April 2009
A U.S. economic update: Perspectives on the Federal Reserve's Treasury securities purchasing policy
We believe that the Fed’s policy of purchasing a preannounced amount of Treasury securities in a short period of time is an attempt to front-load this new source of monetary ease into the coming months to fight the recession. By buying large amounts of both Treasury securities and mortgage-backed and Agency securities, it is trying to drive down mortgage rates immediately both by holding down Treasury yields and by narrowing the spread of mortgage yields above Treasury yields. We believe that the short run objective is to prevent house prices from overshooting fair value on the downside. Lower mortgage rates should help stimulate the volume of mortgages issued for refinancing and for the purchase of new and existing homes. It should help the transition later this year from the recent sharp decline in house prices to a phase of increased transactions at depressed prices, in keeping with the L-shaped pattern we expect in house prices. Mortgage rates have dropped below 5 per cent, affordability for conventionally-financed homes has improved substantially and there is already increasing evidence of rising transaction volume in response to substantially lower house prices.
It is controversial whether Federal Reserve policy is too easy or even too tight. The answer is crucial to key investment decisions. The Taylor Rule provides a framework for judging monetary policy. We are not going to detail the complexities of the Taylor Rule, but the basic ideas are simple. First, monetary policy should be easy if inflation is too low and should be tight if inflation is too high. Second, monetary policy should be easy if there is a great deal of excess capacity in the goods and labor market and tight if current output is already near the maximum output possible. Some economists have attempted to judge what the appropriate 2010 Federal funds rate should be based on reasonable estimates of inflation and the output gap. Some of these estimates have been close to minus 7 per cent. It is not practical to get the Federal funds rate below zero, so that implies that a zero Federal funds rate would at that time be about 700 basis points too tight. It is likely that the Fed staff have done similar calculations, especially since one of these studies was done by Laurence Meyer of Macroeconomic Advisers, who is a former Federal Reserve Governor.
We believe that this analysis strengthens the case that the Fed has had sound reasons for its decision to generate rapid growth of the money supply and its balance sheet. Not everyone agrees. Some argue that the Fed is creating a major inflation risk for the future. One version of this view is that current policy is too easy for current conditions and will quickly generate inflation. We believe this view is incorrect, given the large excess supply of goods and labor worldwide. Another version of this view is that current policy may be appropriate for now, but that you cannot count on the Fed to tighten quickly enough in the future when it becomes appropriate. This is a legitimate concern, but in our view, it is very much premature.
There are implications for the dollar from this debate about how easy Fed policy is and how inflation-prone the economy is. If Fed policy proves to be merely anti-deflationary in a deflation-prone context, current Fed policy need not create major weakness in the dollar. Serious dollar weakness would be much more likely to occur if U.S. inflation is destined to soar over the next several years. We do not think that that outlook will prove correct. Given his inflation-targeting mindset, Chairman Bernanke is trying to prevent the global and U.S. recession from generating any sustained consumer price deflation or permanently locking in deflationary expectations. We believe that cyclical forces remain deflationary and that the Fed has a cyclically appropriate policy.
March 30, 2009
By Richard B. Hoey, chief economist, The Bank of New York Mellon Corporation
Printed with permission
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