Felix Salmon

The Fed gives up on tightening

By Felix Salmon
August 10, 2010

The big market reaction following today’s FOMC statement took place in the 10-year Treasury bond, where yields sank to 2.77% right after the statement came out, from 2.82% beforehand. That’s a big move by Treasury-bond standards, and constitutes the continuation of a longer trend: the yield was above 3% as recently as July 29, and we’re now well into yields not seen except during the very worst part of the financial crisis, when the flight-to-quality trade was in full force.


Today’s Treasury yields aren’t a function of flight to quality, necessarily, and the immediate impetus for this move was the fact that the Fed has committed to buying up more Treasury bonds itself:

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.

In other words, the Fed’s balance sheet had been shrinking, up until now, but that shrinking has now come to an end, and it’s going to remain at its current bloated level for the time being.

This is tantamount to a very modest rate cut — not a full quarter-point, perhaps, but maybe half of that. Of course, when rates are at zero, basis points loom larger than they normally do, so these moves on the side of quantitative easing become very important. And more important still is the signal that the Fed is sending: we thought we were OK to tighten things up a little bit, but now we’ve changed our mind, and we’re getting a little bit looser instead. The recovery, in other words, still needs Fed support in order to maintain any semblance of sustainability or momentum.

The bigger picture, however, is one of the Fed largely having run out of ammunition. Most of what it’s doing now is symbolic: the real national response, as Mohamed El-Erian says, needs to come from the government rather than the central bank, and needs to be structural rather than monetary in nature. Given today’s decision, though, we can at least assume that any moves from the White House to try to bolster the national economy will be met with the strong support of Ben Bernanke.

8 comments so far | RSS Comments RSS

Welcome back, Felix!

The Fed will have no chance to significantly tighten until the economy is on sound footing again. In the meantime, it must be very tempting for hedge funds to leverage up.

Posted by TFF | Report as abusive


“To relieve the present exigency is always the object which principally interests those immediately concerned in the administration of public affairs. The future liberation of public revenue they leave to the care of posterity.”
- Adam Smith, The Wealth of Nations (1776)

The only “national response” that will save the American era would be a constitutional amendment to stop the federal politicians from buying our votes with our own money. Borrowing from Science instead of posterity, it would be an amendment with specificity, objectivity, and accountability.

How to get such an amendment? Elect a government managed by a new political party . . . a party with a platform based upon Science not just Politics. Such a party could begin with the few, truly conservative Republicans; the fewer, conservative Democrats; the Libertarians; and the Constitutionists. It could begin now.

Gene Richard Moss
Author, Inescapable Consequences

Posted by Moss_GR | Report as abusive

From where we stand now, we’re looking at 9 months at least before this economy improves really and significantly. I guess we may as well watch the Fed piss in the wading pool while we’re wishing for the economy to improve materially on its own. It’s good for some mild entertainment, anyway ..

Posted by Woltmann | Report as abusive

“The bigger picture, however, is one of the Fed largely having run out of ammunition.”

Not just that; Obama Corp. is also running out of ideas if they had any to start with in the first place.

So 9 months would be too optimistic, my dear Woltmann. It’s starting to feel like rheumatism to me, the pain is going to be here for a long time if it ever goes away.

Let’s start praying.

Posted by doctorjay317 | Report as abusive

Missed your insights, hope the furlough was good.

I’m rapidly reaching the view that we’ve left the material world and have somehow morphed into the subatomic zone where everything is the wrong way round.
I’m being more than half-serious: yesterday’s ‘decision’ was no decision, because the Fed, the UK Treasury, the Chinese, the Russians and the EU – they no longer even THINK they know what to do….and yet somehow, everybody is squabbling internally.

We need some lateral thinking after the fashion of something Bruce Willis might pull just as the asteroid is about to hit San Francisco. For myself, I have believed since late 08 that zero interest rates were a big mistake on both sides of the Pond, and the assumption that only Government should ease the situation is crazy: the private sector has far more money than the Governments.

But ultimately, failure to reform (and partly replace) a globalised banking system was always going to store this up: the US and UK have become too expensive as producers – and need to change strategy radically – but even without mad banking practices that would’ve been a tough mission. Now it’s Mission Impossible.

Maybe what we need is Tom Cruise to throw some scientology at the issue.

http://nbyslog.blogspot.com/2010/08/anal ysis-what-lies-ahead-article-to.html

Posted by nbywardslog | Report as abusive

Hi Felix and welcome back from a break that I hope you enjoyed.

I think that this move is expressed well by something raised on the notayesmanseconomics web blog.

“It hits the fundamental problem that asset purchases have taken place on an enormous scale in the US, so that if such enormous purchases have not worked why will an extra $250 billion a year that will take time to build up let alone have an economic impact?”

Also treasury bond yields are already quite low and it is hard to see how nudging them lower is going to do much good for the US economy

Posted by Sally32 | Report as abusive

Why would a failure to re-invest MBS proceeds be a de facto tightening when reserves are currently piling up unused at the Fed? Letting the size of the Fed’s balance sheet shrink would seemingly only have a tightening effect if there were not excess reserves.

Now if people want to argue that we need further loosening via additional Fed intervention in asset markets, then that seems like a logical argument–and many are making such a claim. But the notion that run-off is tightening when there are excess reserves seems incorrect to me.

Posted by ryanmburke19 | Report as abusive

ryan, I’m not 100% positive that I understand it correctly, but…

“Reserves” at the Fed are out of circulation, not part of the active economy. When the Fed buys something (anything) with those reserves, the money is injected into the economy. When bonds they hold are redeemed, or yield interest payments, then that money LEAVES the economy.

Doesn’t sound like the amounts involved are sufficient to make more than a symbolic difference, however.

Posted by TFF | Report as abusive

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