According to James Hamilton,
the difference between what the Fed has been doing in 2009 and true quantitative easing is that under the latter strategy, the Fed would be funding the MBS purchases with zero-interest money, with the intent of the operations indeed being to get that cash into circulation rather than trying to construct a device to persuade banks to hoard it.
The problem with the Fed’s preferred tactic– borrowing short and lending long– is the same as that facing anyone else who plays that game: are you sure you’re going to be able to continue to roll over the short term debt (i.e., persuade banks to keep holding a trillion in excess reserves) or liquidate your long position (i.e., sell a trillion in MBS back to the market without loss) when the playing field changes?
But at the moment, borrowing short and lending long proved to be a very profitable trade for 2009.
The Fed is now the world’s biggest carry trader. In Hamilton’s view, the Fed’s huge injection of bank reserves, on which it pays interest, amounts to borrowing from those banks at the short-term rate. It then lends long term in the mortgage securities market.
This is what the Savings and Loans did back in the good old days. They borrowed money short term at 3 percent and made mortgage loans at 6 percent. It worked really well until the mid-1970’s, when interest rates moved up. Those 6 percent mortgages don’t look so sweet when short-term money costs 10 percent.
Long-term mortgage rates are now lower than they were in the heyday of the S&Ls. Taxpayers bore some of the cost of the S&L blowup. We stand to bear all of the interest-rate risk that the Fed is taking.
Have a nice day.
READER COMMENTS
E. Barandiaran
Jan 17 2010 at 4:39pm
Arnold,
Look at these transactions from the viewpoint of the Fed’s balance sheet. On the asset side, anything that the Fed buys (from apples and gold to mortgages) indeed has an effect on its price. On the liability side, the Fed can finance its purchases by issuing currency or issuing bonds or borrowing from banks or someone else. The question is which of these liabilities are “perfect” substitutes of currency. The concept of monetary base assumes that currency and bank reserves with the Fed are “perfect” substitutes. Any reserves that pay interest are not “perfect” substitues of currency and any reserves that banks cannot use freely are not “perfect” substitutes of currency. So JH, GM and anyone else that analyze the supply of “money” using the monetary base and the multiplier are wrong. The inflationary impact of these special reservers that are NOT “perfect” substitutes of currency is quite different from what one may conclude from applying the quantity theory of money or any concept of nominal shock.
Doc Merlin
Jan 17 2010 at 6:08pm
The fed can raise or lower interest rates at will, so I don’t really understand your point. Could you clarify it please?
ThomasL
Jan 19 2010 at 2:32pm
Traditionally the Fed has purchased assets which are of a liquid type. The most obvious examples are Treasuries, which made up the bulk of its sheet, and gold.
Its new actions of buying agency debt (eg, Fannie Mae) and MBSs which were illiquid even at the time they were purchased (which opens a line of question on their purchase price as well) is new.
Why it is doing this must have a political, not a monetary, component. There is no monetary policy reason the Fed would rather have X units of MBSs when it might have had Y units of Treasuries or Z ounces of gold. It is a basic principal of commodity money that one always wants to hold the commodity that everyone else wants to hold. Conversely, one does not want to hold the commodity that no one else wants to hold. Looking at those MBSs, agency debt, etc. as something like commodities behind the Fed notes, it is bizarre in the extreme to choose assets which no one else wants, and consequently cannot be easily disposed of and have very uncertain value. No central banker would do such a thing except for political reasons.
Comments are closed.