The Fed Can Do Only So Much

 | Apr 03, 2012 | 5:00 PM EDT
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Federal Reserve Chairman Ben Bernanke's recent comments referencing concerns about U.S. economic activity were greeted by equity speculators as validation that stimulus would not be removed anytime soon, and perhaps even that another round of quantitative easing was on the way.

The last round of easing, Operation Twist, a $400 billion program, commenced last September and ends this June.

Given that the markets are now speculating on the prospects for another round of QE, especially after the rise in long-end Treasury yields this year, this is a good time to revisit what the limits of monetary policy are, if any.

When Operation Twist was implemented, with the goal of extending the duration of the Fed's balance sheet by buying Treasuries at the long end of the curve, the Fed's rationale for doing so was to force down borrowing costs, especially for durable goods. The greatest impact would be on loan rates for automobiles and mortgages.

And indeed, this is what happened. The 10-year Treasury yield declined by about 50 basis points in the four weeks prior to the expected announcement, from about 2.28% to 1.88%, dragging down loan rates for autos and mortgages commensurately.

Today, however, yields and loan rates have risen and are again near to what prevailed before the Fed began Operation Twist.

This naturally leads the markets to speculate on whether or not the Fed will again target the long end of the yield curve with another round of QE, repeating the attempt to force down loan rates and stimulate lending and borrowing.

There is another component to this kind of activity that is less discussed by the financial media but far more important to money managers who are charged with generating income for investors. When the Fed targets the long end of the curve, it is also making an overt threat to bond vigilantes.

By buying the long end of the curve, the Fed can force down yields, causing losses to private market actors who have been speculating in the opposite direction.

When the Fed announced Operation Twist last September, it did so after about a month of speculation by the markets about the Fed's willingness to extend the duration of its portfolio.

The Fed essentially telegraphed its intentions so as to not catch any market participants wrong-footed. But once it did implement the program, the message to potential bond vigilantes was that they should be careful not to try to drive long yields up, because the Fed was willing to stop them out with its own counter-cyclical moves.

It was a smart move by the Fed to signal its intentions ahead of time, but it certainly signaled to the bond market that there would now be a new layer of complexity that bond market participants need to be aware of when dealing in the long end of the Treasury curve.

The steady increase in yields for the 10- and 30-year Treasuries this year, especially the 35-basis-point increase in yields between March 12 and 19, may be an indication that the bond vigilantes are poking the Fed in search of a reaction that would provide insight to the Fed's intentions once Operation Twist expires in June.

I don't know if that is the case, but it is something we are mindful of and watching for, especially since the jump in yields occurred three months before Operation Twist is set to expire.

While there is no doubt that the Fed has the ability to quash any attempt by private market participants to drive up yields, the Fed's ability to do so is not infinite, nor is it perpetual.

An expanding Fed balance sheet, by way of QE, also causes dollar depreciation. Dollar depreciation is reflected in the capital markets as price inflation, most visibly in stock and commodity prices. The rise is stock prices does not have an immediate economic impact.

However, the rise in commodity prices does have an immediate economic impact and is reflected most obviously in food and energy prices. An increase in food and energy prices can cause a drag on economic activity, not only because it causes consumers to allocate more income to these areas, but more importantly because it can cause consumers to postpone purchases of durable goods, even as the Fed is holding down debt costs for acquiring homes and autos.

If this kind of scenario begins to play out, it is indicative of an end to the potential positive economic impact of QE, regardless of where on the curve it is targeted, unless the Fed wants to go further into nontraditional policy measures and target food and energy prices directly, which is highly improbable.


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