Confused about the Fed’s latest round of pseudo-quantitative easing?
Fear not.
Bank of America Merrill Lynch’s Michael S. Hanson and Ethan S. Harris are on hand to answer all your lingering questions. Including, err, why the Fed can’t just go ahead and buy up the US stock market:
Will it work?
Fed officials are aware and concerned that there are diminishing returns to unconventional policy. The Fed can push long rates lower either through open market operations (buying Treasuries) or “open mouth” operations (committing to keeping rates low for even longer than the market currently anticipates). But with rates already near historic lows and with credit spreads fairly tight, the marginal benefit of these policies is likely much smaller than the first time around. That isn’t to say that such policies are completely powerless, but the “bang for the buck” likely would be much less. QE can be an effective tool for unfreezing capital markets or stopping deflation; it is a less effective tool for ending a crisis of confidence or offsetting fiscal tightening.
Can’t the Fed just buy corporate debt / CMBS / stocks outright?
Not under the restrictions of the Federal Reserve Act. They could ask Congress to give them that right, but that seems like a stretch in the current political environment and might invite limits on Fed independence. As Bernanke noted in his 2002 speech, although the Fed cannot buy, it can lend. Under unusual and exigent circumstances, the Fed can lend directly to individuals and businesses — but again, it would prefer to not go down that road. Note also that the Frank-Dodd bill now requires any emergency lending by the Fed to be approved by the Treasury Secretary.
The Fed still could ease by lending directly to banks through fixed-term loans at very low interest rates collateralized by a wide range of private assets — this would effectively be lending to the private nonbanking sector, which might be a more effective policy approach given that private bank lending is still falling. However, if weak demand is the primary constraint on bank loan growth, then this program would similarly have a limited reach. Also, Fed actions are limited by the requirement that its lending agreements are over-collateralized.
Shouldn’t the Fed just cut the IOR rate and force banks to lend?
Cutting the 25 bp interest on reserves (IOR) rate to zero (or even negative, as Sweden had done) might encourage some lending on the margin, but tight lending standards, elevated liquidity requirements, impaired bank balance sheets, low demand, and depressed collateral values all likely matter much more. And there is the risk that cutting the IOR rate further would wipe out the last vestiges of profit in the money fund industry.
OK, fine — but isn’t this just monetizing the debt?
This is one of those ideas that sounds good, but falls apart on closer inspection. If the Treasury were directing the Fed to buy its debt or if the Treasury could not market its debt at reasonable interest rates, we would worry about monetization. However, today there is a huge demand for Treasuries and Fed policy is clearly aimed at stimulating the economy, not at bailing out the Treasury. The main risk here is that, down the road, Congress attempts to compromise the independence of the Fed, preventing a timely exit from unconventional policy.
More BofAML answers for your QEIIs FAQs in the usual place.
Related links:
Is Fed buying behind the stock rally? - Motley Fool
The Fed’s asset-liability mismatch - FT Alphaville