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The Fed Lacks Urgency
Balance-sheet expansion is the right plan, but it needs to be implemented at a much quicker pace.


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David Malpass

The Federal Reserve made the correct call last week to increase its purchase commitments for mortgage-backed securities and bonds linked to mortgage lending. However, the Fed didn’t say it would speed up its pace of purchases. Thus, the plan is not ideal, and it may not be sufficient to restart credit markets or sustain the recent rally in stocks.

There’s an almost daily urgency for the Fed to unfreeze credit markets. Jobless claims are running 650,000 per week. Locked credit markets are draining liquidity fast with each foregone bond rollover. And the costs from idle capacity — workers and capital — are immense.

But the Fed is only purchasing assets at an average rate of $4 billion a day. That’s not fast enough.

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The Fed’s most useful purchases are of higher-yielding guaranteed debt, including Fannie Mae and Freddie Mac mortgage-backed securities (GSE MBS) and FDIC-guaranteed paper. The objective of these purchases is to provide new liquidity to the sellers of those securities — liquidity that can be used to buy other credits, such as corporate bonds or private-label mortgage-backed products.

Right now the Fed is spending between $20 billion and $25 billion a week on these securities. And it’s possible that new weekly data will show that the Fed has ramped up its buying to a more appropriate pace of $100 billion a week. But the Fed’s March 18 statement doesn’t leave that impression.

The ideal statement would have included this wording: “To provide greater support to mortgage lending and housing markets, the Committee decided today to materially accelerate its purchases of agency mortgage-backed securities and, as conditions warrant, to expand its purchases beyond the existing $500 billion commitment.”

Instead, the statement specified that the purchases of GSE MBS and GSE bonds are to be accomplished “this year.” The statement would have been stronger without that phrase, and by specifying this period it’s clear that at least some members of the Fed’s Open Market Committee (FOMC) want to keep going slowly.

The statement also indicated that the Fed “anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” This is intended to build market confidence that interest rates will stay low, but instead it points to a long recession, recalls the “considerable period” phrase from the 2004 monetary-policy disaster, sounds tolerant of inflation, and scares money away from dollars.

As usual, the Fed made no commitment to protect the long-term value of the dollar, a key issue in attracting capital to U.S. credit markets. As a result, the dollar weakened sharply against gold, the euro, and the yen.

The Fed also said that in order to “help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.” This is fraught with problems.

There are roughly, and only, $500 billion in 10-year-and-longer Treasuries. Many are locked into structures or owned semi-permanently abroad, meaning the free-float of long-term Treasuries is less than the intended Fed purchase. The Fed may buy some low-yielding 5-to-10-year securities. And over time, the Treasury will lengthen its debt maturity by increasing its issuance of longer-term notes and bonds, which I have advocated. But the Fed is buying into a bubble in Treasury prices, a bad idea.

With credit markets still not functioning well, it’s not clear that lower Treasury yields will be arbitraged into lower corporate, municipal, or even mortgage yields. The first effect of the Fed’s announcement was to widen credit spreads, hurting those investors who were carrying out the spread arbitrage. And while Fed purchases of Treasuries might give existing holders (like China) confidence to keep holding them, it instead might offer a convenient exit yield.

Fed chairman Ben Bernanke and New York Fed president William Dudley seemed to have been opposed to Treasury purchases. Yet the vote last week was unanimous, implying a compromise on the FOMC (i.e., I’ll vote for your idea, if you vote for mine).

That said, on net, the Fed statement is a positive. It is constructive for the Fed to seek to expand its balance sheet in the face of a deflationary credit freeze.

When the Fed announced this plan, which amounts to a balance-sheet expansion of more than $1 trillion, many voiced concern that the Fed’s new asset purchases will be inflationary. But the Fed is funding these purchases with excess bank reserves. It is not printing money or adding to the currency outstanding (the classic definition of debasement). There’s not “too much money chasing too few goods,” but the opposite: tight credit conditions with a surfeit of goods, services, and fixed assets (like offices and houses).

Gold — an inflation indicator — did rise $45 an ounce on the FOMC announcement. But that strength may be temporary. Gold’s trend will depend on the pace at which the Fed buys assets (probably slowly), indications from the administration and the Fed about the future value of the dollar (unclear), and risks to the global financial system (which bolster gold but hurt other commodities).

Taken together, the present Fed actions are strong enough to preserve the global financial system, but they’re coming at too slow a pace to offset the credit-market contraction.

– David Malpass is president of Encima Global.



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