Wednesday, January 28, 2009

The Fed Will Buy All Treasury Bonds in Existence if Necessary

The Federal Reserve and Treasury have taken unprecedented action over the past year. A record low in the federal funds rate, the purchase of large amounts of securities, the bailing out of countless financial institutions and other activity ad nauseam. It might seem like many are making things up as they go along, and in some respects I believe that they are. Ben Bernanke, however, knows exactly what he is doing. How do I know this? Because he told us everything he has been doing and what he will do going forward back in 2002.

Want to know what Bernanke and the Fed will do next? Continue reading.

Today the Financial Open Market Committee made another of their regular announcements. To read the full announcement, click here.

After you are done reading that, please read a very important speech that Ben Bernanke gave back in 2002. The speech, titled Deflation: Making Sure "It" Doesn’t Happen Here is now very famous. Why? Because it tells you the exact playbook that the Fed and Treasury have been using for the past year. Below I have excerpted the most important sections from that speech. If you read the following you will know exactly what the forthcoming Fed and Treasury actions will be. I kid you not. Ignore at your own peril...

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero?

This is precisely where we stand today. From today’s announcement “The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent.”.

Do you think the following might be a bit relevant? Keep reading!

One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.

This is exactly what the Fed is attempting to do at the moment.

There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates.

The Fed has stated as such already. From today’s announcement: “The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).

This has not been done yet. Is this the next step?

The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.

From today’s Fed announcement: “The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.” The Fed has not made mention of an interest rate ceiling or unlimited purchases yet. Make no mistake about it, this is the next step.

If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

The Fed has already purchased agency debt. From today’s announcement: “The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets…”

Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable.

The Fed believes that it can control the prices of treasury bonds across all maturities. Note that this speech was given in 2002 and that government debt to GDP has increased tremendously since that time and will continue to increase into the foreseeable future.

At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding. For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt.

So there you have it. The Fed absolutely believes that it can keep Treasury bond rates down all across the yield curve. They will do this by enforcing a ceiling on yields. They believe that they can do this by buying only a small portion of outstanding bonds but if that does not work they are not sunk. Bernanke said “At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills.” Therefore, the Fed plans to buy as many bonds as necessary to enforce their policy. If the market does not respond with a small number of purchases, they will just keep on buying until they are the only buyer left. We are talking about the purchase of trillions upon trillions of securities.

What would these actions do from an economic perspective? I think I will leave that for another article so for now draw you can draw your own conclusions and if you would like share your thoughts please visit the comment section.