Posted in the Wall Street Journal by Jon Hilsenrath:
Brian Sack, who runs the markets group of the Federal Reserve Bank of New York, spoke to the Money Marketeers of New York University this evening on the Fed’s expanding balance sheet and its implication for interest rates. (See full transcript here.)
One key takeaway: The Fed’s large holdings of mortgage backed securities and Treasury bonds could some day create pressure on the Fed to jack up short-term interest rates.
Mr. Sack is a key voice on the Fed’s expanding balance sheet, because he manages most of the central bank’s interactions with financial markets and thus many of its asset purchase and money lending programs.
The speech is worth reading in its entirety. It’s also worth remembering that he isn’t a decision-maker at the Fed. Instead, he’s the guy advising the decision makers on their choices. Here are some key points on how he sees the Fed’s balance sheet and what it means for interest rates:
- Mr. Sack’s group estimates that the Fed’s purchases of $300 billion in long-term Treasury securities earlier this year helped to push yields on 10-year Treasury notes down by about half a percentage point. Some critics have argued that the Treasury purchases didn’t have the intended impact of pushing rates down. But Mr. Sack – a long-time proponent of such purchases – said his estimate is supported by regression analyses by the Fed. Purchases of mortgage backed securities, he says, pushed those rates down by a full percentage point.
- In a key passage, he notes that the Fed’s massive purchases of mortgage backed securities and Treasury securities could be pushing up prices of other, risky assets through a process he calls the “portfolio balance channel.” It works like this: As the Fed drives down yields on Treasury bonds and mortgage backed securities, investors bid up the prices of other assets, like corporate bonds and equities. He goes on to say the Fed may some day need to raise short-term interest rates “further than would otherwise be the case” to offset the potentially powerful portfolio balance effects of these holdings. (Plain English Translation: If the Fed’s fast-growing balance sheet creates a lot of froth in the markets, the Fed might need to raise interest rates aggressively.) An alternative would be to dump the holdings. He doesn’t advocate either approach, but lays out the arguments for them.
- The mortgage purchase program is already so large that it could be crowding out other buyers in the mortgage market. The New York Fed, he says, is “taking steps to try to limit the adverse effects on market liquidity.” One of those steps is to do smaller purchases over a longer stretch of time to make room for other buyers. The Fed’s plan to gradually taper off its purchases of mortgage backed securities should limit a rebound in mortgage interest rates as the Fed gradually stops buying the securities. He takes heart that Treasury yields didn’t back up when the Fed stopped buying in that market. But he can’t be sure its exit from mortgage backed securities purchases will be as smooth, because it is so much bigger. One way to keep mortgage rates from rising sharply would be to “allow its asset holdings to passively run off as they mature,” as opposed to selling them, he said.
In all, it is enlightening window into the complicated choices the Fed has ahead of itself.