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According to a story in Wednesday’s
Wall Street Journal, the US Federal Reserve is
considering buying long-term Treasury and mortgage bonds in return for
deposits held at the Fed. There has been no comment from the Fed and the
story might have been no more than a trial balloon, in which case Bernanke
and Co may be considering skewing the yield curve so that long-term bonds are
less attractive than the time-preferences set by the market.
The deal the Fed appears to be
thinking of is a reverse-repurchase agreement (a reverse repo), whereby it
buys long-maturity bonds financed by credit drawn from the commercial banks.
The important monetary distinction is that unused bank credit funds the deal,
not hard cash. The Fed can always set the terms so that it is an attractive
proposition for its counterparties. This being the case, upward pressure on
short-term rates will be minimal while the Fed can manage long-term rates
lower. And by buying bonds with long maturities, asset prices generally
benefit which is why stocks rose on the story.
More intriguing are the reasons
why this option might be being explored. The answer is probably found in the
rising yields of longer maturities, illustrated by the US 30 year Treasury
yield shown below:
 
While the Fed has been able to anchor short-term rates, long-term rates have
started to rise. This is perfectly normal and ordinarily nothing too much to
worry about when the economy shows early signs of improvement. Importantly,
it suggests we are moving into a more inflationary environment which rules
out raw quantitative easing as a policy option, because printing money would
now quickly undermine the dollar. Therefore, it is in the Fed’s
interest to seek a disguised form of quantitative easing that expands bank
credit and not raw money.
There are two underlying motives
that come to mind other than just bolstering asset prices. Firstly, on
balance central bankers are still worried about a possible deflationary
collapse, and while there may be early signs of economic recovery, commercial
banks remain risk-averse when it comes to lending. Also low mortgage rates
are seen as vital to the housing market, which is still mired in its own
debt-deflation: this is why the Fed might want to buy mortgage debt as well
as Treasuries. Secondly, there is the cost of government borrowing, and any
rise in interest rates wrecks budget deficit assumptions. These are already
alarming enough. Furthermore, US Treasury debt maturities are skewed heavily
and dangerously towards the short-term: hence the importance of keeping
long-term bond yields low, so that the Treasury can issue longer-dated bonds.
To summarise,
the Fed is still trying to avoid deflation and it needs to assist the
Treasury by buying long-term debt at artificially low bond yields. Growing
public concerns about the inflationary effects of quantitative easing calls
for a different approach, perhaps using reverse-repos funded by an expansion
of bank credit.
While this might satisfy some,
all that happens is that the engine of monetary inflation becomes expanding
bank credit, rather than quantitative easing: the long-term effects on prices
are exactly the same
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