Wednesday, April 22, 2009

Is the Fed going to buy more bonds next week?

In light of next week's scheduled meeting of the Fed, we thought we would look at the potential for further announced quantitative easing. Last month, the Fed rocked most major markets with the announcement of a major purchase of long rates to push down yields. Since then, many have dismissed the purchases as a one-time event that are not likely to repeat. However we have to question that thinking as it is very much in line with the pre-crisis mentality that quantitative easing is the equivalent of a nuclear bomb in a central bank's arsenal and the unpredictability of any resulting inflation would destroy all credibility that a central bank may have to price stability. 

There has been a lot of criticism of Big Ben (us included) but one thing that has come out is he is not afraid to take relatively risky moves to combat whatever he perceives as the biggest threat. As we have noted before, he has clearly revealed his playbook in the past and we see little indication that he will stray from it going forward. On the balance between inflation and deflation, much has been made of the Chinese response if we try to print our way out of this situation but the much larger problem has always been deflation. Combining what we know about the available policy options and the effectiveness of the last round of QE, we have to believe that more purchases of long rates are on the table as a serious consideration.

We are not saying that the Fed is deaf to the concerns of price stability; indeed, the specific concern is addressed in last month's minutes.

Also, some participants were concerned that Federal Reserve purchases of longer-term Treasury securities might be seen as an indication that the Federal Reserve was responding to a fiscal objective rather than its statutory mandate, thus reducing the Federal Reserve’s credibility regarding long-run price stability. Most participants, however, saw this risk as low so long as the Federal Reserve was clear about the importance of its long-term price stability objective and demonstrated a commitment to take the necessary steps in the future to achieve its objectives.

However, consumer spreads continue to stay at high levels.

Additionally, long rates have given back much of the gains made from the time of the previous announcement.

In light of the minimal impact of the announced $300B bond purchase last month, we have to think that the Fed will give it at least one more go. The Fed can really only directly control the benchmark - if the Treasury figures out a way to strong arm banks into flowing credit again, that may put a stop to further QE but that isn't a likely scenario in the short-term.
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