The Fed Gives Up on Tightening

by: Felix Salmon

The big market reaction following today’s FOMC statement took place in the 10-year Treasury bond, where yields sank to 2.77% right after the statement came out, from 2.82% beforehand. That’s a big move by Treasury-bond standards, and constitutes the continuation of a longer trend: the yield was above 3% as recently as July 29, and we’re now well into yields not seen except during the very worst part of the financial crisis, when the flight-to-quality trade was in full force. (Click to enlarge)


Today’s Treasury yields aren’t a function of flight to quality, necessarily, and the immediate impetus for this move was the fact that the Fed has committed to buying up more Treasury bonds itself:

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.

In other words, the Fed’s balance sheet had been shrinking, up until now, but that shrinking has now come to an end, and it’s going to remain at its current bloated level for the time being.

This is tantamount to a very modest rate cut — not a full quarter-point, perhaps, but maybe half of that. Of course, when rates are at zero, basis points loom larger than they normally do, so these moves on the side of quantitative easing become very important. And more important still is the signal that the Fed is sending: we thought we were OK to tighten things up a little bit, but now we’ve changed our mind, and we’re getting a little bit looser instead. The recovery, in other words, still needs Fed support in order to maintain any semblance of sustainability or momentum.

The bigger picture, however, is one of the Fed largely having run out of ammunition. Most of what it’s doing now is symbolic: the real national response, as Mohamed El-Erian says, needs to come from the government rather than the central bank, and needs to be structural rather than monetary in nature. Given today’s decision, though, we can at least assume that any moves from the White House to try to bolster the national economy will be met with the strong support of Ben Bernanke.

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