Full Scale QE occurs only if the Greek election creates no government. Otherwise, this scenario will likely not be relevant. In full scale QE, the fed will purchase treasuries and MBS. Speeches from Evans and Lockhart show they are comfortable with current economic conditions and said no further easing is needed at this time. They attribute it to the safe haven flow that is currently occurring. It is driving the yield on long dated bond down without the Fed. Although their speeches came before the recent CPI and PPI, the numbers came in near expectations. Also, core CPI came in exactly at 0.2 and this was what the market was expecting. The recent decline in oil likely caused the headline CPI to come in at -0.3 without dragging down core CPI. The volatility of headline CPI and core CPI coming neart expectation will likely not force them to implement full scale QE.
It will be difficult to do another round of full scale QE without extreme financial stress in the system. Bernanke, Evans, and Lockhart all had variations of the line “extreme financial stress” in their speeches. The Fed is limited in what they can purchase. Purchasing short term bonds will nullify the purpose behind Operation Twist. Operation Twist was created to combat the “voluntary” capital destruction in the market. Another full scale QE will limit high quality short term quality even further because the Fed will drain the supply with their further. QE exacerbated capital destruction; Dodd Frank added fuel to the fire. Before Dodd Frank, money markets and financial institutions had a larger pool of short term high quality assets to choose from to meet capital requirements. Instead of buying treasuries, they bought CODs that had a higher yield. As we know now, the CDOs were not high quality assets. Post Dodd-Frank, the pool became even more limited due to new regulations on what can be considered collateral. Unless the Fed wants to nullify operation twist, the pool of assets they can purchase will be limited.
They can purchase medium to long dated bonds and MBS. Buying more medium and long dated bonds will increase the duration of their portfolio even further. The Fed is already sitting on nearly 1 trillion dollars of 6 to 30 year and 600b of 3 to 6 year bonds. The two times they initiated full scale QE was when the 10y yield was above 3. Currently, the yield is sitting at 1.59. It would not make sense for the Fed to extend the maturity on their portfolio at this point with the safe haven flow already pushing yields down. The Fed does not lose money on their purchases. How does buying more bonds at these rates make them money? Also, how does the Fed unwind their portfolio later on? Purchasing more of these long dated bonds will make it more difficult because they will be the market at some point. They have shown glimpses of how they plan to unwind in “The Mechanics of a Graceful Exit.” Unless these questions can be truly answered, it will make it difficult for them to launch another round of full scale QE without extreme financial stress to the market.
Truly QE is nothing more than a great way to help clean up the balance sheets of banks and create inflation expectations. If the Fed truly wanted to get inflation going and flood the market with liquidity, then they could stop paying the IOER. The banks would stop holding their excess reserves at the Fed and would actually start lending the money. Before 2008 there was an opportunity cost for banks to hold their reserves at the Fed because it didn’t pay interest. Post 2008 the Fed was granted the power to pay interest on those reserves for the first time in history. Why would banks lend money when their NIM is so low and take on risk? Instead they can receive a risk free interest payment at the Fed.
The monetary base has grown, but the money multiplier and money supply are both very low. So ask yourself this: if the Fed has been printing wildly, how is it possible for the money supply YoY growth to be so low? Compare it to China’s money supply YoY growth over the past few years and you will see a drastic difference. The reason is the money never really left the Fed. IOER was a way to sterilize their purchase and keep monetary inflation from truly getting out of control. QE perpetuated the notion that inflation was being created without inflation actually being created. Instead the expectation of inflation was created. A sterilized form of QE was rumored in March; however, the Fed already has been sterilizing QE with IOER. An announced version of sterilized QE would eliminate the benefit of inflation expectations. It wouldn’t make sense to announce a sterilized QE when they need inflation expectations to combat deflation.
Now that full scale and sterilized QE are eliminated from what the Fed may do. QE lite and an extension of operation twist must be examined. An extension of operation twist will be difficult to pull off. The Fed is only sitting on 180b to 200b of short term bonds (1-3y) compared to 600b when they first announced twist. An extension can be used as a stop gap between now and the elections without too much of a threat to Fed’s independence. However, they may not have a large enough pool of short term bonds to extend operation twist for that long.
The second possible scenario is a twist on QE lite. In QE lite, the Fed reinvested the proceeds of maturing MBS and bought treasuries with it. This time they may do the same or use the maturing MBS proceeds to buy more MBS. Evans mentioned buying MBS was an option. This scenario allows them to keep their balance sheet the same without a contraction or expansionary component to their purchases. Also, it keeps the duration of their portfolio the same.