Flash Point: Fed Math

Bloomberg has printed a summary of today’s FOMC meeting: Fed Expands Asset Buying, Links Rates to Joblessness, Prices. We will preempt the usual misinterpretations of a summary of the now and future position of the Fed’s balance sheet.

Going into the meeting, the Fed’s balance sheet (Tracking the Fed Balance Sheet) stood at $2,861,340 million. The Fed is committed to buying $40 B of mortgage backed securities (MBS) per month. They also committed to extending Operation Twist to the end of the year, recycling $45 B of Treasuries /month. Their position prior to today was summarized in the October 23-24 FOMC minutes as:

  • The Committee judged that continuing both the purchases of MBS at a pace of $40 billion per month and the existing program* to extend the average maturity of its Treasury securities holdings remained appropriate.
  • The Committee also agreed to maintain its policy of reinvesting principal payments from its holdings of agency debt and agency MBS into agency MBS.

* Refer to the September 12-13 FOMC minutes for the authorization to extend the program to December 31:

The Committee directs the Desk to continue the maturity extension program [MEP] it announced in June to purchase Treasury securities with remaining maturities of 6 years to 30 years with a total face value of about $267 billion by the end of December 2012 [this works out to be $44.5 B /month over 6 months].

We will note again that the MEP does not affect the Fed’s balance sheet since for every dollar invested in longer maturity instruments, an offsetting dollar is recovered by selling shorter-dated instruments.

And What’s New

According to today’s press release from the Fed, the key points on Fed policy are:

  1. [T]he Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.
  2. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities [MEP] is completed at the end of the year, initially at a pace of $45 billion per month.
  3. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and, in January, will resume rolling over maturing Treasury securities at auction.
  4. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
  5. this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Our comments in numerical order are:

  1. This program will add $40 B/mo to the Fed’s balance sheet if fully exercised and until it is terminated.
  2. Starting in January, this program will add $45 B/mo to the Fed’s balance sheet until it is terminated. It is of note that they specified “longer-term” Treasuries, consistent with the maturity extension policy of the MEP.
  3. The implication of this policy is that the balance sheet cannot shrink by natural attrition.
  4. This statement is a tacit admission that their policies to date have been largely ineffective. Consider that the business cycle is a natural cycle and that recovery is a natural part of the economy in the cycle. The fact that the current recover is the slowest post WWII, one has to ask how any impact of Fed policy can be measured or even inferred. The Fed’s abnormal and aggressive intervention might even be suspected of retarding the recovery. What can a continuation and increase of such policies be expected to achieve?
  5. We have suggested in the past that high unemployment is structural. If this is the case, the Fed may have to remain accomodative for quite a while, especially if the economy goes through a normal business cycle downturn.

The bottom line is the Fed is scheduled to increase its balance sheet in January at the rate of $95 B/mo in an opened ended expansion. That’s $1.14 T/year which will bring us to $4 trillion in total assets this time next year.

Next Day Hangover

We have been mulling over a couple if items that we did not report on but now think are worth noting. The press release noted:

In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

The bold part we interpret as giving the Fed the latitude to modify the programs as necessary. In particular, if they are seen to be either achieving desired results or not working at all (efficacy) or are threatening to create permanent damage to the Fed’s balance sheet (costs) then we think they are saying they may wind them down early. For example, see Initial Claims Plunge: QE4EVA Ending Sooner Than Expected? from ZeroHedge that suggests an improving employment picture might cause the fed to act sooner than later in shutting things down.

And when they head for the exit it will be done carefully. They recognize that to unwind their position, rates will rise, slowing the economy and raising unemployment. A dangerous uptick in inflation would force them to do this.

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

Addendum: 20121217

Bob Eisenbeis, Vice Chairman & Chief Monetary Economist of Cumberland Advisors, published a thoughtful analysis of the nuances in the Fed’s positioning and wording, titled: Fed Watching and Forecasting Has Just Become More Important. It is quite detailed so we won’t attempt to summarize it. If you are serious about Fed policy and Fed actions, then it’s worth the read.

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