“The Fed currently owns some $413 billion in Treasurys.”
The Federal Reserve should stop dropping hints that it could buy longer-maturity Treasurys to help the economy, said former St. Louis Federal Reserve President William Poole, adding that buying long-end Treasurys to anchor rates would be a serious mistake.
Poole, who retired from the central bank last spring after serving for 10 years, said instead, the Fed should let the expansion in money work its way through the economy. While that will take some time to kick in, it will eventually aid the recovery.
Poole said the costs of potential Treasury-buying aimed at anchoring interest rates far surpass the benefits, and exiting such a strategy would be a messy affair for the government bond market. Already, speculation over what the Fed might do has led to volatile trade.
Treasury yields shot lower in December after the Fed first said it was considering the benefits of Treasury-buying. The 10-year yield, which moves inversely to price, dropped by about 25 basis points after the Fed’s hints. The Fed’s failure to shed more light on possible buying Wednesday led to a 13-basis-point rise in the 10-year yield.
“The Fed has completely and unnecessarily whipsawed the market by putting this idea out there,” said Poole in an interview with Dow Jones Newswires on Thursday. “The Fed ought to abandon these hints that it might intervene directly in the Treasurys market for the purpose of setting a particular Treasury rate or price.”
That, however, wouldn’t preclude the Fed from continued buying of Treasurys to adjust the makeup of its open market portfolio, Poole said. The Fed currently owns some $413 billion in Treasurys.
Poole was a voting member of the Federal Open Market Committee in 2007. He is now a senior fellow at the Cato Institute in Washington.
Treasury-buying has been floated as another possible step to help the economy, because lower Treasury rates would in theory help to keep borrowing rates in the real economy down as those yields are tied to long-end government debt yields. The connection between Treasury yields and consumer borrowing rates has broken, though – mortgage and other key rates are still high despite historic low Treasury yields.
Poole said that the Fed buying Treasurys to pin rates would be unwise as it puts the central bank in the position of financing the federal deficit by printing money. The Fed also has limited power in controlling long-end rates as it has just about a 10% share of the outstanding stock of Treasury bonds held by the public, he said. To keep yields low, the central bank would have to add to its already bloated balance sheet.
“The Fed would be making a terrible mistake to make any kind of pledge to peg the long Treasury yields,” Poole said.
An exit strategy in a Treasury rate pegging program would also prove to be sticky, Poole said, pointing to problems during World War II when the Fed pledged to keep long-end Treasurys rates at 2.50%.
After the start of the Korean War in 1950, with rates anchored, the Fed’s portfolio was expanding rapidly and inflation pressures were mounting. To cut off possibly painful inflation, the government passed the Treasury-Fed Accord, eliminating the Fed’s obligation to monetize the debt of the Treasury at a fixed rate.
Exiting a similar strategy today would also prove to be problematic, Poole said. Once the economy begins to improve, Treasury rates will have to rise, meaning pegging would have to end. Timing that pullback would be hard, he said – backing off too soon could maim Treasurys, but waiting too long could spark a monetary explosion.
This isn’t the first time government bond rates have been battered around by references to possible Treasury buying. In 2003, Fed officials mentioned Treasury-buying as an option for a central bank dealing with interest rates near zero. At the June 2003 Fed meeting, policymakers failed to deliver on any unconventional policy moves, however. The 10-year yield was a bit over 3% then, and by early August had shot up to nearly 4.50%.
“I think we’re going through a repeat of that experience right now,” Poole said.
Poole said that for a recovery, the massive expansion of the Fed’s balance sheet is key, as it will eventually kick in and help revive the economy. Expanding the supply of money by adding to bank reserves should help more than the Fed’s various credit programs, he said.
One measure of money supply – M1, which includes cash in circulation, checking deposits and travelers’ checks – is currently running at a growth rate of approximately 35% annually, Poole said. Other measures, including a measure developed by the St. Louis Fed, are growing at an annual rate of 15% to 20%.
Conventional wisdom says there’s a six- to nine-month lag between money growth and the effects on employment and output, Poole said, meaning March to June would be the period when a difference could be noted after the dramatic increase in money growth since mid-September.
Given the extreme strains on the economy, though, the lag could last longer this time, Poole said, possibly nine to 12 months.
“There’s an enormous amount of money being created right now,” said Poole. “Bank reserves have grown enormously, and money creation has a powerful effect on the economy in due time.”
As for the inflationary impact of such money growth, that is not an immediate risk, Poole said, but will become one once the economy begins to recover. He doesn’t expect a return, though, to the 1970s double-digit inflation levels, but said “we could get halfway there.”
Deborah Lynn Blumberg
January 30, 2009, 11:33 am
Source: The Wall Street Journal