There has been much debate about the Federal Reserve's recent action to reinvest proceeds from its maturing securities in longer-term Treasuries. Its motivation was initially a little cloudy, though subsequent clarification has been provided by Chairman Bernanke. The August meeting minutes were released today, and they provide even more detail to what the committee was thinking.
Here's how the paragraph on the action starts, just after noting the weakness of the recovery:
Against this backdrop, the Committee discussed the implications for financial conditions and the economic outlook of continuing its policy of not reinvesting principal repayments received on MBS or maturing agency debt. The decline in mortgage rates since spring was generating increased mortgage refinancing activity that would accelerate repayments of principal on MBS held in the SOMA. Private investors would have to hold more longer-term securities as the Federal Reserve's holdings ran off, making longer-term interest rates somewhat higher than they would be otherwise. Most members thought that the resulting tightening of financial conditions would be inappropriate, given the economic outlook.
It's clear from this that there were two things going on here. First, the Fed's portfolio was shrinking more quickly than it anticipated. If the U.S. was in the midst of a strong recovery, then that might have been okay. But considering the that Committee believed the economic outlook had deteriorated (stated earlier in the minutes), a shrinking portfolio wasn't good. The committee wanted to keep long-term interest rates low until the recovery strengthens.
The minutes continue:
However, members noted that the magnitude of the tightening was uncertain, and a few thought that the economic effects of reinvesting principal from agency debt and MBS likely would be quite small. Most members judged, in light of current conditions in the MBS market and the Committee's desire to normalize the composition of the Federal Reserve's portfolio, that it would be better to reinvest in longer-term Treasury securities than in MBS. While reinvesting in Treasury securities was seen as preferable given current market conditions, reinvesting in MBS might become desirable if conditions were to change.
This is somewhat revealing, because it shows that reinvesting in MBS is probably the Fed's next move if it feels that the economy is deteriorating further. So we can look to that action as a sign that the Fed is very worried.
Moreover, some committee members rightly feared that the market would overreact to its new reinvestment action:
A few members worried that reinvesting principal from agency debt and MBS in Treasury securities could send an inappropriate signal to investors about the Committee's readiness to resume large-scale asset purchases.
Indeed, that appears to be precisely what it did. Some in the market wanted, and likely now expect, even more. Will Bernanke's recent comments, in conjunction with these minutes, soften that expectation? We'll have to wait to see the market's reaction to the September meeting to find out. Unless we see a major shock in economic indicators between now and then, like unemployment ticking up by several tenths of a percent in August, additional asset purchases don't appear to be very likely at that time.
Finally, not everyone agreed with the action:
Another member argued that reinvesting repayments of principal from agency debt and MBS, thereby postponing a reduction in the size of the Federal Reserve's balance sheet, was likely to complicate the eventual exit from the period of exceptionally accommodative monetary policy and could have adverse macroeconomic consequences in future years.
That member was almost certainly Kansas City Fed President Thomas Hoenig, who dissented with the decision. Of course, the vast majority won out.