Friday's strong jobs report seems to have accelerated the discussion of the Fed's eventual size reduction. Since the crisis began in early 2020, the Fed has been buying Treasuries and mortgage-backed securities at a monthly rate of $120 billion. At some point, such purchases may slow down until they stop completely.
Of course, the idea of starting to undercut makes some people nervous because it is reminiscent of the 2013 downsizing storm, when yields soared and markets fluctuated sharply as a result of the Fed's reduced asset purchases.
This time, the market doesn't seem to worry too much about it. However, people are obviously very interested in the theoretical timing of code reduction.
However, when considering reducing the size, you should take a step back and ask the exact target of the asset purchase. These asset purchases have attracted a lot of attention and are seen as a core tool in the fight against the crisis. There is a lot of controversy over how this policy of quantitative easing works or what has been achieved. Ben Bernanke once joked: "the problem with QE is that it works in practice, but it doesn't work in theory." When one form of government debt (treasury bonds) is taken away from the public and becomes another type of debt (reserves held by the Federal Reserve), it is hard to explain what can be achieved.
Perhaps the most persuasive explanation for QE is that it provides a signal mechanism for future interest rate hikes. Traders speculate (and may be right) that as long as the Fed is buying assets, it will not raise interest rates. In theory, once the Fed stops buying assets, the focus can really turn to raising interest rates for the first time.
In the latest episode of the Odd Lots column, Dallas Fed President Rob Kaplan puts forward an idea. The reduction is accompanied by a stronger signal to keep interest rates lower for longer, so that a reduction in asset purchases will not be seen as an imminent signal.
The following is an excerpt from the speech:
Rob:
So from this point of view, I will distinguish between our actions on the federal funds rate and our actions on asset purchases. I think these two aspects should be separated more thoroughly. In terms of the federal funds rate: in my opinion, this is not a matter to be decided in 2021, but something that we will debate based on the situation in 2022. I think the near-term judgment is in terms of asset purchases. It may be argued that we may have adjusted the federal funds rate prematurely in the past few years. I'm not really sure about these arguments. I'm not sure I agree with these arguments, but even putting them aside, I'm more confident of the effect of keeping the federal funds rate at its current level. I am more sceptical about the value of these asset purchases.
My worry is that they will exacerbate surpluses and imbalances. They tend to benefit those who own assets rather than those who do not. I know that we can participate in this kind of inflation discussion, and its impact on large enterprises is different from that on small and medium-sized enterprises. I think the impact of the imbalance between supply and demand and inflationary pressures on low-and middle-income communities is different from that on high-income communities. And I think-- I can understand why I say that-- for all these reasons, I think adjusting these purchases earlier may actually make us more patient with the federal funds rate in the future. The analogy you heard me use is that I'd rather release the throttle as soon as possible so that we don't have to hit the brakes in the future. I think this may be the case under such circumstances.
Joe:
It's really interesting, and I think you obviously know, or at least some people in the market will interpret the start to reduce as some kind of interest rate signal. It's like, well, let's start by assuming that the Fed starts cutting in October, and then the market may implicitly advance the expected date for the first rate hike. Therefore, do you think that the initial subtraction should be accompanied by some kind of communication, some specific communication, to show that the initial subtraction should not necessarily be interpreted as some kind of sequential signal, which does not mean that the next step is to raise interest rates for the first time?
Rob:
Yes, I do think so, and in all my communications I have stressed that adjusting asset purchases earlier may actually make us more patient with the federal funds rate in the future. In my opinion, these two themes should be separated, and we should make it clear in public communication that the two processes are separate. I think these purchases and injecting so much liquidity into the economy every month have their own considerations and side effects, which I think is different from our consideration of the federal funds rate and its side effects.
Of course, there is no guarantee that the Fed will make this distinction clearer when it starts to reduce its size. However, doing so would make the process smoother, allowing the Fed to stop using one tool without affecting the market's interpretation of another.