-Kocherlakota: Need Unemp/Infl Metrics To See If Mon Pol too Stimulative

By Steven K. Beckner

(MNI) – Federal Reserve Gov. Jeremy Stein said Friday buying long-term
Treasury securities has stimulative benefits for the economy, but said buying
mortgage-backed securities is likely to have “more kick.”

Stein said Fed purchases of long-term Treasuries lowers not just Treasury
bond yields but also corporate bond yields, which enables them to reduce their
borrowing costs and extend the maturity of their debt.

However, he said buying MBS is likely to have a “more pronounced effect,”
making homes more affordable and spurring household spending.

Stein’s remarks, prepared for deliver to a conference co-sponsored by the
Boston Federal Reserve Bank and Boston University, come less than two weeks
before the Fed’s policymaking Federal Open Market Committee faces a major
decision on how to proceed with its asset purchases.

The Fed’s Maturity Extension Program, better known as “Operation Twist,”
under which the Fed has been buying $45 billion a month of long-term Treasury
securities, expires Dec. 31.

If the FOMC does nothing, aggregate Fed asset purchases will shrink from
$85 billion a month to $40 billion – the amount of mortgage-backed securities
the Fed is buying under the third round of “quantitative easing.”

Market expectations are high that the FOMC will continue buying assets at
an $85 billion a month pace in 2013, and MNI reported earlier this week that
there is “substantial sentiment” for doing so. But the FOMC must decide not just
the total amount of asset purchases but the preferred composition of those
purchases.

Stein seemed to be suggesting the FOMC might get more bang for the buck
from expanding MBS purchases rather than extending long-term Treasury purchases
at the current $45 billion a month pace. But he also cited benefits to Treasury
purchases.

Speaking at the same conference, Minneapolis Federal Reserve Bank President
Narayana Kocherlakota briefly reiterated his support for numerical thresholds
for unempoloyment and inflation in guiding the FOMC on how long its should keep
the federal funds rate at zero, but devoted the rest of his remarks to the “too
big to fail” bank issue.

Stein cited Fed Board estimates that past large-scale asset purchases
(LSAPs) of Treasury bonds have reduced Treasury term premiums to an historic low
of minus 80 basis points, and he said “there has also been substantial
pass-through to corporate bond rates.”

He said “a reasonable estimate is that, if the Fed were to undertake an
additional $500 billion Treasury LSAP, both long-term Treasury and corporate
bond rates might be expected to decline by something on the order of 15 to 20
basis points.”

The resulting reduction in the term premium on corporate bonds would likely
elicit a change in corporate financing behavior, making firms more likely to
issue longer term, rather than short-term debt, Stein said.

Stein said that would be “a good thing,” given firms tended to depend too
much on short-term financing in the past.

But he said reducing corporate bond yields would not necessarily induce
more capital spending.

In fact, “one might expect future rounds of Treasury-based LSAPs to have
diminishing returns, at least for corporate investment,” he said.

“(T)he data make clear that past rounds of LSAPs have pushed down interest
rates and term premiums,” he elaborated. “But the further the term premium is
driven into negative territory, and the more financing constraints are thereby
relaxed, the more the previous logic comes into play, and hence the weaker is
likely to be the response of aggregate spending to further downward pressure on
long-term rates.”

Stein noted that “as borrowing costs have fallen, Federal Reserve staff
estimates of the expected return on the stock market … remain high by historic
standards.”

“This unusually large divergence in the costs of debt and equity – due in
part to the cumulative effects of our LSAP policies – is likely to be one factor
that makes debt-financed repurchases of equity attractive,” he said.

When Stein went on to analyze the economic impact of MBS purchases, he
concluded that they are likely to be more effective because of their focus on
one credit market segment: housing finance.

He noted that MBS yields “fell dramatically” after the FOMC announced $40
billion a month in MBS purchases until the labor market improves
“substantially.”

While buying Treasuries has “a breadth of effect across markets,” MBS
purchases have “a more pronounced effect in a single market – namely, the
mortgage market,” he said.

“If … corporate investment reacts only weakly to further changes in term
premiums, there may be more ‘kick’ to be had by focusing efforts on a sector
that is more responsive,” Stein said.

“Moreover, it seems plausible that households’ spending behavior will in
fact be more strongly affected by changes in the mortgage rate,” he continued.
“As compared with many of the large firms that are active in the corporate bond
market, one might expect a greater proportion of households to behave as if they
are financially constrained. Hence, a reduction in the cost of mortgage
borrowing might be expected to allow households to spend more, either on a new
home or by using the proceeds from a mortgage refinancing for non-housing
consumption.”

Stein said “the bottom line is that I suspect that mortgage purchases may
confer more macroeconomic stimulus dollar-for-dollar than Treasury purchases.”

On the other hand Treasury purchases have their own benefits, he added.

For one thing, buying long-term Treasuries “are associated with increases
in stock prices, which in turn can have wealth effects on consumption and
investment.”

What’s more, they “may have something of an unintended benefit for
financial stability” to the extent they cause firms to rely less on short-term
debt, he said.

“I suspect that LSAPs have, by changing the structure of term premiums in
the market, helped encourage an extension of debt maturity by both financial and
nonfinancial firms,” he said. “All else being equal, this development is a good
thing from a financial stability perspective.”

Kocherlakota, in his prepared remarks, did not address the asset purchase
question at all, but did talk about “forward guidance” on the path of the funds
rate, though only briefly.

He recalled that in a recent speech he “stressed the importance of using
metrics about the inflation and unemployment outlooks to gauge the
appropriateness of monetary policy in light of those congressionally mandated
objectives.”

“Without these metrics, it is challenging to know whether monetary policy
is overly accommodative or not,” said Kocherlakota, who has advocated a 5.5%
threshold for unemployment and a 2.25% threshold for inflation.

Kocherlakota said similar “metrics” are needed to guide banking supervision
and regulation.

The Dodd-Frank Act mandates an end to “too big to fail,” the government
policy of bailing out some large financial firms but not others. But he said
“the public can only hold Congress and its delegees responsible for achieving
this mandate if there are quantitative measures of the size of the TBTF
problem.”

Kocherlakota recommended that market indicators, such as the difference
between large banks and small banks pay to borrow, be used to measure TBTF
banks.

–MNI Washington Bureau; tel: +1 202-371-2121; email: sbeckner@mni-news.com

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