Monday, April 7, 2014

Why is the Fed ignoring a "differentiated taper"?

“I believe I am a sensible central banker and these are unusual times” - Janet Yellen, Testimony before Congress, February 11th, 2014.

In watching Janet Yellen's Testimony before Congress in February, and in reading Edward Luce's excellent commentary on the Fed in the FT (see here), it struck me that although Janet Yellen appears to be boxed in in terms of having an appropriate policy tool to get us out of the apparent slow growth US economy we now find ourselves in (see here for the latest Larry Summers opine about secular deflation), she is not.  And I'm not referring to "forward guidance" as the appropriate policy tool ( - a tool which I think has been ridiculous and based on flawed thinking).

As usual with these things, the answer is staring her right in the face.  Yes, the taper itself offers up the solution.  How?  Well in one of my previous blogs I outlined one exit strategy (see here) that I thought might be appropriate for the Fed to adopt. Although the Fed is currently reducing the purchases of both T Bills and mortgage backed securities (MBSs) at equal rates by $5bn each to $35bn of Treasuries and $30bn of MBSs (as most recently announced by the Fed on March 19th in the Fed's press release), this doesn't make too much sense to me in the current climate.

Why is this?  First, the Federal government Treasury interest rates really need to rise, and to be honest the Fed should be selling Treasuries right now, and certainly not buying anymore, given their recent (unwarranted) rally.

Second, the Federal government purchases were a way of stimulating the economy in two ways during the Federal government's economic stimulus a couple of years back - that is now not necessary as the stimulus is over and if anything the government deficit is rapidly shrinking. The chart below shows the US government budget deficit over the last decade, and we are now below the levels of deficits in terms of % of GDP that we experienced in the last major recessions, and more to the point, the trend line looks promising in terms of where we are going.

Third, with enough geopolitical risks in the rest of the world, I think it is safe to say that US Treasuries have enough demand support to weather a withdrawal of Fed support, so these purchases are really not optimal in terms of the objectives of monetary policy.

So I would argue that the Fed should heavily cut back on its purchases of US Treasuries while at the same time continuing to stimulate the housing market through purchases of MBSs.  I am calling this a "differentiated taper" as instead of just cutting purchases of both US Treasuries and MBSs, we can lower the overall amount of purchases while at the same time having a differential effect on the markets for each type of security.

Why is the concept of a "differentiated taper" important?  The reason why is that purchases of MBSs have an indirect impact on the housing market, as it lowers mortgage rates, thereby stimulating the construction of new housing.  Specifically, it should stimulate the employment of both blue and white collar workers in the construction industry, as more housing construction equals more hiring of architects, builders, contractors and subcontractors. What does purchases of government Treasury securities get us?  Lower borrowing rates for government, that's for sure, but not much else. Certainly there is no stimulus to the job market there right now as the government is cutting back on spending to move towards a balanced budget.

So if I were working at the Fed right now I would at the least be recommending a "differential taper" with an increase in purchases of MBSs of around $10bn, and a reduction in purchases of Treasuries by the Fed of around $20bn. This still balances out to a "taper" of $10bn, but it is differentiated, by stimulating the housing market, while allowing a longer term correction to the yield curve, a correction in my view that is now sorely needed.  

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