The Fed decision announced last night seems to have disappointed markets, yet it will surely come to be seen as a clear win for the doves. Prior to yesterday, the default option at the Fed was to allow the size of its balance sheet to decline whenever its holdings of mortgage debt matured. Although this would not have led to much shrinkage of the balance sheet in the near future, it signalled that the Fed was looking for opportunities to reverse its policy of unconventional easing. That bias has now been removed, though not yet reversed.
James Mackintosh has called this QE 1.1, which is some distance from QE 2. Goldman Sachs economists estimate that the decision will lead to the purchase of an extra $15bn a month of treasury securities, which is about one tenth of the gross issuance of treasuries each month. Although this sounds like a negligible amount, we should remember that the prices of financial assets are determined at the margin, so the effect may be larger than it seems at first sight. Francesco Garzarelli at Goldman thinks this could result in 10 year treasury yields dropping to about 2.5 per cent, which is not that far from the low points reached at the height of the crisis.
More important, I suspect that yesterday’s decision was a good litmus test of where Fed opinion would stand if the US economy continues to weaken in the next few months. If (and only if) that happens, it now seems that the centre of gravity on the FOMC would probably be to increase QE further, though when this might happen, and by how much, are issues which were certainly not settled yesterday. This is important for risk assets, since it suggests that we are now less likely to face a situation in which the US economy is seriously weakening, but the Fed decides to do nothing. (In general, I would argue that there are two very bad scenarios for risk assets. This first is when an economy collapses so precipitously that the central bank cannot prevent it, even though it takes rapid action. That was what happened in 2008. The second is when the economy weakens, but the central bank decides not to respond. That is the issue now.)
James Politi argues that the victory for the doves was tempered by the fact that the proceeds from maturing mortgage bonds will be re-invested in the treasury market, not in mortgage debt. This was apparently desired by the hawks because it would improve the quality of assets held on the Fed’s balance sheet. I am not sure whether this matters all that much. Yes, it is a signal that direct Fed support for the mortgage market ( and therefore for mortgage rates and the valuation of mortgage debt on bank balance sheets) will be less than before. But the mortgage market will surely be helped if treasury yields fall. The main thing that matters is the overall size of QE, which is measured by the size of the Fed’s balance sheet. The composition of the Fed’s balance sheet probably matters less than its overall size.
Markets will therefore now focus even more than they did before on the size of central bank balance sheets as indicators of monetary policy ease. The graph shows how balance sheet size has shifted for each of the four major central banks since the crisis started. On this basis, the Bank of England has done more QE than the Fed, and both have done much more than the ECB. The Bank of Japan has hardly responded at all to the financial shock, which is presumably the main reason why the yen has strengthened so much recently – today hitting a 15-year high versus the US dollar.
The gap between the actions of the Fed and Bank of England on the one hand, and the ECB and BoJ on the other hand, could widen before the year end. The Bank of England’s Inflation Report for August has downgraded the Bank’s GDP forecast, and once again suggested that the MPC is ready to overlook the current inflation overshoot, in the belief that this will prove temporary. Meanwhile, the ECB is busy saying nothing at present, and the BoJ is busy doing nothing.
So it is business as usual, with the Anglo Saxon central banks appearing a lot more dovish than the hard currency mob at the ECB and BoJ.
Related reading:
The Focal-Point Fed – Paul Krugman, New York Times
What the Fed can’t buy - Tracy Alloway, FT Alphaville
Money Supply blog – FT
Related video:
Bond terms dictate reaction to Fed – James Mackintosh, FT Short View
