Doug
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· The Federal Open Market Committee pushed conventional monetary policy to the limit in December when it lowered the fed funds target to a range of 0-25 basis points and stated that it expected "exceptionally low levels of the federal funds rate for some time." · The focus of investors and policymakers has now turned to unconventional easing. However, with both policymakers and investors operating in uncharted territory, it is much more difficult to gauge the stance of Fed policy. The Fed is transparent about the size of its balance sheet and the nature of the interventions it is pursuing, but there is no obvious translation of the results into metrics that investors can easily understand-e.g. the federal funds rate. · In today's comment, we utilize the framework of our GS Financial Conditions Index to analyze the impact of some of the Fed's actions on broader financial conditions, and ultimately to translate balance sheet growth into "funds rate equivalents." Our preliminary analysis suggests that $1 trillion - $1.6 trillion of balance sheet expansion is required to generate an easing in the FCI equivalent to a 100bp rate cut. While there are plenty of caveats to such an exercise, the fundamental point is clear: unconventional easing is likely to require truly massive balance sheet expansion to be effective.
The Federal Open Market Committee pushed conventional monetary policy to the limit on December 16 when it lowered the fed funds target to a range of 0-25 basis points and stated that it expected "exceptionally low levels of the federal funds rate for some time." With this action, the Fed used up its conventional policy ammunition. Unconventional easing-already initiated prior to that meeting in the form of emergency liquidity provision to financial institutions, direct lending to critical private sector borrowers, and asset purchases-is likely to be the primary focus of Fed policy at least through 2010.
With both policymakers and investors operating in uncharted territory, it is much more difficult to gauge the stance of Fed policy. What does it mean if the Fed announces a plan to purchase $500bn of agency mortgage-backed securities, as it did in late November? The Fed is transparent about the size of its balance sheet and the nature of the interventions it is pursuing, but there is no obvious way to translate the results of those interventions into metrics that investors can easily understand-e.g. the federal funds rate.
In an effort to bridge this gap, we have utilized our GS Financial Conditions Index (GSFCI) to assess the impact of recent Fed asset purchase and lending programs on financial conditions. Our approach is as follows:
1. Estimate the impact on key lending spreads. The first step is to assess how much the Fed's action lowered spreads. In general, we do this by comparing the level of spreads just prior to the announcement of a Fed program to the level shortly after the program begins. Of course, many factors affect these spreads, so it is impossible to be certain about the exact effect, but the order of magnitude of the announcement and purchase effects are quite clear in the data. For example, yields on agency mortgage-backed securities fell roughly 150 basis points from just before the Fed's November 25 announcement that it would buy these securities until early January after the purchases began. Rates on A1/P1 financial commercial paper fell a similar amount following the announcement and launch of the Commercial Paper Funding Facility (CPFF).
2. Convert the spread impact into GSFCI terms. The GSFCI framework, discussed in detail elsewhere, consists of four components: a short-term reference rate (3-month LIBOR, 35% weight), a long-term reference rate (10-year Treasury plus 10-year CDX, 55% weight), the trade-weighted US dollar (5% weight), and an index of equity values (S&P 500, 5% weight). To estimate an FCI impact from tighter lending spreads, we select the component of the FCI that is closest in form to the Fed's target spread. For the CPFF, this is the short-term reference rate, 3-month LIBOR; for agency debt and MBS purchases, it is the long-term reference rate. We estimate the FCI impact as (spread move x reference rate weight x (outstanding debt affected/outstanding debt in reference class)). For example, in the case of CPFF purchases, the first term is approximately 150bp, the second term is 35% (the weight of the long-term reference rate in the FCI), and the third term is the share of financial commercial paper in the short-term debt markets (we estimate slightly more than one- tenth). Depending on the precise estimates of the spread impact, we get an impact of 5-7 basis points on the GSFCI.
3. Convert the GSFCI impact into funds rate terms. Here we simply divide by 35%, the weight of the short-term reference rate in the FCI. Again using the CPFF example, the 5-7 basis point move in the GSFCI translates into a 15-20 basis point funds rate move.
4. Take the ratio of the program's size to the funds-rate-equivalent impact. The final step is to divide the size of the program by the funds-rate-equivalent impact. This leads directly to a measure of how big the program would need to be, in theory, to move financial conditions by a 100bp-equivalent move in the funds rate. In the case of the CPFF, while the potential size of the program is $1.4 trillion, the more relevant number is the amount of CP actually purchased and held in the facility-roughly $240 billion in recent weeks. As this generated a 15-20bp funds-rate-equivalent improvement, the implication is that 100bp of FCI improvement via the CPFF would "cost" between $1.2 and $1.6 trillion.
Our preliminary assessment of the agency debt/MBS purchase programs and CPFF is that it takes between $1 trillion and $1.6 trillion of balance sheet expansion to generate a funds-rate-equivalent easing of 100bp. These are clearly huge numbers, especially when compared with the Fed's current balance sheet ($1.9 trillion, of which securities held outright make up roughly one-third), and we expect them to meet with some skepticism. However, they should be considered in the context of the more than $50 trillion of credit market debt outstanding in the most recent Flow of Funds report from the Federal Reserve.
We urge our readers to view these calculations as illustrative only. Several specific caveats are in order:
1. Positive spillovers are excluded. Some readers might object that our focus is too narrow-after all, we are only looking at the impact on the spreads the Fed is actually targeting. Perhaps a successful intervention is having a beneficial impact on yields elsewhere as well. (For example, long-term Treasury yields fell significantly in the days following the announcement of the Fed's agency debt/MBS purchase program.) Although this is a legitimate criticism, recall that in step 3 of our procedure above, we translated into a funds-rate equivalent change by dividing the FCI move only by the funds rate weight. In practice, an unexpected easing of 100bp in the funds rate would likely have a beneficial impact on other components of the GSFCI as well. So we are being consistent by excluding spillover effects from both the numerator and denominator of this calculation, and have no reason to believe that one dominates the other. Also, in the case of the mortgage interventions, we have rolled the impact on agency debt, MBS, and retail mortgage rates into one calculation to try to capture the obvious direct effects of this program.
2. The marginal cost of unconventional easing is unlikely to be constant. If the Fed were to expand its purchase programs, it would end up owning a larger and larger proportion of the assets in question. With fewer assets remaining in private hands, incremental purchases could have a greater effect on prices and spreads, and hence a greater bang for the buck. Conversely, once rates were driven close to zero, the incremental effect of Fed purchases could diminish.
3. Quantity effects are excluded. Our analysis, like the GSFCI itself, deals in prices rather than quantities. Clearly, one of the key issues in the current crisis has been the availability of credit, not simply its cost. Insofar as these Fed interventions increased the overall quantity of credit, they may have had beneficial effects on the economy beyond the impact on rates alone-and hence the "bang for the buck" of unconventional easing would be greater than we estimate.
This third point is particularly crucial, and is certainly not lost on Fed officials. The Fed's Term Asset-Backed Securities Lending Facility (TALF), to begin lending imminently, is explicitly designed to increase the volume of available credit as well as decrease its cost. So if it works as designed, the TALF's ultimate impact on credit and financial conditions could be considerably larger than implied by our calculations. But this should not obscure the fundamental conclusion: it takes massive balance sheet expansion to generate a significant easing in financial conditions.
In light of the apparent cost of unconventional easing, it is easier to understand Fed Chairman Bernanke's desire to draw a distinction between "credit easing" and the "quantitative easing" approach pursued by the Bank of Japan. In essence, Bernanke is arguing that the Fed's approach of targeting specific credit spreads and/or borrower groups will generate a better bang for the buck-more effective FCI easing for dollar of balance sheet expansion-than untargeted quantitative easing. We hope he is right.
Andrew Tilton