MNI EXCLUSIVE: Fed May Shift QE Purchases Towards Long End

The Federal Reserve may shift more of its bond-buying program towards the long end of the yield curve in order to keep up with Treasury issuance plans and as it awaits more clarity on the economic outlook before considering any increase in the amount of its purchases, former Fed officials told MNI.

Officials have discussed both potentially increasing the pace of bond buys if conditions worsen or extending the current average maturity of purchases, the former officials said, adding that such a move could come as early as December or by the spring. The Fed is currently buying USD40 billion per month in MBS and USD80 billion in Treasuries, at an average duration of about 5.5 years while the Treasury's new issues have an average maturity closer to 7.5 years.

"What benefit does the Fed get in buying 2-year, 3-year Treasuries at the moment?" said Roberto Perli, a former Fed Board economist. "None, because those short-term rates are anchored by the forward guidance." And the case could be made that yields at the long end are relatively high "compared to where they should be based on the fundamentals."

PATH OF LEAST RESISTANCE

Keeping total purchases at USD120 billion per month while directing more of the funds to longer-dated bonds may be the "path of least resistance" for the 17-member Fed rate-setting committee, Perli said, noting that some FOMC members had already dissented against the shift to new forward guidance at the September meeting.

"The bias that the Fed has is towards doing more rather than doing less for the moment given the uncertainty and especially with uncertainty on the fiscal side," Perli said. "The first step is shifting maturities."

Yet, though the Fed would react if financial conditions tightened around its Nov. 4-5 meeting, it would rather not act so close to the elections, said Jonathan Wright, a former Fed Board economist now at Johns Hopkins University.

"Maybe December is a better time" to say "a little bit more" about the asset purchase program, when more information will be available about potential fiscal stimulus, Wright said. "There is a tradition of trying to avoid big monetary news around an election and this would be one meeting to stay in the shadows a bit more."

OUTLOOK FACES HEADWINDS

With stimulus delayed as Washington politics takes front and center stage, the outlook faces headwinds. Before stimulus talks crumbled, Fed Board staff said the pessimistic economic outcome was "less likely than the baseline forecast," FOMC minutes showed.

Some of the caution from Fed officials comes from a desire "to preserve their options," said Wright, who agreed that changes to its asset purchase program will include more focus "on the long-end."

"So far the Fed has been in the lucky position that saying it is standing ready to do all it can is all it takes," he said in an interview. "But you can't be assured that it will stay like that."

An increase in 10-year real yields without improved growth expectations could prompt the Fed to act quickly to buy more longer-dated debt, said Jon Hill, a former Treasury Department official.

Currently 10-year real yields are at -0.95%, just where the Fed would like them, he said. "If all of a sudden they jump to -50 basis points or zero that's a totally different story."

But Larry Meyer, a former Fed governor and now head of Monetary Policy Analytics, said that while a change in the asset purchase program could provide additional support to the economy by lowering long-term rates relative to short-term rates it was not likely before the spring.

"This is not imminent," Meyer said, adding that Fed would prefer to wait until "additional data for economic activity becomes available and when the fiscal outlook is more certain."