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.