10 August 2010 – The Aleph Blog

Redacted Version of the August 2010 FOMC Statement

Posted on 10 August 201010 August 2010 by David Merkel

Comments

Adds new paragraph for quantitative easing, round 2.? Will invest maturing Treasuries, Agencies and Agency MBS in longer term Treasuries.
Four months ago I wrote: The FOMC is overly optimistic on employment and housing issues.
Now the weakness is evident.? Hope has given way to modest pessimism, as they have shaded virtually all of their views of economic strength down.
Two months ago I wrote, ?Implicitly blaming the Eurozone is cheap, we have enough issues on our own for the weakness ? residential housing, commercial real estate, and over-indebted consumers.?
Now they have given up that evasion, and continue to shade down their views.
Hoenig still dissents; hasn?t gotten bored with it yet.? Fight on, Tom.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.

Queasing over Quantitative Easing

Posted on 10 August 2010 by David Merkel

The world’s largest hedge fund, the Federal Reserve, is trying to decide whether it should expand its operations.? Unlike most hedge funds, the Federal Reserve has a big advantage in that it can fund itself cheaply, and for the most part, at its own discretion.

Unlike most hedge funds, it issues 0-day 0% Commercial Paper, which is accepted almost everywhere as a means of completing transactions.
Banks affiliated with them must place reserves with the Fed, on which they earn interest of around 0.25%
The affiliated banks, not finding as many opportunities as they would like to lend privately on a risk-adjusted basis, leave more money than they have to at the Fed, again earning about 0.25%.

What a cheap funding base.? They can buy almost any asset and make money, so long as equity/credit risk is limited, and so long as the yield curve doesn’t hit new records for steepness.? Given that the Fed does not have to mark most of its positions to market, and does not have to worry about margin calls in the conventional sense of the term, they make money year after year, and hand most of the profits over to the US Treasury, which keeps accounts for the Fed’s main owner, the US Congress.

Life is tough when you have to serve multiple conflicting interests.

They demand that you create conditions for full employment, something beyond your control.
They ask that you restrain inflation, which is possible.
They ask that you lend, because the banks affiliated with you are not lending, and an increase in lending is always a good thing, right?

So, like Keynes, the fools that think that a lower rate of interest is always better urge that the Federal Reserve should expand its balance sheet and buy up more Treasuries, Agencies and Agency MBS, forcing rates lower.? What good can come from forcing high-quality long rates lower?

My answer is, not much.? Existing debts if non-callable, will be worth more.? If debtors are solvent, and can refinance, they? can lower their debt service costs, though that is a minority of borrowers.? Beyond that, it will lead the favored debtors to borrow more — Treasury, Fannie, Freddie, etc.? We need more borrowing, right?

But a greater effect can be the speculative frenzy engendered by dropping the rate that savers earn to such a low level, leading them to invest more aggressively to meet their income targets.? As with any other sort of speculation, the game is over when people rely on the occurence of capital gains.

I think quantitative easing is a mistake; I also think it does not help matters much.? It transfers resources from creditors to debtors in a funky way.? That is not the right way to go if you want a country to grow.? (Which, contrary to the received wisdom, would mean that raising short term rates would be better for the US and Japanese economies than engaging in quantitative easing.? There would be short-term pain, but there will be pain regardless of how this policy is conducted.)

If the Fed makes a bow in the direction of quantitative easing on Tuesday, such as reinvesting the proceeds of MBS in more MBS, the markets will rally, but I would fade it, because it will have no long-term beneficial? impact on the economy.

There is no free lunch.? Any action that seems to cost nothing on the part of the Fed or the Federal Government will have no long-term effect on the economy.? Quantitative easing is one of those comforting fairy tales that is a fraud, whether intentionally so, or not.

June 2010	August 2010	Comments
Information received since the Federal Open Market Committee met in April suggests that the economic recovery is proceeding and that the labor market is improving gradually.	Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months.	Shades down their views on production and labor.
Household spending is increasing but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Shades down their view on consumer spending.
Business spending on equipment and software has risen significantly; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.	Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.	Shades down their view on business spending on equipment and software.
Housing starts remain at a depressed level.	Housing starts remain at a depressed level.	No change.
Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad. Bank lending has continued to contract in recent months.	Bank lending has continued to contract.	Gives up the ?We?re fine, this is a foreign problem? idea.
Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time.	Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.	Finally accepting that their forecasts were too optimistic.
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.	Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.	Toots the ?At least inflation is low? horn.? Not a popular instrument at the moment.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	No change.? Fed funds are useless at this point.
	To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.¹ The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.	New paragraph for quantitative easing, round 2.? Will invest maturing Treasuries, Agencies and Agency MBS in longer term Treasuries.? May be avoiding Agency MBS in order to stop problems with the rolls.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.	The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.	No change.? A meaningless statement.
In light of improved functioning of financial markets, the Federal Reserve has closed all but one of the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities; it closed on March 31 for loans backed by all other types of collateral.		Paragraph removed.? The programs are gone, leaving behind a legacy of increased moral hazard risks.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	No change.
Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee?s flexibility to begin raising rates modestly.	Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.	Hoenig continues his dissent.? Thinks economy is improving, and that quantitative easing should roll off.
	1. The Open Market Desk will issue a technical note shortly after the statement providing operational details on how it will carry out these transactions.	Footnote added to QE paragraph.