We saw the Fed liquefy the world in ’09 including non-member foreign banks over which they have little influence or authority. And now we have learned that they secretly loaned huge amounts to the primary dealers in the aftermath of the financial crisis. Then we saw them intervene again with the late August, 2010 announcement and subsequent June, 2011 completion of QE2. During the latter intervention, the Fed essentially monetized much of the U.S. budget deficit.
Given the fact that the presidential election cycle has already begun, we strongly suspect that the weakening economy and upward pressure on interest rates due to oversupply will cause further Fed intervention, even if it isn’t called QE3. Bernanke said as much today before Congress.
Earlier, at his post-Federal Open Market Committee (FOMC) press briefing, Bernanke indicated that if job growth falls below 80,000 per month, the Fed would likely intervene again. (Job growth has now been below 80,000 for two consecutive months!) So, “when” it comes (not “if”), what sort of intervention can we expect?
A look back at then Fed Governor Bernanke’s November 21, 2002 talk before the National Economists Club of Washington, D.C. entitled ‘Deflation: Making Sure ‘It’ Doesn’t Happen Here,’ gives us some clues. In that talk, he ostensibly outlined all of the tools available to the Fed if the overnight (Fed Funds) rate hit zero. After all, at the time of the speech, deflation wasn’t expected in the foreseeable future, so he would have no reason not to outline all the tools he could think of. I have outlined them below:
- #1: Expand the scale of asset purchases;
- #2: Expand the menu of assets the Fed buys.
Both QE1 and QE2 used these tools. In QE1, the Fed purchased non-traditional assets for its portfolio, including mortgage backed securities (MBS) and derivatives. In both QE1 and QE2, the “scale” of asset purchases was dramatically increased.
- #3: A commitment to holding the overnight rate at zero for some specified period.
This tool is currently in practice with the Fed’s “extended period” language in the Federal Open Market Committee (FOMC) minutes.
- #4: Announcement of explicit ceilings on longer-maturity Treasury debt.
This isn’t new. The Fed did this in the 1940s and a version of it again in the 1960s. During a period of approximately 10 years ending with the Federal Reserve-Treasury Accord of 1951, the Fed “pegged” the long-term Treasury bond yield at 2.5%. And, during the Kennedy Administration, the Fed sold T-bills and purchased an equal amount of longer dated T-Notes in order to reduce long-term rates. Bernanke believes that the announced policy of pegging will cause arbitrageurs to keep yields near the announced peg, especially if the Fed intervenes several times to prove its commitment.M
