Questions over the Fed’s Treasuries buy

Questions over the Fed’s Treasuries buy
By Krishna Guha in Washington
Copyright The Financial Times Limited 2009
Published: April 7 2009 22:47 | Last updated: April 7 2009 22:47
http://www.ft.com/cms/s/0/1810caba-239f-11de-996a-00144feabdc0.html?nclick_check=1


When the Federal Reserve announced plans to buy US government securities on March 18 it made a big splash in the markets – much bigger than many Fed officials expected.

The interest rate or yield on 10-year Treasuries instantly fell from 3 per cent to 2.5 per cent and a little more than half of this decline was passed through to private borrowers according to the swaps market.

It looked as if the Fed had discovered a potent way of driving down private borrowing rates without getting ever more embroiled in financing private credit markets directly.

However, three weeks on, the impact is much harder to discern. Ten-year Treasury yields are back above 2.9 per cent and swap rates have also returned almost all the way to pre-March 18 levels.

This raises questions as to how effective a tool buying Treasuries is likely to be in stimulating the economy.

Minutes released on Wednesday of the March 18 meeting will cast new light on how the Fed reached its decision and what policymakers might make of the evidence since then. The minutes are likely to show that Fed officials disagreed as to the probable effectiveness of Treasury purchases, but ultimately agreed to go all in and try every tool at their disposal to fight the crisis.

The problem is that market developments since March 18 can be read in several ways. One interpretation is that once the shock of the announcement wore off, the market figured out that Fed purchases of Treasuries would not make much difference because the market was so deep and liquid.

Another is that the rebound in yields reflects positive economic news and/or growing concern about government deficits – and that without the Fed purchases borrowing costs would be even higher today. It is impossible to tell.

“I think what we have learnt is that the Fed is most effective in private credit markets because the limits to arbitrage are greater in these markets,” said Mark Gertler, a professor at New York University.

The decision to buy Treasuries indirectly supported efforts to drive down mortgage rates – now at 50 year lows – and may have had a positive effect through its impact on confidence and inflation expectations.

“I think the action did raise inflation expectations,” said Ken Rogoff, a professor at Harvard. “I would have thought it would raise them more than it did.”

Larger-scale purchases could have a bigger impact. The Fed’s initial commitment – to buy $300bn (£204bn, €227bn) of Treasuries – is smaller proportionately than the Bank of England’s commitment to buy British government bonds.

Moreover, officials may have undermined their impact by raising the possibility that the Treasuries could be sold back to the market in future.

However, Rick Mishkin, a Columbia professor, said that while the Fed could increase its quantity of purchases, it had to be careful not to get drawn into defending a de facto target for the 10-year rate.

“If buying Treasuries doesn’t work, you don’t just keep doubling up. There has to be a limit because there has got to be a viable exit strategy,” he said. “There are a lot of parallels with exchange rate intervention.”