Vince Reinhart Summarizes The Perils Of The Fed's Nine Month QE Winddown

With no keynote speaker at the Federal Reserve Bank of Kansas City’s Jackson Hole Economic Symposium, there was no opportunity for Fed officials to send signals about their policy intent. However, while it’s unlikely that the papers discussed did much to change opinions of the FOMC participants, as Morgan Stanley's Vince Reinhart notes, there were themes discussed that may reflect committee members’ views regarding how tapering should proceed: all signs are still that the Fed will start the process of trimming its asset purchases at its meeting on September 17-18. Further, we wouldn’t be surprised if they initially trim just Treasury purchases. So it seems the primary dealers will get what they expect and the market (ever-hopeful of its bad-news-is-good-news meme) will be disappointed.


 


Via Morgan Stanley's Vince Reinhart,


With no keynote speaker at the Federal Reserve Bank of Kansas City’s Jackson Hole Economic Symposium, there was no opportunity for Fed officials to send signals about their policy intent. Instead, they had to sit and listen politely to advice from others.


For the few academics invited to present papers, Jackson Hole is the premier platform to provide such advice.


Stanford University economist Robert Hall presented a paper making the case that low inflation and high unemployment was an equilibrium phenomenon. Part of his argument was conventional enough: with low inflation, the zero lower bound to nominal interest rates kept the real interest rate from dropping enough to match the decline in the equilibrium real rate resulting from the economic dislocations of the financial crisis. Thus, demand has been deficient in the US over the past five years. Less conventional to central bankers was Hall’s view that a reduction in aggregate supply matched the decline in aggregate demand. The net present value of the benefits of hiring workers fell sharply after the crisis because the discount rate firms applied—the high real rate plus an elevated risk premium—has been prohibitively high. This drop in both demand and supply explains to Hall why inflation has not fallen much despite the prevailing elevated unemployment rate.


The Fed is probably well advised to wonder about the extent of slack currently, but Professor Hall probably did not get much traction with central bankers more comfortable with standard new Keynesian models.


Where Hall hit closer to home with policy advice was his puzzlement about why the Fed has not cut the interest rate on excess reserves. He argued that the Fed is encouraging banks to hold, not use, reserves on outsized fears of causing dislocations to money market mutual funds. In the discussion after the paper, though, no policy maker swam up to the topic.


Northwestern University professor Arvind Krishnamurthy focused attention on large-scale asset purchases (LSAPs) in his discussion of a paper written with Annette Vissing-Jorgensen. The two have written several papers on the topic that usually draw blank stares from market participant because they explain their empirical results in terms of an overly simplified model that suggests financial trading takes place in silos, not on a global market. The empirics, however, are carefully done. In their event studies, it appears that LSAPs have mostly local, not broad, effects and that flows, not stocks, matter once you control for the signal about the path of interest rates.


The basic message is that asset purchases influence the prices of the assets purchased, with little spillovers except from signaling about the path of the policy rate. Purchases of Treasuries mostly influence Treasury finance, not the macroeconomy, a message already offered by Governor Jeremy Stein in June. MBS purchases, because they are of current coupon securities, have a powerful direct effect on the prices of those assets and thereby provide the most effective policy stimulus for the overall economy.


The paper offered two main strands of policy advice.


First, given the relative effects of asset purchases, their preferred sequence for the exit from QE is:



  1. Cease Treasury purchases;

  2. Sell Treasury portfolio;

  3. Sell older MBS;

  4. Cease new MBS purchases.


The basic logic is that the Fed should extend for as long as possible the asset purchases that are most influential on spending - current-coupon MBS - while otherwise renormalizing the rest of its balance sheet.


Second, the Fed should be more formal and specific in its communication of its exit strategy. Indeed, the authors point to the back-up in volatility and yields in global markets in June on first mention of a sooner-than-expected tapering as evidence of what goes wrong because of imprecise policy signals. The governor of the central bank of Mexico, Augustin Carstens, piled on in favor of predictability during the question-and-answer session.


The discussion did not change any opinions in the crowd, but the Krishnamurthy-Jorgensen paper probably encapsulated the views of a part of Fed officialdom scurrying for the exit. They see themselves on the road to end a policy of doubtful efficacy in markets and no longer necessary for signaling to markets about the path of interest rates now that they have the infrastructure of Evans thresholds.


This brings us to the taper. Fed officials have already paid a high price (in terms of market volatility) for expressing their desire to see the back of QE. It is their responsibility to explain how they will extricate themselves from the program.


Absent a poor employment report in the first week of September, all signs are that the Fed will start the process of trimming its asset purchases at its meeting on September 17-18. Taking them at their word, that gives them about nine months to scale back the program, ending net purchases in June 2014 but continuing to reinvest proceeds of maturing and prepaying securities so as to keep their balance sheet steady.


Do not be surprised if they initially trim just Treasury purchases. Treasuries were the last bit added on to QE3, policymakers disagree most about the marginal cost of purchasing them relative to the marginal benefits, and delaying trimming of MBS purchases might offer a little insurance on the housing recovery.


This implies that there may well be two hawkish messages conveyed after the September meeting. For one, they will announce the onset of tapering. For another, they will add another year to the Summary of Economic Projections, giving FOMC participants their first chance to forecast the fund rate expected to prevail at the end of 2016. The further out in time the forecast, the more participants will rely on reversion to the long-run mean, which they have previously indicated to be 4 percent for the nominal federal funds rate. Thus, do not be surprised if more than a few respondents project much faster rate renormalization than currently embedded in market prices. This might incline them to wrap that message in a dovish interpretation of their thresholds.


Knowing all this is in store in September, overlaid by the ongoing drama of Fed succession, is a compelling argument to linger in the wilderness.

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