When the Federal Open Market Committee (FOMC) meeting ends later today, we’ll find out
if the Federal Reserve will taperits large-scale asset purchase (LSAP) program, which includes the monthly purchases of $US45 billion worth of Treasury bonds and $US40 billion worth of mortgage backed securities (MBS).
This LSAP, also known as quantitative easing (QE) has been intended to lower interest rates to stimulate the economy.
Generally speaking, market economists expect the taper to reduce purchases by $US5 to $US10 billion dollars, split between the Treasury securities and MBS.
But some economists argue that the tapering should and will be focused on the Treasury securities.
This expectation is largely inspired by a paper presented at the Kansas City Fed’s Economic Policy Symposium in Jackson Hole last month.
Arvind Krishnamurthy and Annette Vissing-Jorgensen’s paper “The Ins and Outs of LSAPs,” was hyped up by the Goldman Sachs economics team even before it was even presented. (NYT economics reporter Binyamin Appelbaum’s got the easy-to-read rundown of the paper and the previous work of the authors.)
In brief: the paper argues that “MBS purchases have been more effective than Treasury purchases in lowering mortgage rates and, thus, supporting the economy,” according to Goldman Sachs’ summary. And the prescription for tapering would be to wind down Treasury purchases first, then follow that with MBS reductions.
From this analysis of the mechanics of LSAPs, we conclude that an exit should proceed in the following sequence: The Fed should first cease its purchases of Treasury bonds and then sell down its Treasury portfolio. Second, the Fed should sell its higher-coupon MBS as this will have small effects on primary market mortgage rates. The last step in this sequence is that the Fed should cease its purchases of current-coupon MBS as this tool is currently the most beneficial source of economic stimulus.
This recommendation seems particularly relevant considering the recent wave of soft housing data in the wake of rising mortgage rates.
And Wall Street’s economists have been mindful of all of this in their FOMC research notes:
“Many on the committee believe MBS purchases are more beneficial than Treasury purchases, and a paper delivered at the 2013 Economic Symposium at Jackson Hole, WY, also reflects this view.”
— Michael Gapen, Barclays
“As follow-on to a paper presented by Professor Arvind Krishnamurthy at the Federal Reserve Bank of Kansas City’s Jackson Hole Conference, several findings are helpful for decision makers and investors…Since the impact on the MBS (and housing) market appears to be significant relative to the Treasury market, if the Fed pursues a more cautious tapering program, the purchase of Treasury debt is likely to be the focus of the early phase of tapering…”
— John Silvia, Wells Fargo
“…In addition to the shifting views on MBS sales, and asset sales more broadly, recent research has raised further questions about the assumed sequence. A recent study by Arvind Krishnamurthy and Annette Vissing-Jorgensen presented at the 2013 Jackson Hole Symposium suggested the most optimal sequence..”
— Aneta Markowska, SocGen
“Fed officials had previously noted that their announced plan for normalizing policy is under review. A presentation at Jackson Hole by Professor Krishnamurthy of the Kellogg School of Management suggests that the Fed may be in the process of rethinking its exit plans. Krishnamurthy argues that the optimal exit sequence would be: 1) cease Treasury buying; 2) sell Treasury debt; 3) sell older MBS; and then, finally 4) cease new MBS purchases. Professor Krishnamurthy’s previous work (with Professor Vissing-Jorgensen of UC Berkeley) has been cited as having had some influence on Fed policy in the past and, as such, his argument that MBS buying has a greater effect on the economy may resonate within the FOMC. This is particularly true if the recent weakness in new home sales reflects the impact of higher rates.”
— Drew Matus, UBS (Aug. 26, 2013)
But ultimately, there’s no guarantee what the Fed might do and what it might thing.
“It must be noted that the Fed’s views on asset sales — and purchases for that matter — are still evolving,” said SocGen’s Markowska.