The Federal Reserve's decision to loosen monetary policy last week was mostly interpreted by the market as its admission that the economy wasn't doing as well as anticipated. But there are other reasons why the Fed might have decided to begin using cash from maturing securities to purchase more securities. Did it have more to do with economic factors shifting the money supply more than the central bank had anticipated?
Minneapolis Fed President Narayana Kocherlakota suggested this in a speech Tuesday (noted yesterday here). He says that the move was purely technical. According to Kocherlakota the mortgage-backed securities that the Fed holds are being paid down more quickly than the Fed anticipated, so it needed to take action to prevent its portfolio from liquidating too quickly:
This kind of fluctuation in prepayments is at the heart of the FOMC's new policy action in August. Long-term interest rates declined surprisingly fast in the past three months. But the fall in long-term rates meant that more people were prepaying their mortgages, and the Fed's MBS principal balances were falling. In this sense, the Fed's holdings of long-term assets were shrinking, leaving a larger share of the long-term risk in the economy in the hands of the private sector. This extra risk in private hands could force up the risk premia on long-term bonds and be a drag on the real economy. The FOMC decided to arrest the decline in its holdings of long-term assets by re-investing the principal payments from the MBSs into long-term Treasuries.
Certainly, ultra-low mortgage interest rates have caused more homeowners to refinance, thus accelerating prepayments. This would result in the MBS portfolio paying down more quickly than anticipated. Consequently, the money supply has been tightening faster than the Fed probably wanted. So it makes sense that the Fed would want to slow down the contracting money supply, which it could do by reinvesting the proceeds from those MBS.
So maybe it had nothing to do with the Fed viewing the economy getting worse? This seems a little doubtful for a few reasons.
First, the Fed must have expected some of its MBS portfolio to pay down, just not as quickly as it has. So its expectation wasn't for a static pool of assets, but for one that declined more slowly. Yet, it isn't reinvesting only some of the proceeds to better hit its expectation: it's reinvesting all of them. If this move was really just technically, then the Fed could target its expectation for slower prepayments -- not a new goal of net zero prepayments.
Second, if the Fed wasn't trying to further stimulate the economy, why didn't it make that clearer in its statement? It said:
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
The emphasis is mine. This language sure doesn't sound purely technical. Now maybe the Fed just screwed up here, and failed to accurately depict why it really took the action. But Fed watchers know that the committee takes great care in crafting its monetary policy statements -- because it knows how closely the market reads them. If this was purely technical, then why not make that clear and say something like:
Because our mortgage-backed securities portfolio is paying down more quickly than anticipated due to very low interest rates, the Committee will keep constant . . .
Instead, the Fed emphasized that the move was meant to help support the economic recovery. The committee probably believed that the market would be somewhat relieved that the Fed was providing additional monetary stimulus. Of course, that's not really what happened, but it sure looks like the central bankers meant for the market to interpret the move than more than just a technical fix to their continuing monetary policy.
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