However, more recently, as the pace of economic growth has slowed somewhat, longer-term interest rates have fallen and mortgage refinancing activity has picked up. Increased refinancing has in turn led the Fed's holding of agency MBS to run off more quickly than previously anticipated. Although mortgage prepayment rates are difficult to predict, under the assumption that mortgage rates remain near current levels, we estimated that an additional $400 billion or so of MBS and agency debt currently in the Fed's portfolio could be repaid by the end of 2011.Now, as an example, suppose that $100 billion in MBS run off because people are refinancing their mortgages. Then, suppose that the new mortgages these people take out are sold to Fannie Mae, which holds them, and finances the purchases by issuing $100 billion in agency securities. What has changed? The private sector is now holding $100 billion less in reserves, and $100 billion more in agency securities. Both of these types of securities are effectively obligations of the (consolidated) federal government. Furthermore, the reserves (under current conditions) are the same as T-bills. Bernanke says that this involves an "implicit tightening." Why? This is of course the key to the whole "quantitative easing" program. The Fed thinks that shortening the average maturity of federal debt obligations in the hands of the private sector is somehow expansionary. Thus the policy action the Fed just announced: we undo the "implicit tightening" by having the Fed buy $100 billion in long-term Treasuries. Now, reserves are unchanged, and this is just a swap of $100 billion in agency securities for $100 billion in Treasuries, and those assets are essentially identical.
At their most recent meeting, FOMC participants observed that allowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome.
On my last post, Jordan sent me a link to a finance paper by Vayanos and Vila, which is a start in thinking about segmented markets, preferred habitat, and the term structure of interest rates. What I am wondering about is the following. By issuing reserves and holding long-term Treasuries, the Fed is intermediating across maturities. Of course there is an array of private intermediaries who do the same thing, including banks and bond mutual funds. If the Fed can change market asset prices by issuing short maturity liabilities and buying long maturity assets, it must be that the Fed has some cost advantage over the private sector in this type of intermediation. Outside of the circumstances of the financial crisis, what would that advantage be?
Now, go one step further. Suppose the Fed has such an advantage. What this says is that the Treasury somehow got things wrong. It issued debt of too long a maturity. But why not have the Treasury fix their own problem then. The Treasury could issue T-bills and buy up existing long-maturity debt. Now go one step further. If this is such a great idea, why doesn't the Treasury issue only T-bills on a regular basis?