-‘Strong Case’ to Continue Asset Purchases

By Brai Odion-Esene

WASHINGTON (MNI) – Boston Federal Reserve Bank President Eric Rosengren
Monday threw support behind continued aggressive measures by the Fed next year
to spark a more sustained improvement in near-term labor market conditions.

Arguing that the Fed’s asset purchases have had a positive impact despite
the major headwinds facing the economy, Rosengren called for maintaining the
current pace of $85 billion a month in long-term security purchases, even after
the Fed’s maturity extension program, known as ‘Operation Twist,’ ends.

“Given the tepid economic recovery, high unemployment, and subdued
inflation – and the uncertainty around fiscal policy – I believe an
accommodative monetary policy is quite appropriate,” he said in a speech
prepared for delivery to the Boston and New York Fed’s joint-workshop on The
Spread Between Primary and Secondary Mortgage Rates.

“So in my view, a strong case can be made for the Federal Reserve
continuing to purchase the current $85 billion in longer-term securities a month
– even after our so-called “Operation Twist” maturity-extension program (a
portion of those purchases) is completed at the end of 2012,” Rosengren said.

He argued the central bank purchases of long-term Treasury securities
flatten the yield curve, causing other medium- and long-term rates -such as
those on autos and houses – to decline, which will stimulate demand.

And buying mortgage-backed securities is likely to have an impact beyond
the mortgage sector, Rosengren added, causing rates to decline for other
longer-duration assets.

“By altering interest rates faced by firms and households, as well as
expanding the amount of reserves, the transmission of monetary policy is likely
to be much more effective given that the economy has already reached the lower
bound for short-term interest rates,” he said.

Rosengren argued that the pass-through from the Fed’s actions to consumers
has been “quite large,” and is an important reason why the U.S. economy has
fared better than its counterparts in the developed world.

He pointed to the fact that while businesses remain on the sidelines due to
uncertainties surrounding the looming fiscal cliff and Europe’s struggles,
household spending continues and housing-related activity has picked up.

“Thus it is heartening that despite the economic uncertainties, households
seem more confident in the economic future and are again purchasing long-term
assets such as houses,” he said. “We want to see continued improvement in labor
markets in the near term, and monetary policy should encourage faster economic
growth to achieve that objective.”

While accommodative monetary policy has provided vital support for an
economy yet to fully break out of its malaise, Rosengren said the Fed’s attempt
to spur growth via lower mortgage rates “is complicated by a variety of
institutional factors.”

Among these factors he listed are the market structure of mortgage lenders,
the cyclical nature of refinance activity, changes in the credit profile of
borrowers, changes in the role of Fannie Mae and Freddie Mac in the mortgage
market, and expectations of future interest rate changes that impact the
likelihood of refinancing activity.

“At times changes in these factors can provide headwinds or tailwinds
impacting the efficacy of the policies,” he said.

Rosengren noted that some believe the Fed should maintain a short duration
Treasury portfolio, arguing monetary policy would be “sufficiently” expansionary
by adding bank reserves.

He countered, however, that exchanging Treasury bills with a low interest
rate for bank reserves carrying a low interest rate will have little in the way
of interest rate effects. In addition, the banking sector would be forced to
hold more low-interest reserves at a time of scarce capital and when many want
to shrink rather than expand their balance sheets.

“Thus, when interest rates are already at the zero lower bound, a
short-maturity reserves-focused policy will not have much impact on inflation or
employment,” he said.

But while he prefers the spread-focused approach, Rosengren acknowledged
that it carries some risk.

“Because the duration of assets is much longer, the balance sheet will not
automatically shrink as rapidly when purchases are discontinued,” he said.

“Furthermore, if the plan is fully effective and quickly restores the
economy to more normal financial conditions – including higher market interest
rates – then the market value of the central bank’s portfolio of low-yielding
securities will inevitably decrease.”

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

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