Notes from Brian Sack's remarks at the 2010 CFA Institute Fixed Income Management Conference, Newport Beach, California
Most FOMC members expect the unemployment rate to remain above 8.25 percent through 2011 and the inflation rate to remain below its mandate-consistent level through 2012.
The economy remains vulnerable to downside surprises that could take both output and inflation further away from the FOMC's objectives.
Fed used to maintain a 'relatively simple portfolio' of between $700B and $800B of Treasury securities.
Announced in November 2008 the purchase of up to $600B of agency debt and agency MBS.
In March 2009 it expanded the program to include cumulative purchases of up to $1.75T of agency debt, agency MBS, and longer-term Treasury securities.
Domestic securities held in the System Open Market Account (SOMA) reached a peak in June 2010 at $2.1T.
At that point this amount started to shrink as agency debt and agency MBS held in the SOMA were allowed to run off as they matured or were repaid.
At August Fed meeting, the decision was made to hold the size of the SOMA portfolio steady.
At this time, 'the Desk' was projecting that approximately $340B of the Fed Reserve's MBS holdings would be paid down from that time until the end of 2011. Another $55B would mature by the end of 2011. So expected shrinkage of $395B (~$400B).
Decision is to purchase longer-term Treasury securities.(As we've witnessed in Permanent Open Market Operations over the past few weeks.)
"The effect of asset purchases on the economy remains a point of ongoing debate..."
"My own perspective is aligned with the view expressed by Chairman Bernanke in Jackson Hole-that the effects arise primarily through a portfolio balance channel. Under that view, our asset holdings keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear. In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed's purchases would likely seek to hold alternative types of securities."
[WOW, not that it wasn't previously obvious to anyone paying attention, but did Mr. Sack just admit that the Fed's real mandate isn't of full (un)employment and stable (bubble-like) asset prices but really about boosting prices of other 'securities' such as....well, stocks??? If that's the case, is the Fed, or at least Mr. Sack, admitting that the Fed is using taxpayer dollars to provide an opportunity to allow insiders to overwhelming liquidate their equity positions in their own companies (as has been shown by the weekly data.)??]
Value of the SOMA portfolio just ahead of the August meeting was $2.054 T.
"We are running at a pace of $27B in purchases this month, and we expect that pace to bump up to around $30B for the next several months."
"We currently project that cumulative amount of principal payments on agency debt and agency MBS through 2011 will be somewhat higher than the estimates provided at the August FOMC meeting."
So...call it $450-$500B in additonal purchases through YE11. If that is the case, and we are done on $27, and running at $30B for perhaps the next 3 months, then the average monthly purchase through 2011 will be approx. $23.583B.
Focus will be on Treasury securities with remaining maturities between 2 and 10 years, although some will occur outside this segment.
Avg duration of 5 years.
Reminds us that the reinvestment strategy, of course, involves a reallocation of the portfolio from agency debt and MBS into Treasury securities.
Mr. Sack believes that Treasuries and agency MBS purchases operate similarly to remove duration risk from the market. Concern however is that as MBS purchases reomve prepayment risk from the market and Treasuries do not, spreads on MBS to Treasuries could widen. If so, Fed would proably again buy agency paper.
Notes the qualitative policy approach of the Fed (the FOMC's communique's) have, "generated a sizable market response."
On Aggregate Demand and the Effect of QE on the Greater Economy (ex-the markets):
"Some observers have argued that balance sheet changes, even if they influence longer-term interest rates, will not affect the economy because the transmission mechanism is broken. This point is overstated in my view. It is true that certain aspects of the transmission mechanism are clogged because of the credit constraints facing some households and businesses, and it is true that monetary policy cannot directly target those parties that are the most constrained. Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be. It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions."
So admits that QE is a tool to maintain artificially inflated asset prices even though this approach does not assist those who most desparately need equilibrium to return to the markets for wages, assets, necessities, etc. He believes it is very unlikely that 1) high stock prices and 2) wealth preservation for the top 20% don't have a trickle-down effect for the average citizen. Well, judging by recent data which suggests all-time record domestic income inequality (that has gone parabolic over the last thirty or so years), I'm not sure anyone puts much credence in Reaganomics anymore...except the Fed, of course.
Costs of balance sheet expansion:
"...an important operational consideration is whether the Federal Reserve purchases would strain the functioning of financial markets and cause an erosion of market liquidity." CHECK!
"This issue was present during the first asset purchase program, especially when the pace of weekly purchases reached a peak of about $40B in the middle of last year. The pace of those purchases at times put pressure on liquidity in the MBS market, leading the desk to take mitigating actions when possible."
Says there is more room to expand without issue as the SOMA holds about 12% of outstanding Treasury coupon securities. Treasury supposed to issue around $1.2T of securities over the next year, so plenty of supply. [GOOD-BYE DOLLAR]
He ends with a discussion of how to design a purchase program in a balance sheet expansion is desired. The key element in this portion of the speech seemed to be the idea that rather than announce the amount and type of purchases in advance that it might be wise to allow for some flexibility given the unknown effects such expansion might have. The important part about this is that it suggests that investors will have little clarity regarding the intermediate term actions of the Fed regardless of near term announcements. The market will therefore be incapable of operating under fundamental assumptions for some time...
http://www.newyorkfed.org/newsevents/speeches/2010/sac101004.html
An afterthought:
Last night, while visiting a friend at his rural home, I witnessed a most unusual scene. A raccoon (Procyon lotor) had become trapped in a neighborhood garbage bin. Another raccoon looking over a second bin filled with corn cobs, chicken bones, and various other sundries, decided against his initial selfish impulse and went to the aid of his fellow raccoon rather than having a feast all to himself. I gazed in wonder that these eye-masked marauders of the night were capable of feeling empathy for their fellow creature and acting to assist one another at the expense of their own personal interest. If only those in charge of monetary policy could experience a similar feeling of empathy while destroying the purchasing power of not just the current, but also the future generations of the American middle class...
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