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INSTEAD OF SHOCK AND AWE, is the Federal Reserve preparing surgical strikes to spur the economy?
An article on the Wall Street Journal's Web site late Monday afternoon said the Fed was considering a smaller, open-ended plan to buy Treasury securities, in contrast to the massive, $1.7 trillion securities purchase the central bank undertook beginning in March 2009.
But instead of the Fed setting an amount of securities it would buy, the WSJ.com story by Jon Hilsenrath said the central bank was studying announcing purchases in smaller increments and conditioned on the state of the economy.
It should be recalled that Hilsenrath broke the story during the summer that the Fed would consider replacing maturing mortgage-backed securities rather than letting them run off. As it happened, that approach was approved at the Aug. 10 meeting of the Federal Open Market Committee in order to prevent a passive tightening of monetary policy.
At last week's meeting, the FOMC pointedly said that inflation is currently "somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." As a result, the panel added "it is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate."
That statement was widely inferred by market participants that the Fed could take further steps toward "quantitative easing"—the academic term for central bank securities purchases—at the next FOMC meeting on Nov. 2-3 (conveniently concluding the day after Election Day.)
A small-scale approach to purchasing, say, $100 billion or less per month, might bridge disagreements on the FOMC, some of whose members are reluctant to commit to a large-scale QE2 (as a second phase of quantitative easing is being dubbed) at this time.
Strategists at the Royal Bank of Scotland also suggest the Fed also could accomplish its aim of stimulating the economy by issuing what they dub as a "Bernanke Put," in which the central bank would peg the yield on longer-term Treasury securities.
That would be more effective in bringing down long-term interest rates than massive purchases under QE2, John Richards, RBS North America head of strategy, and Eric Liverance, its head of quantitative strategy, argue in a provocative research note.
Moreover, pegging long-term yields has ample precedent and required relatively few purchases of bonds when it was practiced during World War II. Treasury bond yields were pegged at 2.5% while the federal government ran massive budget deficits to finance the war effort.
Indeed, Richards and Liverance also point out, this would be Bernanke's favored tack. In his famous speech in November 2002—in which the future Fed chairman invoked Milton Friedman's metaphor of dropping money from helicopters to describe what's now called QE—he said:
"A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt."
Thus, this is not a concept the Richards and Liverance conjured out of whole cloth. "Clearly, putting a ceiling on yields has been in Chairman Bernanke's mind for some time. Gone now are worries that the Fed will be accused of creating inflation by monetizing the debt. Indeed, low—not high—inflation has been identified as a concern requiring targeted attention," they write.
Call it a sort of "qualitative easing" since the quantities are indeterminate.
To explain how the Bernanke Put would work, Richards and Liverance utilize options theory to calculate how much such a program would would lower long-term interest rates.
By their calculations, if the Fed were to put a 3% ceiling on the benchmark 10-year note (by giving investors the right to sell their securities if their price fell to levels to push the yield up to 3%, from 2.55% when the calculations were done), the yield on the note would fall sharply, to around 1.93%.
Why? Because that "put" provides an insurance policy of sorts and lessens the risk of large price losses. Lower risk results in lower yields.
Moreover, a drop in long-term interest rates has about four times' the stimulus as cuts in the Fed's target for overnight federal funds, which is currently pegged at nearly zero, according to one economic study Richards and Liverance cite. That argues for another round of QE rather than extending the duration of the zero-fed-funds policy, they add.
Richards and Liverance emphasize, however, the Fed needs to be especially attentive to weighing the rate at which it would peg the long-term interest rate—the "strike price" of the Bernanke put option. The higher, or farther out of the money, the strike, the less bonds the Fed would have to buy, but the impact would be smaller.
The impact also depends on the market's perception of how long the peg will last. "This speaks to the value of an open-ended or data-dependent commitment, such as keeping the program in place until inflation returns to a desired range, while a short expiration period will limit the program's impact value," they write.
If the Fed were successful in bringing inflation back to its desired level, the RBS strategists conclude, "market participants will eventually aggressively test the Fed's resolve. Then it will have to decide whether or not to end the program or be prepared to step up its bond buying until it is satisfied with the level of inflationary expectations."
As with any campaign, the exit strategy is critical. That is regardless of the tactics, of which "shock and awe" of the Fed's massive previous purchases is but one. Others, more like surgical strikes, also apparently are being studied in the central bank's policy war rooms.
Comments? E-mail randall.forsyth@barrons.com
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