significant policy change will be announced at the last meeting before an election.
The debate about the impact of balance sheet size continues unabated. Recently we quoted some statistical work done by BCA Research. They attempted to estimate the number of basis points interest rates would fall for every $100 billion in Fed balance sheet size increase. Their original work guessed that the effect was 7 bps. A subsequent dialogue between Ron Torrens at BCA and Cumberland’s Bob Eisenbeis examined some of the statistical methods used and the various ways to make this estimate. Of course, all studies like this are assumption-driven, and therein one may find difficulty in obtaining precision. Ron offered that the change could be closer to 5 basis points.
BCA also noted that the impact was strongest at the time of Fed policy announcements, and the subsequent actual change was more muted. That observation was enhanced in our dialogue, and BCA gave us permission to add clarity for our readers. Ron emailed: “Another point to think about: this analysis assumes that the entire effect of the announcement is discounted in markets on the day of the announcement. I think what really happens is that some percentage of the total (between 0 and 100%) is discounted on that day and the balance is discounted as the Fed firms up its commitment to act, the final confirmation of which occurs on the day they actually follow through and purchase the securities. So the 5-basis-point number may actually under specify the coefficient. This may be offset, however, by the zero-bound issue – the lower that the term premium goes, the more purchases it takes to push it lower still.”
We appreciate the help and candor of BCA and their dialogue about the math and assumptions.
Other firms have derived different estimates. Reuters quotes Macroeconomic Advisors economist Antulio Bomfim. He estimates, “Each $100 billion in asset buys lowers yields on the 10-year Treasury note by three basis points or 0.03 percentage points” That means gradual buying might go unnoticed. “That might actually be counterproductive because people might start thinking the Fed is powerless, if they see new purchases having little effect,” he said.
So what is it? 7 basis points, 5, or 3? Moreover, is there a change from the initial reaction after Lehman failed to the present construction? Could we be at the point where a few $100 billion of additional Fed treasury purchases has little impact? Alternatively, would the market immediately respond favorably to an announcement of balance sheet enlargement by discounting additional future purchases? Here we are back to the Lucas critique and the role of expectations in pricing. Moreover, we must remember that there are many other factors involved in pricing treasury securities.
At Cumberland, we keep working on quantification, even though we know we are chasing an unholy grail. We know that every estimate is wrong the minute we make it. Our best guess is that a large ($500 billion to $1 trillion) announced addition to treasury purchases would lower the 10-year Treasury note yield to about 2.2% or 2.3%. Stocks would rally; bonds would, too. The dollar would fall against most currencies as the gold price rose.
We know that the Fed is finding its own way down this path of expanded balance sheet policy making. The Fed is studying this issue, too. It has been clear that using the balance sheet size and an enlarged excess reserve is a new tool and uncertainty is high. We applaud the Fed for trying to be transparent about it. Their task is not an easy one.
We are confident that Ben Bernanke does not want to be the Fed Chairman who presides over an economic relapse. He knows what happened in the late 1930s when the Fed tightened too soon. He would rather be late and successfully engineer some sort of recovery than too early. He knows that the closer we get to deflation the greater the risks are. In addition, he knows that extracting an economy from a deflationary psychology is very difficult.
At Cumberland, we expect the Fed to hold the short-term interest rate at the present near-zero range for at least another year and perhaps two years. We do not see any near-term inflation threat. Anchoring the short rate this low has profound implications for longer-term rates. Forward rates give clues to that pricing. We continue to invest our bond portfolios with a longer-duration bias and will slowly move to some defensive positions as the economy shows more, albeit gradual and tepid recovery.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com