MNI EXCLUSIVE: Fiscal Stasis May Prompt Fed QE Boost

Delays in approving fiscal relief for the Covid-hit U.S. economy could compel the Federal Reserve to take fresh accommodative steps via its asset purchase program in upcoming meetings despite concerns that quantitative easing provides diminishing returns when interest rates are already very low, former policymakers told MNI.

No change in policy is anticipated at the FOMC meeting next week but sources expect a detailed discussion of balance sheet policy options that include ramping up QE, lengthening the average weighted maturities of Treasuries purchases, yield curve control and expanding the reach of purchases to include more private assets, ex-officials said.

"I detect a real rising concern about the Fed having to substitute for missing fiscal action and at the same time realizing that there's only so much they can do, in an environment in which they have used all their cannons and they're down to lower gauge weapons," former Atlanta Fed President Dennis Lockhart said in an interview. "They have to be thinking about what more they can do in the range of QE policy options and at the same time worrying that it won't be enough to replace the lack of fiscal action."

DIMINISHING RETURNS

Stepping up QE can push already-depressed yields even lower, but the cost of doing so becomes ever greater even as the stimulus effect fades, all while potentially exposing the Fed to greater political scrutiny.

"Based on the experiences of Japan and Germany, QE could probably push the 10-year yield down to 0.20% or so" from its current level of around 80 bps, Joseph Gagnon, a long-time Fed board staffer who was associate director of the Fed's Division of Monetary Affairs during the financial crisis, told MNI.

"To get it down to 0.20% would require about USD2 trillion in additional QE purchases according to one rule of thumb the Fed has used. However, it might take even more QE to do that because I suspect that QE becomes less effective as yields approach their lower bound," he said.

The Fed has taken on roughly USD3 trillion of Treasuries and mortgage-backed securities since March and promises to keep buying at least another USD120 billion a month to keep financial conditions loose. Fed Board economist Michael Kiley estimated in a research note earlier this month that the Fed would need to buy another USD3.5 trillion of securities to offset its inability to cut rates below zero.

"QE can push bond yields closer to zero, but long-term yields cannot go lower than the Fed is willing to push short-term yields. As long as Fed is reluctant to have a negative federal funds rate, bond yields will remain positive," Gagnon said.

No Fed official has publicly advocated for cranking up QE but neither has anyone ruled it out. Sources told MNI the Fed could take forceful action in the event of another outbreak of financial market tension or if inflation or inflation expectations move down.

Cleveland Fed and Chicago Fed presidents Loretta Mester and Charles Evans said they might support shifting purchases to longer-dated bonds. Such a move could come as early as December or by the spring while the Fed awaits more clarity on the economic outlook, former policymakers told MNI.

YIELD CURVE CONTROL

Yet another idea the FOMC may revisit is to follow the BOJ and the RBA and institute yield curve control, pegging intermediate term rates near zero with the aim of driving down longer-term rates to encourage spending and investment. This would potentially require fewer asset purchases, but would also put the central bank's credibility on the line if it were forced to prove its determination to meet its yield targets.

With diminishing returns to Treasuries purchases, the Fed could also turn to a discussion of whether it should expand purchases of mortgage-backed securities or corporate bonds, sources said.

"Should it try to increase private asset purchases or do more MBS to affect spreads between Treasuries and other assets more?" asked former Richmond Fed adviser John Weinberg in an interview with MNI. "But mortgage rates are also pretty low right now, so I don't know if there's a view of the incremental impact of doing that would be that great."

And there may be reluctance to go beyond the back-stop support provided by facilities created in March, Weinberg added.

New leadership at the Treasury after the election could see the Fed relaxing the standards of their lending programs and offering more support that way.

"Right now they are set so strictly that there will be very few losses and Fed will surely make money overall. They could increase lending to firms that have some probability of failing, which would mean using up some of the capital that Congress authorized," Gagnon said.