In the past three weeks there have been several indications that the
Federal Reserve is reconsidering the extent and perhaps necessity of its
extraordinary liquidity provisions to the Treasury market. How far have the
chairman and governors pulled back from their quantitative easing
On June 3rd Chairman Bernanke commented in Congressional
testimony that federal deficits cannot
continue forever. In fact the deficits can continue, but the Fedâ€™s $300 billion
Treasury purchase plan will end unless additional funding is authorized by the
Fed governors. At this past weekâ€™s FOMC
meeting the board specifically did not authorize further Treasury purchases.
The Fed is also letting one of its emergency liquidity programs expire and
curtailing two others. None of these developments is an overt change in policy,
but they are assurances that the chairman and the board view these liquidity
measures as crisis expedients and not as permanent institutions of monetary and
It is easy to forget that the Fed policy of direct
support for credit markets was an emergency response to the crisis of confidence
that overwhelmed the financial system last fall. Fed purchases of various
securities supplied liquidity to non-functioning markets; they were not intended
to be permanent. The Fed said as much at the time, though in the ensuing months
market focus shifted from the programs themselves to the lack of a clear
strategy for absorbing the excess money supply from the economy.
the market reaction to the financial crisis was at its peak. Treasury prices had
been driven to historical highs by sustained panic buying of US Treasuries.
Treasury interest rates and rates on 30-year fixed rate mortgages were at record
lows. But even though mortgages rates were extraordinarily low the Fed judged
that the reeling economy could not tolerate the surge in interest rates that
would occur if Treasury prices began to fall. The governors may have suspected
that the Treasury market would begin to drive prices lower and rates higher on
its own as credit conditions
In that context the Fed announced its $300 billion Treasury
purchase in the FOMC statement of March 18th. The governors may also have been
worried about the impact of the federal
deficit on the bond market whose reaction was then an unknown quantity. But
despite the Fed backstop the Treasury market fell relentlessly after March 18
with the 10-year rate rising more than 1.5%. More dangerously the dollar index
fell 10% from March 18th to June 2nd.
For the currency markets the Fed Treasury program has had one meaning,
monetization of the Federal debt. Judging by the subsequent rise in Treasury
rates the Fed governors may have known that the $300 million committed would be
insufficient to hold the line on Treasury rates. But that relatively minor
amount had a deadly effect on the dollar. The merest suspicion that
monetization of US debt was possible sent the dollar into a three month swoon.
The inflation that would result from a rapidly falling dollar and the effect of
a collapsing dollar on the Treasury market itself could undo much of the
economic and rate stabilization that the Fed was striving to achieve.
The Fed concern about the Treasury market was for the economic effect of
higher interest rates on the US economy, particularly on the housing market
thought by many to be at the heart of the economic collapse. But higher
Treasury yields and mortgage rates have not, at least so far, choked whatever
positive change in the economy has occurred since March. 30-year fixed
mortgages have gained more than a point but the housing market has stabilized;
new home and existing home sales in May were both in the center of the range
they have exhibited since January.
Personal Consumption Expenditures Index
has revived since last
December.Itgained 0.9% in January, 0.4% in February, 0.3% in
May, was flat in April and lost 0.3% in March. The half
year prior to January had six negative months in a row. Non Farm Payrolls
were substantially improved in May at -345,000, with the three month moving
average (-500,000) having gained almost 200,000 since March (-691,000).
Consumer sentiment numbers have moved up steadily since the beginning of the
quarter. The economic situation that prompted the Fed quantitative easing has
returned to more normal territory.
The Treasury market has also
stabilized in the past two weeks. After reaching 4.00% the yield on the 10-year
note had declined to 3.54% on the Friday close. The government Treasury
auctions, a record $104 billion in the past week alone, have been subscribed at
higher rates than normal. The bond markets are not demanding substantially
higher rates on American debt, despite the vast continuing supply of US
The key to the extension of the Fed Treasury program is the
attitude of the credit markets. It is relatively simple. If bond purchasers do
not demand higher yields for US debt, then whatever the long term effect of the
ballooning US debt and inflation the government will not be forced to pay higher
rates. If Treasury prices are not falling the Fed will not have to support the
market with further Treasury purchases and the currency markets will not be
stampeded away from the dollar by monetization.
Foreign central banks
have been unusually critical of the US governmentâ€™s fiscal and debt policy. The
Chinese were so again this week. But what matters are not the bankerâ€™s words or
their musings about a world reserve currency. What matters is action. As long as
the Chinese, Russians, Japanese and private investors continue to buy US
Treasuries, the Fed will not have to choose between supporting the US economy
and supporting the dollar.
It is a delicate balance but so far the Fed
has, with the cooperation of the Treasury markets, kept the pointer right in the
middle of the scale. The Fed has managed to mitigate the scare it threw into the
currency markets in March with its recent statements and actions.
are still a huge amount of Treasuries to be sold over the next three months and
the economic situation is still dangerous. But the Fed view as reflected in the
FOMC statement, no more quantitative easing and a slight though significant
withdrawal from the credit markets may be the right and artful balance between
keeping down US interest rates and avoiding a dollar panic in the currency
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