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September 22, 2011

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Fed Watch: FOMC Reaction – The Extended Version

Posted: 22 Sep 2011 12:15 AM PDT

Tim Duy:

FOMC Reaction – The Extended Version, by Tim Duy: Earlier I posted my quick reaction to the FOMC statement. Now it is time for some extended comments. First off, the Fed sees increasing risks of disappointing news in the months ahead. The August sentence:

Moreover, downside risks to the economic outlook have increased.

was changed to:

Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.

The downside risks are now "significant," and we can thank the Europeans for that. I already commented on the twist operation – I tend to think it is too little to have much impact, largely just changing the composition of already safe assets. There was a reaction at the long end of the curve, with the 30 year yield down nearly 20bp. I am sure the Fed is pleased with that; the stock market, however, did not view it as much of a silver bullet, and sold off 2.5%.

What I didn't have a chance to digest earlier was this:

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

That the debt overhang in mortgage markets is weighing on the recovery is not much of a secret. The Fed views that overhang as hampering the effectiveness of monetary policy, and rightfully so. By keeping assets in the mortgage markets, the Fed is hoping to encourage even lower rates and, by extension, a greater pace of refinancing. Worth a try, to be sure. I don't know that this addresses the critical impediments to refinancing – underwater mortgages and tighter underwriting conditions. Yes, if we allow the loan to value ratio of federally insured mortgages to increase, then we can get some traction. And the Fed's move may be in anticipation of such action – I am hoping this is so.

Increased opportunities to refinance, however, may not have as much of an immediate impact as would normally be the case. It depends on the ratio of households that refinance into another 30-year mortgage, reducing their payments by extending the payoff date at a lower interest rates versus those that refinance into a 15-year mortgage and reduce their current consumption to save more.

For what it is worth, here is what I am doing. With my children now in kindergarten and first grade, we finally experienced a drop in child-care expenses. The drop just happens to be almost exactly what I need to refinance into a 15-year mortgage. Better to pay down debt than allow my standard of living to ratchet up. And, quite frankly, paying down debt at a more rapid pace is pretty much the best safe investment right now. Holding cash in the bank yields nothing, paying down the mortgage debt at least earns around 4-5% depending on your mortgage, tax-free. That said, in the long-run, by holding rates low, the Fed is contributing to balance sheet restructuring. I just tend to think the process would be quicker and more effective via wage inflation.

The Fed reiterated their expectation that rates will hold near zero through 2013, and once again committed to additional action should it be necessary. Of course, arguably it is already necessary. Still, it is the marker that keeps hopes of another round of quantitative easing alive.

Ezra Klein argues the Fed struck a blow for independence today, coming in slightly above expectations and effectively ignoring the thinly-veiled Republican threat. Yes, kudos to Federal Reserve Chairman Ben Bernanke on that point. Stan Collender nails this one – the Republicans have effectively put an end to fiscal stimulus, and now hope to derail monetary stimulus as well. I think the Republican leadership is doing themselves a disservice with this line of attack. Quite frankly, the remaining monetary tools are very weak, and the willingness of the Federal Reserve to ramp them up to levels that might be effective is very low. In effect, the Republicans are needlessly taking a hard line position on this one. The Fed isn't going to come to the rescue. The numbers are simply too big – remember Goldman Sach's $10 trillion figure for the Fed's portfolio if they wanted to deliver the correct level of policy accommodation in 2009? Something like that is not even on the outer edges of the radar screen.

Bottom Line: I think Fed official believe they are being bold; I see them as continuing to ease policy in 25bp increments. Expect that to continue. Assuming the economy fails to regain momentum, the Fed will follow up with additional action – QE3 will be the next stop. Ignore the dissents; they are background noise. Don't expect miracles; expect small moves, the equivalent of 15bp here, 25bp there. The real leverage could potentially come from fiscal policy leveraging the easy monetary policy. Print the money and spend it. Open up the refinancing channel. Overall, make the objective of national economic policy simply be to decisively move us off the zero bound. Not deficits, not the dual mandate, just commit to pulling us off the bottom.

links for 2011-09-21

Posted: 21 Sep 2011 10:10 PM PDT

FOMC Decides to Implement Operation Twist

Posted: 21 Sep 2011 11:43 AM PDT

Here's the FOMC statement. The big news is the attempt to lower long-term interest rates by shifting $400 billion of the Fed's portfolio from short-term to long-term assets (i.e. what has been described as a "twist"):

Press Release, Release Date: September 21, 2011: Information received since the Federal Open Market Committee met in August indicates that economic growth remains slow. Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has been increasing at only a modest pace in recent months despite some recovery in sales of motor vehicles as supply-chain disruptions eased. Investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action were Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who did not support additional policy accommodation at this time.

On the run, so very quick reaction:

1. This shifts the duration of the balance sheet, but it does not change its size. I would have preferred balance sheet expansion, i.e. QE3, as that would have a much better chance of helping the economy. But the inflation hawks on the committee will not tolerate further expansion in the balance sheet due to worries about inflation.

2. It's not big enough.

3. Even if it causes rates to fall, will consumers and businesses respond?

That is, this might help some, but not enough to solve our employment crisis -- not by any means. Thus, this does not alleviate the need for Congress to implement serious job creation programs as soon as possible.

The unemployment crisis needs to be attacked vigorously, and we need aggressive action from both monetary and fiscal policymakers. But neither the Fed nor Congress has the will to do more than half-hearted measures at this point, and even that might be too much for Congress.

I wish the people making these decisions had to face what households struggling to find a job endure daily -- the world policymakers see from their insulated shell is very different from the world of the unemployed. Maybe then they'd finally get it and, more importantly, do what needs to be done.

Update: Tim Duy reacts to the decision.

Update: Via Daniel Indiviglio:

...But the other action announced by the Fed shouldn't be overlooked. Previously, it was reinvesting its maturing mortgage securities in new Treasuries. By instead targeting agency mortgage securities, it will more directly push down mortgage interest rates. The size of this effort is not provided, in large part because its size will depend on external factors.

As prepayments from mortgage refinancing increase, so will the amount of money the Fed will reinvest. And with mortgage rates heading towards historical lows due to this campaign, you should expect to the Fed provided lots of principal with which to reinvest. It wouldn't be surprising to see $40 to $45 billion per month in reinvested in agency mortgage securities through this effort. That's about the amount of monthly maturing principal reinvestment from mortgage securities we saw last year as rates were dropping. So this effort could actually outweigh Operation Twist.

"The Distributional Effect of Tax Cuts"

Posted: 21 Sep 2011 09:45 AM PDT

Paul Krugman outlines the tricks that are used to obscure the distribution of the tax burden:

The Distributional Effect of Tax Cuts — A Brief Note, by Paul Krugman: With taxes on the wealthy on the political radar, we're going to drowning in a vast wave of double-talk and smothered by vast amounts of fuzzy math. Still, one has to try. So, a couple of notes.
One is that you have to beware of the old trick of saying "taxes", then slipping into "income taxes". Most Americans pay more payroll than income taxes, but the reverse is true at high incomes. So focusing only on income taxes makes it seem as if the rich pay much more of the burden than they really do.
Another, more subtle trick involves comparing percentage changes in taxes as opposed to tax changes as a percentage of income.
The starting point is that federal taxes are indeed progressive on average (although there are billionaires who pay a lower rate than their secretaries). And this in turn means that you have to be careful about the question when evaluating a change in taxes.
Suppose that it's 1979, and individual A is a member of the working poor, paying 12 percent of his income in taxes — basically payroll tax and not much else. Meanwhile, individual B is very wealthy, and pays 40 percent of his income in taxes — as the very wealthy did on average 30 years ago.
Now suppose that 30 years of conservative governance lead to a fall of a quarter in both individuals' average tax rates; A's rate falls from 12 to 9, B's from 40 to 30. Would it make sense to say that they have gained equally from tax cuts?
Clearly not. A's after-tax income has risen from 88 to 91 percent of pretax income, a gain of 3.4 percent. B's after-tax income has risen from 60 to 70 percent of pretax income, a gain of 16.7 percent. The distribution of after-tax income has become substantially less equal. And that's the calculation I was doing here.
Now, right-wingers come back and say that this is what has to happen when you cut taxes. No, it doesn't. And anyway, cutting taxes is itself a choice — and they're a choice that then leads to demands that we cut programs for the poor and middle class to close the deficit those tax cuts created.
The point is that yes, tax policy these past 30 years has been very much tilted toward benefiting the rich.

Another trick is to say that taxing the rich won't raise much revenue, certainly not enough to close the debt gap, with the implication of why bother at all if it won't fix the problem? But while it's true that raising taxes on the wealthy isn't enough by itself, it can still make a hefty contribution:

Is There Enough Income at the Top to Make a Difference to the Deficit?, by Kash Mansori: In response to Obama's proposal (pdf) to let the Bush tax cuts expire for high-income households as one of the ways to close the budget deficit in future years, I've heard and seen a number of commenters assert that there simply aren't enough people at high levels of income for that particular idea to make much difference to the federal budget deficit. Are they right?...
[I]f the US is only willing to raise taxes on the very top of the income distribution, the US's medium-term budget problems cannot be solved through additional revenue alone. However, tax increases that are limited to just the very top of the income distribution, while not sufficient by themselves, would actually probably get us about one-third of the way toward fixing the US's medium-term deficit problems. So while not a cure, it would make a significant dent in the problem.

And if the wealthy don't pay their share, guess who will, one way or the other?

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