Fed is split but QE2 looks a done deal
– The opinions expressed are the author’s own-
FOMC meetings are usually a strange combination of formality and easy-going familiarity but levity may be in short supply this week. The Fed’s institutional credibility is on the line, and the normal decorum that characterizes relations among committee members has become increasingly strained over the summer.
Divisions between proponents and opponents of a second round of quantitative easing (QE2) have been on display as never before. It is not clear what members will say to one another to fill two days since all the arguments have already been rehearsed in detail and in public over the last six weeks.
In a thinly veiled swipe at his colleagues, Kansas City Fed President Thomas Hoenig has stumped around his patch on the Great Plains denouncing QE as a “dangerous gamble” and “a bargain with the devil”.
Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser have made no secret of their skepticism or outright opposition to launching QE2 at this point. Minneapolis Fed President Narayana Kocherlakota has questioned whether it will work. Richmond Fed President Jeffrey Lacker has seemed to doubt whether it is necessary.
In contrast, the New York Fed (always the closest to the major money centre banks) and the St Louis Fed (the spiritual home of monetarism in the Federal Reserve System) have openly campaigned for the benefits of a second round of asset purchases.
The final vote to adopt QE2 looks set to be 10-1 (with Hoenig dissenting). But the tally will mask much wider misgivings among the non-voting regional presidents and perhaps among some members of the Board of Governors itself, who will nonetheless fall in line with the chairman to support his authority.
The decision to launch QE2 already seems to have been taken. No senior member of the Fed system has sought to downplay market expectations the committee will announce more asset purchases this week. But the details are as important as the overall decision to press ahead. The committee must make choices on at least five points:
* First, the headline amount of securities the Fed agrees to purchase — whether it is specified as simply a first phase or the total amount for the program.
Most market participants seem to be expecting purchases of around $500 billion in the first phase. This amount has probably been priced in already.
Announcing a half-trillion dollar program risks a limited impact on the markets. But announcing a bigger total will stoke fears that Fed policy is being driven by Wall Street and that the central bank has lost control.
* Second, the Fed must specify the rate at which securities will be purchased. Most participants seem to expect the $500 billion worth of purchases to be completed over a period of about six months — implying asset buying at around $80 billion per month.
The Fed is already buying about $30 billion of Treasury notes each month as a result of its earlier decision to re-invest funds from maturing mortgage-backed securities in its portfolio back into the government bond market.
Combined purchases as a result of QE2 and re-investment will thus come to over $100 billion per month — equivalent to the Treasury’s entire borrowing requirement. It will open the Fed to accusations of “monetizing” the government borrowing. Purchasing any more than $80 billion per month as part of QE2 will only make the accusations worse.
* Third, the Fed must decide what type of securities to buy — whether to restrict purchases to Treasury notes (and if so what maturities) or broaden the program to include agency notes, mortgage-backed bonds or even corporate bonds.
The Fed already controls short-term borrowing costs via the federal funds rate. In theory it is meant to be using QE2 to drive down medium-term borrowing costs. By implication the Fed should be buying medium-term Treasury notes. But there are not enough of them. So the Fed may also buy some shorter-term 2-year and 3-year Treasury securities, or broaden its purchases to include other bonds.
The Fed has been trying to pull back from the more unorthodox and interventionist measures it used in 2008 and 2009. When it announced the mortgage-bond reinvestment programme in August the Fed made clear the proceeds would be re-invested in Treasuries. But the scale of QE2 means the Fed may have to consider buying short-term notes or even agency and mortgage bonds to avoid cornering the market for medium-term notes.
* Fourth, the committee must make a decision on the program’s duration — whether purchases will be for a finite period or continue indefinitely until some exit condition is met (what policymakers have taken to calling a “state-dependent” strategy).
A finite program (e.g. $500 billion over six months) would preserve flexibility, and mollify some of the skeptics. It might prevent Plosser, Fisher, Lacker and Kocherlakota joining Hoenig in outright opposition and denouncing the policy in their speeches. But it also risks disappointing markets that have already priced this much in and are hoping for more.
* Fifth, if the program is to continue indefinitely, will the Fed spell out the exit condition in terms of a hard number (an inflation target, price-level target or unemployment rate) or leave it to a softer qualitative judgment by the committee about when the danger of deflation is passed and recovery is sufficiently strong?
A state-dependent target linked to inflation, the price level or unemployment would send a strong signal to the markets. But it would lock the Fed into an open-ended and possibly dangerous commitment to buy a lot of government bonds and force it to persist with the policy even if the benefits prove marginal and costs start to mount. It would widen the committee’s divisions even further and risk driving the doubters into opposition.
LOSING THE ARGUMENT?
The actual announcement on Nov. 3 marks only the beginning. Once the formal decision is taken, Fed Chairman Ben Bernanke has to sell the strategy to an increasingly skeptical investment community and public.
In a sense, Hoenig has already won the argument even if he has lost the vote. His high-profile campaign has shifted the focus onto the uncertain and possibly marginal benefits of QE2 while pointing up the risks and problems. Bernanke and other supporters of QE have been forced to defend the policy against the criticism that it will be ineffective at best and create a new set of dangerous distortions at worst.
It puts the committee in something of a bind. If the FOMC announces a finite $500 billion purchase program it risks disappointing the markets and triggering a sell-off as investors conclude the good news has already been priced in. But if the committee opts for a much higher total or an open-ended commitment to gin up the markets, fears the Fed has lost control and is over-reacting will grow.
Monetary policy works as much through its impact on expectations as its actual effect on borrowing costs. Whatever happens on Nov 3, Bernanke and other QE supporters must go out and sell the program.
They have to explain how it will work and be managed; dispel the impression QE is being driven by Wall Street and its allies in the New York Fed rather than be the System as a whole; and convince the growing ranks of doubters that the Fed still knows what it is doing.