Thursday, August 12, 2010

The Fed didn't announce QE2

Fortune published an op-ed piece by Keith R. McCullough at Hedgeye (h/t to my Mom). He argues (not very well, I might add) that QE2 is the doomsday scenario for "markets".

I'd like to point out the following (mostly because this is a common mistake): what the Fed announced is NOT QE2. Furthermore, the Fed's been considering investing options for months now, why the shock and awe treatment from markets?

Here are the FOMC's announced investment intentions:
...the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.
The Fed announcement is NOT a second version of quantitative easing (QE2). Quantitative easing is a "super" policy response, where the Fed grows its balance through reserve creation and the purchase of (usually) government assets.

The Fed is reinvesting the principal of maturing securities into longer-dated Treasuries from reserves already created. Therefore, the Fed is simply shifting the asset side of the balance sheet toward a Treasury-only portfolio. Reinvesting maturing Treasuries is regular practice for the Fed. No new quantitative easing.

The announcement should not have been a surprise; it wasn't to me. According to the FOMC minutes, the Fed has been considering investment options regarding the principal of the maturing securities for months now. From the June 22-23 FOMC minutes:
First, the Committee could consider halting all reinvestment of the proceeds of maturing securities. Such a strategy would shrink the size of the Federal Reserve's balance sheet and reduce the quantity of reserve balances in the banking system gradually over time. Second, the Committee could reinvest the proceeds of maturing securities only in new issues of Treasury securities with relatively short maturities--bills only, or bills as well as coupon issues with terms of three years or less. This strategy would maintain the size of the Federal Reserve's balance sheet but would reduce somewhat the average maturity of the portfolio and increase its liquidity.
The Committee decided to go with the second strategy, but in an altered form: reinvest the proceeds of maturing securities to maintain both the size of the balance sheet and the average maturity of the portfolio. And a few members favored the Fed's August announcement:
A few participants suggested selling MBS and using the proceeds to purchase Treasury securities of comparable duration, arguing that doing so would hasten the move toward a Treasury-securities-only portfolio without tightening financial conditions.
So you see, the FOMC announcement to buy longer-dated Treasuries is not QE2; is not a surprise; and for reasons that I did not describe here, doesn't portend economic collapse (see this policy brief, or the working paper, by Randy Wray and Yeva Nersisyan, where they refute the application of the Reinhart and Rogoff findings).

Rebecca Wilder

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