As Federal Reserve policy makers consider a world without quantitative easing, they are dusting off an idea similar to one proposed by Ben S. Bernanke a decade ago to ward off deflation.
Policy makers discussed creating a program to buy short-term Treasury securities to keep yields in line with their policy intentions, according to minutes of their Oct. 29-30 meeting released this week.
Such a tool could help reinforce the Fed's commitment to keep the benchmark overnight lending rate near zero even after it starts to reduce its $85 billion in monthly bond purchases. Fed officials are concerned that tapering those purchases, which focus on mortgage securities and Treasuries between four and 30 years, could cause a sudden increase in yields that would threaten the expansion.
"If you say 'I'm going to commit to keeping rates at zero for three years' but the market doesn't believe you, then you could just buy up three-year notes until they do," said Michael Feroli, the chief U.S. economist at JPMorgan Chase & Co. "It's a way of backing up their words with deeds."
The idea resembles a proposal from a 2002 speech by Chairman Bernanke, who was then a Fed governor, titled "Deflation: Making Sure 'It' Doesn't Happen Here," said Feroli, a former Fed economist. The speech laid the groundwork for many of the Fed's actions during the financial crisis and its aftermath.
Well, no one could accuse the Fed of secrecy. Instead, it is publicly airing 'solutions' to the conundrum over how to phase out quantitative easing (QE), without driving up medium to longer-term interest rates before the US economy is sufficiently strong to withstand a return to more normal interest rates.
So why not just continue with the current policy until the US economy eventually becomes more robust? Clearly because the Fed and many other people are increasingly worried about the destabilising effects of this policy.
One more recent development that I hope they are concerned about, and they certainly should be, is the growing disconnect between the US stock market and realistic fundamental valuations. This year's big stock market gains have led to valuation expansion. While it would be premature to call this a bubble, it is certainly 'frothy' and a 'sugar high' in Wall Street vernacular. Moreover, somewhat overvalued stock markets can easily balloon and become bubbles if the conditions creating them remain unchanged.
Meanwhile, investors are benefiting from this stock market run; QE policy remains unchanged for now, and US stock market trends are very consistent, albeit clearly overextended, as you can see from the S&P 500 (weekly & daily) and the NASDAQ (weekly &daily). Perhaps the Fed will get lucky and some other factor will trigger an orderly reaction and consolidation. However, we should bear in mind that as valuations rise, so also do risks.Back to top