Thursday, June 21, 2012

FOMC Statement

I'm a bit behind on this, as I've been traveling. As anticipated, the FOMC voted to do something in its meeting earlier this week. From their point of view, this is the least dramatic policy action they could have taken, which is an extension of the "Operation Twist" program which began in September 2011 and was scheduled to end this month. Just to refresh your memory, Operation Twist involves doing this:
Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less.
As I have argued, most recently here, given the large stock excess reserves outstanding, asset swaps by the Fed - whether they are swaps of reserves for government debt or swaps of short maturity government debt for long-maturity government debt - are essentially irrelevant. What matters under these circumstances is the interest rate on reserves.

A program such as QE2, which involved swaps of reserves for long-maturity Treasuries, increases the size of the Fed's balance sheet, and potentially has some effect on asset prices as it could change beliefs about the future policy rate. However, I don't see that happening as a result of an Operation Twist program. Thus, the Fed's policy action won't accomplish anything, but it's for the most part harmless. The only harm comes if the Fed expects too much from the policy, and projects those expectations to the public. However, the Fed's problem with the public now has more to do with the people who are screaming for more.

One interesting issue: Why did Lacker bother to cast a dissenting vote?


  1. "...for the most part harmless."

    I've been wondering about this. If QE/twist don't create inflation, what's the harm in it? Adding duration or credit risk to the Fed's balance sheet increases taxpayers' contingent tax liability. It is essentially a transfer of wealth from private actors to taxpayers.

    The contingent tax liability -- even with a $2.5tr risk asset balance sheet -- seems small in most states of the world. So did the perceived Value at Risk of shadow bank balance sheets in 2006. The question is what happens at the tails: say, if inflation spiked and the Fed was forced to choose between recognizing large losses on the twist portfolio (and a recapitalization from Congress) or issuing reserves to cover those losses. In that instance, the Fed would lose control of the money supply.

  2. Anon1, I'm not sure it's fair to say that the Fed's increased duration solely matters as a tail risk. There are plenty of worlds in which inflation begins to increase and threaten B/S losses and the Fed can choose a middle ground by monetizing only "a little" but then asking for a recap beyond some new reaction function for inflation (or only a little is needed). The extent to which this spirals out of control depends on (1) How much inflation people believe the Fed will allow before panhandling to Treasury, assuming (2) People believe Treasury will recap the Fed on request, and (3) People believe the Treasury is capable of increasing primary surpluses sufficiently to recap the Fed. It's easy to imagine a Cochrane world in which (3) fails and results in spiraling inflation. But it's also easy to imagine middle-worlds, where the Fed is motivated to accept slightly higher inflation to minimize recap requests (bad press), or the Treasury is capable of increasing primary surpluses -- but only at a point that maintains (say) 3% inflation. Duration risk on the Fed balance could be a tail risk but it could also boost inflation expectations toward a much more moderate Fed target, because it might seem more credible that the Fed would allow slightly higher inflation later to avoid humiliation -- but also that it would take its medicine if inflation got to high and the government budget constraint didn't get in the way.

  3. enuhd,
    The political effect of moderate central bank balance sheet losses can be large. Agreed. This "middle worlds" issue may well be a factor for central banks in the near term. A Greek restructuring of official sector debt would force recognition of ECB losses. The ECB will try to revert its "monetary policy" purchases back into fiscal policy by looking to offload its loss-making bonds to the ESFS or ESM at par. This would create a strange political battle between the central bank and its member states. The public battle would perhaps result in an "equivalence moment", when taxpayers realize that the central bank has been creating contingent tax liabilities on their behalf.

  4. Lacker released a comment on his dissent: the risk of inflation. heh.

  5. Any thoughts on the arguments by John Cochrane and others that this is a bad idea because we should be locking in long term rates right now to improve the longer term fiscal outlook and reduce the risk of rising servicing costs as we roll over short term debt whenever interest rates start to climb?

  6. one intresting thing that may come from operation twist being extended is overnight fed funds rate going above the intrest on excess reserves the fed has set that would lead to less reserve being held at the fed and those reserves going into the fed funds market

    thats what im watching anyway to see how fed funds market operates once that happans by the end of july

  7. "...overnight fed funds rate going above the interest on excess reserves..."

    That can't happen. Arbitrage dictates that the two rates should be equal, but the fed funds rate is less than the interest rate on reserves. GSEs earn zero interest on reserves, but there's a poorly understood obstacle to arbitrage. Most of the activity on the fed funds market currently involves the GSEs lending reserves to institutions that can earn interest on reserves, and the GSEs get less than 0.25%. It can't go the other way, though. If the fed funds rate were greater than 0.25%, then everyone wants to lend on the fed funds market rather than holding reserves with the Fed. But who wants to borrow at that rate? That can't be an equilibrium.

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