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Large-Scale Asset Purchases (LSAP)

A bubble got us here, a bubble will get us out

Breaking down the Fed’s strategy

In the next FOMC meeting on November 3, officials will be significantly marking down their economic outlook. Given the length of the easing cycle, this is an unacceptable situation alongside deviations from their dual mandate. Therefore, the Fed will continue to implement alternative monetary policies, primarily through balance sheet expansion. The Fed believes that removing duration risk from the financial system will lower financing costs across the entire economy, thereby recalibrating risk and boosting aggregate demand. The term premium is the additional return investors require over and above expected future short-term rates for accepting a fixed long-term yield. Traditionally, the term premium remains high when uncertainty on the recovery is elevated. If enough duration is removed from private sector hands, the term premium will decline and investors will shift to other assets, helping avoid the liquidity trap.

Implementation will: 1) be relatively continuous but small steps; 2) be conditional on the evolution of the FOMC’s economic forecasts; 3) demonstrate persistence for lasting effects; 4) foment anticipation to accelerate effects of interventions; 5) incorporate flexibility in asset choice to respond to evolving market conditions; 6) avoid major distortions to the yield curve; 7) ensure that intervened markets remain sufficiently liquid. Operationally, the New York Fed will need to monitor all these issues as well as systemic and macroeconomic considerations.

Currently the Fed purchases roughly $25bn in Treasuries per month as part of its plan to maintain the size of its balance sheet as mortgage-backed securities (MBS) runoff from prepayment or refinancing. This established pattern of preannounced monthly goals will likely continue under a new LSAP scheme. However, it is also likely that the Fed will announce a final target number, but with lenient conditions attached related to financial stability or the macroeconomic outlook. In our estimation, this target number is likely to be around $1tr.

Since the object of the exercise is to reduce the term premium, there is a tradeoff between the desired impact and the amount needed, which could increase or decrease the final target amount. To maximize the impact on the term premium, purchases will commence with Treasury bonds with a higher concentration in the five- to ten-year range. Purchases of Treasuries of other maturities will support the overall implementation strategy.

Anemic economic data and disinflation prompted the market to heavily discount additional LSAPs and the term premium has declined to a level consistent with the first LSAPs. Thus, in relative terms the marginal impact may not be as large as when markets were not functioning correctly. In fact, Fed officials recognize that: “The market response to the reinvestment decision at the August FOMC meeting seemed largely in line with the estimated effects from the earlier round of asset purchases, once we account for the size of the surprise and the anticipatory pricing that occurred ahead of its announcement” (Sack, Oct 4, 2010).

Ultimately, success of the LSAPs will depend on the portfolio allocation decision of investors towards higher risk taking that generates a positive impact on real activity and elimination of deflationary risks. A mission accomplished banner will not be unfurled until several quarters. The term premium – a key measure of how the Fed will gauge the effect of LSAPs – demonstrates comovement with credit growth and unemployment.

In an ideal scenario, investors would shift from Treasuries to AAA Corporates, which in turn would displace existing holders into AA bonds, and so on, until the market for higher risk assets such as ABS, CMBS and MBS generate higher lending and supporting real estate prices. However, there is a risk of investors viewing options in a more sanguine way. For example, CMBS very risky, corporates without need of capital spending, ABS pools shrinking, etc. In addition, if the policy is not credible investors could seek refuge in emerging markets or commodities, which do not spur direct domestic credit growth. In this scenario, Fed is likely to support LSAPs with additional measures other than balance sheet expansion. Furthermore, there are also risks of generating another asset bubble, competitive devaluation or undue currency volatility.

Public statements by Fed officials show that most FOMC members view higher benefits than costs to LSAPs. This reflects that these officials believe that the troubles facing the economy are mostly cyclical rather than structural and thus they can be alleviated with monetary policy easing. However, it is difficult to confirm structural unemployment contemporaneously. In addition, many of the challenges to increase potential GDP growth can only be solved through legislative reforms.

Overall, the main purpose of all the above is to avoid a tail risk scenario even if this causes undue future costs in the form of slower economic growth. This could result in a new asset bubble to combat the ill effects of the old asset bubble, a bet that the Fed is willing to take.

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