The U.S. Federal Reserve should spell out its conditions for winding down quantitative easing (QE) to avoid further damaging rises in long-term interest rates, according to a paper delivered at the Jackson Hole symposium.
So far, the Federal Reserve has been deliberately vague about its plans for asset purchases – so-called large scale asset purchases or LSAPs - to retain flexibility in its policy given its limited knowledge of how this tool affects the real economy, according to economists Arvind Krishnamurthy and Annette Vissing-Jorgensen, both professors of finance who received their PhDs at MIT.
Krishnamurthy and Vissing-Jorgensen used to be colleagues at the Kellogg School of Management, Northwestern University, but Vissing-Jorgensen has now moved to University of California-Berkeley while Krishnamurthy remains at Northwestern. (corrects from earlier versions that said both professors were still at Kellogg).
But the jump in global bond yields and the plunge in stock markets following the June 19 meeting by the Federal Reserve is evidence of the acute sensitivity of investors to the future of LSAPs, mainly because QE targets long term bonds whose prices are very sensitive to expectations of future policy.
“Lacking clear guidance on the states that drive LSAP policy, investors will react to any information regarding the Fed’s intensions over LSAPs,” the economists said in “The Ins and Outs of LSAPs.”
One of the distinguishing features of QE is that it entails the purchase of longer maturity assets, such as mortgage-backed securities (MBS) or Treasury bonds. This compares with traditional monetary policy that typically focuses on short-term rates, and in the case of the Fed, the overnight fed funds rate.
“Since the prices of long maturity assets are much more sensitive to expectations about future policy than short maturity assets, controlling those expectations is of central importance in the transmission mechanism of QE. Therefore, how an exit is communicated to investors matter greatly,” they said.
Looking closer at the volatility in financial markets around the June 19 meeting - when Fed Chairman Ben Bernanke said purchases of assets would be reduced later this year and ended by mid-2014 if the economy continues to improve – the authors found that financial markets pulled forward the timing of a rate tightening cycle by about four months but it was not clear whether that was the intention of the Fed.
“By being imprecise in the state-dependence of LSAP policy, the Fed has left it to investors to form expectations over the future of LSAPs,” they said. “The large moves in rates on that day is clear evidence of the role of policy shocks – if investors found it easy to predict Fed policy changes, one should not see large moves in rates upon announcements.”
One of the challenges facing the Fed in communicating its plans to exit QE is that investors appear to have closely tied together the path of the fed funds rate with QE, a reaction to the Fed not articulating a framework for the use of LSAPs.
“Investors only understand that LSAPs are a tool to be used when the zero-lower-bound is binding. Thus when the Fed communicates that it plans on not using LSAPs, investors assume that the zero-lower-bound will not be binding and that rate hikes will follow,” they wrote.
Apart from asset price volatility, another drawback of the Fed’s imprecise communication over LSAP policies is that the Fed cannot tailor an exit.
“Currently, with the Fed’s discretion strategy, any exit step will be taken by investors as a signal of policy-maker preferences, which then can have wider consequences,” as illustrated by the sharp moves in asset prices around June 19.
Based on their analysis of how LSAPs have affected the yields in the market for mortgages and U.S. Treasuries, Krishnamurthy and Vissing-Jorgensen propose a specific exit strategy for the Fed from almost five years of asset purchases.
First, the Fed should stop buying Treasury bonds and then sell down its portfolio. The reason is that a sale or cessation of Treasury bond purchase will have minimal negative effects. Although it will raise rates on long-term Treasury bonds, and thus the financing cost for the U.S. government, it will have limited negative consequences to private borrowers as corporate bonds have been less affected by QE.
One of the important findings by the two economists is that QE largely works through narrow channels that affect the price of the purchased assets with limited spillover on other assets.
“It does not, as the Fed proposes, work through broad channels such as affecting the term premium on all long-term bonds,” the economists write, returning to one of the controversial themes that characterized some of their earlier work.
The second step in the Fed’s exit should be the sale of its higher-coupon, older MPS as this will have minimal effect on primary market mortgage rates.
“The last step in this sequence is that the Fed should cease its purchases of current coupon MBS as this too is currently the most beneficial source of economic stimulus,” they wrote.
In order to grasp the impact of the Fed’s purchases of MBS, the authors find that a new channel, the so-called scarcity channel, provides the best explanation.
The Fed’s purchases of a substantial amount of newly-issued MBS has led to a scarcity premium on the current coupon MBS, driving spreads relative to Treasury yields below zero.
This generates incentives for banks to originate more loans and relieve the shortage of current coupon MBS, lowering secondary market MBS rates with beneficial economic effects.
Since current MBS prices depend on the expectations of Fed purchases, news that the Fed is likely to stop purchases will lead to an immediate rise in yields, regardless of what the Fed does with its portfolio.
“Sales of higher coupon, older MBS from the Fed’s portfolio will have minimal negative spillover effects,” as these securities do not have the same scarcity as new, current coupon MBS.
Over time, as the Fed tapers purchases of MBS, the scarcity premium will gradually diminish and after the Fed ceases the purchases, this premium will fully disappear as new loans are originated, they wrote.