Fed Watch: Note on the FOMC Statement

Includes: TBT, TLT
by: Tim Duy

Many will parse yesterday’s FOMC statement; I will keep my comments focused on this sentence:

The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

Conventional wisdom has it that any Fed action to purchase longer-term Treasuries would be done with the intent of holding interest rates low, thereby stimulating economic activity. That, however, is not the implication of this sentence. Instead, the Fed views Treasury purchases only as a mechanism to support effective functioning of credit markets, which suggest that the Fed is not worried about controlling the level of longer term interest rates, but the spread between Treasuries and other assets.

This also suggests that the Fed is not particularly interested in expanding the balance sheet further via Treasury purchases. They may be willing to, but I am not sure how Treasury purchases will improve market functioning. To date, improving credit market efficiency has meant purchasing or holding as collateral risky assets, or even safe assets that the market currently shuns, not riskless Treasuries. What factors would cause a reversal of that position?

Moreover, one should also question the willingness of the Fed to fight against rising interest rates if those rising rates were the result of a shift to riskier assets and credit spreads fell to more normal levels. Presumably, this would correspond to a loosening of credit conditions, which in and of itself would be stimulative even if rates edged upward.

In short, as long as the Fed is focused on the issue of improving credit markets – what they view as the asset side of the balance sheet – they are not likely to engage in Treasury purchases that effectively shift policy to the liabilities side of the balance sheet. This shift, however, is what Richmond Fed President Jeffrey Lacker wants to see:

Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

Lacker views the Fed’s adherence to its asset side approach as an encroachment on the role of the fiscal authorities (not to mention a power grab by the Board). He would prefer the Fed conduct straightforward monetary policy – drive up the monetary base, effectively monetizing deficit spending. His colleagues are not there yet.

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