The Minneapolis Fed Chief Narayana Kocherlakota became the latest to weigh in on new purchases of government bonds by the Fed, highlighting the differences that exist within the central bank. See text.
Popularly known in academic and financial circles as quantitative easing (QE) – buying government securities over and above what’s needed to keep rates at or near zero, and thus, create excess reserves (cash over and above what banks need to keep on hand for unforeseen emergencies) - Kocherlakota gave his views on the much-debated subject and suggested new measures of quantitative easing may have only a “muted effect.”
The newly appointed Fed president began his speech with an overview of how the Federal Reserve is structured and quickly moved into the nuts and bolts of monetary policy.
He discussed the sluggish recovery and the uncomfortably low rate of inflation but said that the “Minneapolis forecasting model predicts that it (inflation) will rise back into the more desirable 1.5-2 percent range in 2011.”
An often stated reason for a new round of QE can be summed up in the fears expressed by St. Louis Fed President James Bullard, who said that new purchases of bonds are needed to prevent deflation from setting in, thus preventing a Japan-like outcome.
Ben Bernanke has also weighed in on the debate but has only discussed the tools the Fed still has available at its disposal.
However, just broaching the subject has brought on speculation that it is only a matter of time before new purchases begin, as the Fed normally telegraphs changes in policy in advance.
The Minneapolis Fed chief went on to say that the “FOMC is also maintaining a portfolio of roughly $2.3 trillion. Over 2 trillion of those dollars are invested in Treasury securities or government-backed securities issued by Fannie Mae, Freddie Mac, and other government-sponsored enterprises.”
He noted that this has created “nearly $1 trillion of excess reserves.” See chart below.
(click to enlarge)
In normal times, inflation would ensue, but these are not normal times. He acknowledged that the excess reserves “create a potential for high inflation at some point in the future if the FOMC does not react sufficiently fast when it starts to see inflationary pressures.
“But I do not see this risk as being heightened in any meaningful way by banks holding even more excess reserves than what they are holding today,” Kocherlakota added.
He went on to say that based on academic research the Fed’s massive purchases that began at the height of the recession has “reduced the term premium on 10-year Treasury bonds relative to 2-year Treasury bonds by about 40-80 basis points (on an annualized basis).
“(The term premium is a measure of the difference in yields that is not explained by the expected path of short-term interest rates.) This fall in term premia led to a slightly smaller fall in the term premia of corporate bonds.”
He concludes that further QE would have a more limited impact this time around.
Summary
Kocherlakota is probably right. There is nearly $1 trillion sitting at the Fed earning 0.25% that could be lent to consumers and businesses. Adding even more reserves into the system would do little to encourage lending, as the effect on rates would probably be small.
Note that falling yields may have already priced in a new round of QE.
Unfortunately, consumers are more interested in saving than spending, fiscal policy is being held hostage to the federal deficit, which leaves only monetary policy to do the heavy lifting.
And since we are at or near a liquidity trap – a theoretical term used by Keynes to describe a period when monetary policy becomes ineffective because it can no longer influence interest rates, the economy may have to heal on its own.
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