The debate over a second round of US quantitative easing is heating up.
And with it, a rather uncomfortable situation for the Federal Reserve.
Without getting too wonk-ish, the idea is that the Taylor Rule beloved by economists currently suggests the need for a (real) negative funds rate. To date that’s been achieved via zero per cent interest rates, plus the Fed’s 2009 $300bn Treasury-buying programme (QE) to lower long-term yields.
The difficulty is what happens if long-term yields don’t stay down.
As the Washington Post notes, even during the Fed’s 2009 QE, rates on 10-year bonds temporarily spiked amid concerns the central bank was printing money to fund budget deficits. If anything, deficit concerns have only deepened in the past year. Which means the Fed might have to figure out a way to keep rates low without stirring up deficit hawks at the same time. Enter QE II — with a difference.
Deutsche Bank’s Dominic Konstam explains:
Despite the Fed’s apparent willingness to consider additional stimulus, we believe the logic of more QE to lower yields is somewhat misplaced since yields are likely to fall anyway as risk assets decline. The policy consensus seems to be that Taylor rules dictated a negative funds rate that was effectively achieved through a near-zero funds rate, for an extended period plus QE that “lowered” longer-term yields as well. In principle if longer-term yields did not fall, as risk assets declined, a case could be made for QE to steer them lower. This may be relevant if it turns out that the Fed wants yields at say 1 ½ percent, but does not seem relevant since there is sufficient scope for yields to fall well below 3 percent in the current environment.
We think instead that the QE debate should be viewed as ultimately amounting to a credible threat to keep yields low, i.e., in a 2- to 3-percent range, rather than as an attempt to propel them meaningfully lower. More specifically its relevance will become evident if risk premia return in the long end, reflecting say concerns about more fiscal stimulus or lack of fiscal consolidation. While this is not central to the Fed’s internal policy debate now, it may become more important as we approach the November elections. Prospects for fiscal tightening might appear to increase (as Republicans vow fiscal rectitude), but the likelihood of post-election gridlock suggests disappointment. If risk assets are more stable by then and, even if deflation risks have abated, the role of QE would be more in the context of buying time for appropriate fiscal tightening without derailing the recovery.
And here’s the big difference. Instead of buying US Treasuries on an unsterilised basis — which was the method of the Fed’s last bout of QEasing — this time around, the central bank would sterilise.
And the benefits, Konstam says, would be myriad:
Typically the Fed manages short rates with an eye on long-term risk premia, primarily reflecting inflation risk. The Greek problem is an example where markets can quickly lead the process and plunge the economy into an enforced deflation. The danger is that US fiscal dynamics are not particularly good either, absent a strong recovery so that risk premia could rise once the dust settles on the initial flight to quality. This would be exacerbated if for example the Administration considered more fiscal stimulus.
QE in these circumstances could be sterilized via reverse repos, term deposits or effectively neutralized by raising interest on reserves. The result would be a substantial twist of the yield curve. Mid-2011 2s might be around 1 ½ percent with a policy rate of, say, 1 percent, but 10s could be 2 ½ to 3 percent. Sterilization would be a way to placate the hawks. Net there is no new monetary stimulus via the Fed’s balance sheet. Yet there is a removal of unwarranted risk premia in return for a delay in fiscal consolidation. Some might welcome higher short rates if it helped reduced precautionary money balances (velocity rises). This is of course more likely if growth is stronger – but with an outlook that is still highly uncertain.
Foreign investors hold around half of the Treasuries outstanding. Ultimately they are the marginal pricers of risk premia. Given their concern for euro periphery financing, it is reasonable to assume they will be among the first to expect appropriate fiscal consolidation if and when downside economic risks abate. The beauty of sterilized QE is that they would be pushed to purchase shorter-term Treasuries as the Fed purchased longer-term Treasuries. To the extent that they are comfortable with low inflation in the short term, but fear long-term inflation risk, this is appropriate and a stable outcome. It allows them to revalue their currencies on that horizon too. The alternative would be to revalue more rapidly and obviate the need to invest in dollars altogether . . .
It is too early to say whether Fed policy will embrace the possibility of sterilized QE to contain long-end risk premia. And perhaps it may not need to if markets are “well behaved”. However, the powerful logic is that unless there is a very strong recovery that allows more rapid fiscal consolidation, either markets need to behave and maintain low long rates or the Fed will need to threaten sterilized QE. It suggests that over the medium term as well as the short term, yield curves are prone to be sustainably flatter.
Finally there is also a certain neat logic to policymakers standing up to free markets. First with regulatory reform and maybe, second, with a greater use of central bank balance sheets to dictate interest rates.
The use of the word Twist is not incidental here.
We are very much talking about a redux of the Fed’s 1961- 1965 Operation Twist. In that episode, the US sold short-term government debt to drive up yields — in an effort to attract capital inflow — and bought long-term government debt to suppress yields in an effort to encourage investment.
There’s a great explanation of Twist available here, on economist Bill Mitchell’s blog, as well as a debate of its efficacy. One point to note though is that — as Konstam’s last paragraph suggests — there is very much a markets vs central bank theme running through the QE II/Operation Twist debate.