Bernanke's Speech: Should the Fed Go Long?

by: Zubin Jelveh

Some takeaways from the Fed Chairman's speech:

1) Tough talk on the need for banks to realize that the easy days are over:

Ultimately, however, market participants themselves must address the fundamental sources of financial strains by raising new capital, restructuring balance sheets, and improving risk management. This process is likely to take some time.

This echoes remarks made by University of Chicago's John Cochrane in a panel discussion a couple of weeks back. Basically, Cochrane believes that the rapid deterioration of the shadow banking system (CDOs, hedge funds, SIVs) means that the big financial institutions will need to live with holding loans they originate (and the risks associated with them) on their balance sheets.

2) The Fed's still worried about inflation, just not right now:

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

3) And as much discussed here, Bernanke believes the inability of paying interest on excess reserves to put a floor on the effective fed funds rate is due to the fact that some institutions, like GSEs, aren't eligible to earn that interest:

In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target. We will continue to explore ways to keep the effective federal funds rate closer to the target.

The Fed also proposes buying up longer-term Treasuries:

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

(emphasis mine)

The buying of longer-term Treasuries is not a tool that the Fed has pulled out very often. The most famous example happened at the start of an administration led by a young, handsome, and charismatic Democrat. This from Floyd Norris in 2002:

The original Operation Twist was conceived in 1961 by the Kennedy administration, which felt a need to lower long-term rates to stimulate business investment, while at the same time raising short-term rates to deal with a current account deficit that was putting pressure on the dollar. Thus the ''twist'' on interest rates.

The twist was not wildly successful, but neither was it a clear disaster. The dollar survived another decade before it had to be devalued as the era of fixed exchange rates ended. And a long period of economic growth began in 1961.

Also in 2002, Bernanke said in a speech that comparisons to the Kennedy plan should be made with care:

Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.

Economists at Wrightson-ICAP also point out that Operation Twist was a joint effort by the Treasury and the Fed (Good thing Geithner is heading to Treasury then). Further, the Treasury could save the Fed from having to expand its balance sheet -- and potentially adding to inflationary pressures -- by changing the mix of debt that it offers.

Our own guess, Bernanke's comments notwithstanding, is that the Fed ultimately will decide that it faces enough demands on its balance sheet without loading up on Treasury bonds as well. However, the same result might be achieved through adjustments in the mix of new issuance by the Treasury. If policy-makers have actually been contemplating the possibility of operations farther out the Treasury yield curve, it is possible that implementation will be left to Tim Geithner at Treasury rather than Ben Bernanke at the Fed.