Monday, September 22, 2014

Fed Policy Risks

Back in 2011 we were pretty lonely writing about the future risks of the unprecedented monetary accommodation that became today's monetary policy. We noted this comment from Minneapolis Fed President Kocherlakota,
"In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before."
He was right and he was early: it made perfect sense to me, but this view was quietly squelched with assurances that the Great Unwind would have several tools in its armamentarium.  Hold this thought as we summarize the Fed's policy risks from Dr. Ward McCarthy of Jefferies.

Ward says that the Fed's recent parsing language meant to say that it is "in no rush to raise rates."  We have long said that there is no fundamental economic case for raising rates.

To the point above, McCarthy says "unwinding this extraordinary accommodation carries...risks that policy makers had not previously had to consider."

He says that if the Fed waits too long to raise rates in response to rising inflation, the markets would overreact and a subsequent move would be roiling to bond markets.  This risk, in my opinion, is one of the lower ones.  There are many data points for inflationary changes, both real and in expectations. At present, there is almost no sign of economy-wide pressure from commodities, wages, or capacity constraints, which are the traditional harbingers.

If the Fed were to remove its accommodation too early, and the economy were to again enter a recession, it would very few options.  Negative rates, Dr. McCarthy says, are not politically or institutionally feasible in the U.S.

The Fed has now defined the federal funds rate as the key policy rate.  Dr. McCarthy agrees with us in saying that the reverse repo facility tool is not the best solution resetting the floor for interest rates. He notes that Fannie, Freddie and the Federal Home Loan banks are not eligible to collect interest on their reserves at the Fed.  Given their continuing enormous influence in the housing market, this makes the RRP program of limited reach, not to mention risky to the system, as others have written.

The IPO market's backlog will comfortably start coming to market given the benign outlook from the Fed.

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