Did Bernanke Get It Right

Richard (Rick) Mills

Ahead of the Herd

Page 1 of 4

As a general rule, the most successful man in life is the man who has the best information

The Federal Reserve thinks recent economic news from the U.S. is good:

• Jobs are being created 
• Consumers are spending money
• Trade & manufacturing growth is strong

So on Dec. 18th 2013, they announced a decelerating QE III environment.

“In light of the cumulative progress toward maximum employment and the improvement in the outlook for labour market conditions, the committee decided to modestly reduce the pace of its asset purchases.” outgoing chairman of the Federal Reserve, Ben Bernanke

If job gains continue and inflation increases, “I imagine we’ll continue to do, probably at each meeting, a measured reduction in buying.” Fed Chairman Ben S. Bernanke

Current Federal Reserve Chairman Ben Bernanke will be replaced, early in the new year, by Janet Yellen who is said to have endorsed the tapering decision.

The Fed reiterated that it plans to hold its key short-term rate at a record low, “well past the time that the unemployment rate declines below 6.5 per cent” and the inflation outlook remains mild. The Fed has held the fed-funds target rate between zero and .25% since 2008.

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.” Federal Reserve

Background Leading to Quantitative Easing

Overheated US housing prices started dropping in 2006. Homeowners were going underwater (they owed more than the house was worth) and many had questionable credit – “fog the mirror loans” were common, if you breathed you got a loan. Banks sold these mortgages to agencies like Fannie Mae and Freddie Mac. They bundled the mortgages with other loans bearing similar interest rates and then sold them as Mortgage-backed securities (MBS), so called because their value was backed or secured by the value of the underlying mortgages.

An MBS is therefore a derivative because its value is derived from the underlying asset – the mortgage that was often underwater and held by someone with bad credit.

The Federal Reserve started easing monetary policy aggressively throughout 2008. By December of 2008, the federal funds rate was between 0 and 1/4 percent. Additional stimulus was injected by expanding the holdings of longer term securities. The System Open Market Account (SOMA) purchased mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae (agency MBS).

Broad Based Programs

“On numerous occasions in 2008 and 2009, the Federal Reserve Board invoked emergency authority under the Federal Reserve Act of 1913 to authorize new broad-based programs and financial assistance to individual institutions to stabilize financial markets. Loans outstanding for the emergency programs peaked at more than $1 trillion in late 2008.” Government Accountability Office (GAO)

The Term Auction Facility was $40 billion in loans to rescue the banks. It wasn’t near enough, the Treasury department got authorization to spend $150 billion more to subsidize and eventually take over Fannie Mae and Freddie Mac, they also bailed out AIG.

Dollar Swap Lines exchanged dollars with foreign central banks for foreign currency to help address disruptions in dollar funding markets abroad.

The Term Securities Lending Facility auctioned loans of U.S. Treasury securities to primary dealers against eligible collateral.

The Primary Dealer Credit Facility provided overnight cash loans to primary dealers against eligible collateral.

The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility provided loans to depository institutions and their affiliates to finance purchases of eligible asset-backed commercial paper from money market mutual funds.

TheCommercial Paper Funding Facility provided loans to a special purpose vehicle to finance purchases of new issues of asset-backed commercial paper and unsecured commercial paper from eligible issuers.

The Term Asset-Backed Securities Loan Facility supported the issuance of asset-backed securities (ABS) collateralized by loans related to autos, credit cards, education, and small businesses. In March 2009, the Fed announced that it was expanding the scope of the TALF program to allow loans against additional types of collateral.

Late in 2008 there was a run on ultra safe money market accounts – according to AMG Data Services a record $140 billion was pulled out in one day.

The Troubled Asset Recovery Program was proposed and $350 billion was approved by Congress – the money was used to buy bank and automotive stocks.

The initial Fed response to the subprime mortgage crisis was to lower interest rates, then, having no traditional tools left in its toolbox the Fed introduced a new policy – quantitative easing (QE).

Quantitative Easing

In September of 2008 the $1.7 trillion QE1 was started. The Fed purchased mostly mortgage backed securities and established a commercial paper lending facility.

In October of 2010 QE2 started. At $600 billion, QE2 was much smaller then QE1 and its buying was mostly confined to purchasing long term government bonds.

Operation Twist

In September 2011, the Fed launched Operation Twist. Operation Twist is the Fed’s initiative of buying longer-term Treasuries while simultaneously selling shorter-dated issues in order to bring down long-term interest rates.

By purchasing longer-term bonds, the Fed drives up prices which forces yields down – price and yield move in opposite directions. Selling shorter-term bonds causes their yields to go up because their prices fall. These two actions “twist” the shape of the yield curve, hence the name Operation Twist.

On September 13, 2012, the Fed announced QE3. It agreed to buy $40 billion in MBS, and continue Operation Twist, adding a total $85 billion of liquidity a month. Key components are:

• The creation of $40 billion a month to buy MBS’s
• The continuation of Operation Twist #2
• An open-ended commitment to keep purchasing securities at whatever level is judged necessary until the labor market improves “substantially”
• An extension of the 0.0% to 0.25% target range for the Fed Funds rate until at least mid 2015

On December 18th the Fed announced a QE3 tapering of $10b a month, the first cutback in bond purchases was to be split evenly between the purchases of MBS’s and Operation Twist.