28 November 2020

Fed Turns Attention to Asset Purchases After Spelling Out Low-Rate Pledges

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Federal Reserve officials at their meeting in September reinforced Chairman Jerome Powell’s statement that they weren’t even “thinking about thinking about raising interest rates.”

By contrast, they offered little to guide expectations around their monthly purchases of $120 billion in Treasury and mortgage securities.

Officials aren’t preparing to announce any changes after their two-day policy meeting ends Thursday but could begin reviewing contingency plans for possible refinements, according to interviews and recent public statements.

Recent surveys show a range of opinions about how long investors and economists expect the Fed to continue to buy assets at the current pace.

More than half of large investment firms surveyed by the New York Fed in September expected the central bank to continue the current pace of bond buying into the first half of 2022. A separate survey of the banks that serve as the Fed’s counterparties on Wall Street shows those firms think the purchases could slow next year.

Fed officials are unlikely to trim those purchases so long as the coronavirus pandemic is menacing the U.S. economy. This means they are likely to focus their discussions on how to provide more stimulus, if they decide it is needed, by shifting the composition of these purchases toward longer-dated Treasurys.

They took one step in this direction in September by clarifying that these purchases were being conducted to support the economic recovery, after being initiated in March to quell market dysfunction.

Fed policy in the past decade has been guided by the theory that holding long-term securities stimulates financial markets and the economy by holding down long-term interest rates. That is thought to drive investors into riskier assets like stocks and corporate bonds and encourage business investment and consumer spending. Holding short-term securities, this theory holds, provides little stimulus.

The idea was at the core of former Chairman Ben Bernanke’s strategy to move the Fed’s holdings heavily into long-term Treasury bonds after the 2008 financial crisis. Fed estimates suggest the strategy lowered long-term interest rates by a full percentage point, making it less costly for millions of homeowners, car buyers, corporations and governments to borrow.

Right now, the Fed is buying $80 billion in Treasurys a month and $40 billion in mortgage-backed securities, net of redemptions. This is larger than the $85 billion in monthly purchases during the Fed’s largest bond-buying program after the 2008 crisis—the third round of quantitative easing, or QE3, between 2012 and 2014.

One important difference between QE3 and the current operation centers on the duration of securities purchased. Right now, the Fed is buying equal amounts of short-, medium- and long-term debt, while QE3 focused on long-term securities.

The weighted average maturity of monthly Fed purchases since March has been just six years, compared with 12 years during QE3, according to TD Securities. “They could have been doing more while buying less,” said Seth Carpenter, chief U.S. economist at UBS and a former Fed economist.

Even if a composition shift provides a small economic boost that pre-empts a future rise in long-term yields, some economists say it would be worthwhile—particularly given threats to the economy from rising coronavirus cases, delays in new fiscal-relief measures and Fed projections in September that show officials don’t expect to meet their inflation and employment goals for at least three more years.

“I don’t know if you can be confident that rates will stay low,” said Mr. Carpenter. “The Treasury is continuing to issue lots of debt, and they have extended the duration of what they are issuing,” creating the potential for greater supply-demand imbalances of long-term debt.

Fed officials have said there is less reason to focus on the long end on the Treasury yield curve because with 10-year Treasury yields hovering at or below 0.8% since June, there is little to be gained by driving down already-historically-low yields.

By contrast, the 10-year rate reached 3.7% in 2011, before the Fed began discussing whether to shift the composition of its Treasury holdings. Rates on the 30-year mortgage fell from 5% to 3.5% over the next two years as the Fed embarked on steps to push down long-term yields.

“I don’t think very much decision-making of households or firms are going to be determined on whether the 10-year Treasury is 0.66% or 0.5%,” said Boston Fed President Eric Rosengren in a Sept. 23 interview.

Federal Reserve Chairman Jerome Powell announced in late August a major shift in how the central bank sets interest rates. WSJ’s Greg Ip explains the strategy behind the changes and what they mean for consumers. Photo: Erin Scott/Bloomberg

Some officials and analysts said low yields give the Fed the luxury of waiting longer to shift the composition of their purchases, for example until yields start rising because the economy is stronger. “Current yields are not disrupting the recovery,” said James Sweeney, chief economist at Credit Suisse.

Others are reluctant to make further changes, absent a rise in long-term rates, because they don’t think the benefits outweigh potential costs. “My concern about asset purchases is they can distort markets,” said Dallas Fed President Robert Kaplan in an Oct. 2 interview.

Most Fed officials also have said what the economy most needs now is additional federal spending to improve public-health measures and to replace incomes lost due to depressed spending in leisure, hospitality and other high-contact service industries.

“The lack of fiscal policy is a much bigger problem than what we’re doing with our balance sheet,” said Mr. Rosengren.

The risks of a subpar economic rebound in the months ahead—together with political wrangling over further relief measures—leave the Fed in an uncomfortable spot. The danger is that any further slowdown lays bare the weakness in the Fed’s remaining tools.

Write to Nick Timiraos at nick.timiraos@wsj.com.

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