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.  

Taper talk and inflation expectations

Any student of economics knows from his or her money and banking course that there are two different effects that occur when you inject money into the economy.  The first is called the "liquidity effect" and it operates when the money supply is increased.  It operates in the short run when prices are sticky, so that no price adjustments take place.  Using the diagram below, you would just increase the supply of money, hence shifting the vertical M curve to the right in the diagram below.  That lowers interest rates.  Of course that should lower interest rates in normal circumstances, unless you hit extremely low interest rates in which case you could find yourself on the flat portion of the L or money demand curve.  In this case, as Keynes pointed out, you find yourself in a so-called "liquidity trap".  In a liquidity trap, increasing money supply will not lower interest rates further, so will not stimulate the economy. We used to teach this as an academic curiosity until it occurred in Japan ( - a zero bound on interest rates), but now most monetary economists realize that it is not just a curiosity - it can happen, and it did, even in the US!!

That is the reason why we have QE, or quantitative easing.  It is a way of stimulating the economy without relying on pushing official interest rates lower. In the longer run though, prices are flexible, and they adjust to changes in the money supply, according to the quantity theory of money.  The mechanism whereby this transition happens though is related to the so-called Fisher effect.  The Fischer effect basically says that higher inflation rates should be reflected one for one in higher nominal interest rates. So as inflation begins to rise after a monetary injection, at some point we should see interest rates rising. Obviously though the Fisher effect only works if you have a response in inflation.  At the moment, as the chart below shows, we really don't see too much response in inflation during 2013 ( - this includes the data release for August, released today, September 17th).

The key thing though is that it is really not actual inflation that matters as interest rates are a forward looking variable.  The interest rate is how much you charge or are charged for lending or borrowing from now into the future.  So it is really inflation expectations that are important here, as they are the equivalent forward looking variable, rather than the current level of inflation.

Luckily the Federal Reserve Bank of Cleveland has come up with some new methodology for teasing out inflation expectations from inflation swsps (a financial derivative in which investors swap a fixed payment for payments based on the CPI), which run the gamut from one to 30 years. The results of this academic work by Joseph G. Haubrich, George Pennacchi, and Peter Ritchken of the Cleveland Fed is updated every month on a special Cleveland Fed website which can be found here.

I have reproduced the current chart of Inflation expectations from the Cleveland Fed's methodology in the chart on the left.  What is striking is that if we use the ten year swaps we appear to be at a turning point in terms of expectations.  Inflation expectations now appear to be potentially moving up again. And that means that if 10 year bond rates are yielding just over 2.8%, that given that inflation expectations are roughly 2%, that the real interest rates, in other words the real gain lenders get from loaning their money out is around 0.8%.

The real interest rate is important in an economy because it signals the rewards from lending.  For very short term loans these are now negative - in other words it is not worth lending short term for most banks.  We can see this if we calculate the short term real interest rate - which is given as say a 2 year bond yield minus the expected inflation rate over a 2 year horizon.

Short term real rates are about -3%.  This means that the Fed has really pushed short term interest rates down to an incredibly low level - well we know this already from my previous blog which you can read here.

But in terms of policy implications, and what needs to happen this week at the Fed's monetary policy meeting, is that these short term lending rates need to rise to turn the real interest rate positive again.  That means that in fact the Fed should, if anything, extract much more short term credit from the market when it tapers than long term credit so as to allow short term nominal interest rates to run to more normal levels again and make it profitable to lend short term.  At the moment, in one sense, the Fed's critics are right - the Fed's monetary policy is distorting the yield curve, and the sooner the Fed extricates itself from this the better.