NEW YORK (MNI) – The following are the remarks of New York Federal
Reserve Bank Executive Vice President Brian Sack Monday evening
prepared for the annual meeting with primary dealers:
I want to thank you all for attending our annual primary dealer
meeting. The primary dealer community plays an important role in our
financial markets. Among other activities, your firms serve as key
counterparties for the implementation of monetary policy and provide an
important backbone for the government securities market. We appreciate
the productive working relationships that we have developed with all of
you over the years in support of these activities.
Given your function as counterparties for monetary policy
operations, I thought it might be useful to take this opportunity to
speak about the implementation of the policy decisions that the Federal
Open Market Committee (FOMC) made at its last meeting. As you know, the
FOMC took two additional policy steps aimed at supporting a stronger
economic recovery and helping to ensure that inflation, over time, is at
levels consistent with the dual mandate. First, the FOMC decided to
extend the average maturity of its holdings of securities by purchasing
$400 billion of Treasury securities with remaining maturities of six
years to 30 years and selling an equal amount of Treasury securities
with remaining maturities of three years or less. Second, the Committee
decided to shift the reinvestment of principal payments on its holdings
of agency debt and agency mortgage-backed securities into agency
mortgage-backed securities (MBS) in order to help support conditions in
mortgage markets.
The broad parameters of these policy steps were communicated in the
FOMC statement. However, the implications of these actions for financial
markets will depend importantly on the details of their implementation.
For this reason, the Trading Desk at the Federal Reserve Bank of New
York (the Desk) issued a statement at the same time as the FOMC
statement specifying the operational details of its plans to implement
the FOMC’s decisions, as it has done after other balance sheet actions.2
Today I will highlight some of those operational details and explain
some of our thinking for putting them in place.
On the Maturity Extension Program
Let me start with the Maturity Extension Program (MEP). The
motivation for this program was the same as that for previous asset
purchase programs by the Federal Reserve. As has been discussed on many
occasions, the effects of the asset purchase programs are thought to
arise from the amount of duration risk that they remove from the
portfolios of private investors. By removing duration risk, the Federal
Reserve puts downward pressure on longer-term real interest rates, which
in turn pulls down private borrowing costs and makes broader financial
conditions more supportive of growth. The MEP was intended to have the
same effects, only under a program that did not involve an expansion of
the Federal Reserve’s balance sheet.3
Duration risk can be measured in a variety of ways, but one common
measure for a securities portfolio is ten-year equivalents, or the
amount of 10-year Treasury notes that an investor would have to buy to
be exposed to the same amount of duration risk contained in the
portfolio. Some of the staff work that calibrates the economic impact of
the Federal Reserve’s balance sheet policies assumes that the effects on
yields and financial conditions are driven by the amount of ten-year
equivalents that the Fed takes into its portfolio.
By that metric, the effect of the Maturity Extension Program is
about equal in size to that of the large-scale asset purchase program
that ended in June of this year (what we have referred to as LSAP2).
This fact was highlighted in a recent post to the Liberty Street
Economics blog.4 In both cases, the effect of the program was to remove
about $400 billion of 10-year equivalents from the market.
However, while similar in their intent, there are differences
between a maturity extension program and an asset purchase program. Let
me highlight three of them that are related to the structure of the MEP.
First, the size of the MEP is limited by the amount of shorter-term
Treasury securities that the Federal Reserve could sell. As announced,
the program involves selling about 80 percent of our holdings of
securities maturing within three years, leaving little room to add to
the MEP. This constraint affected the choice of securities to be
purchased, as the purchases had to be at long maturities in order for
the program to remove a meaningful amount of duration risk.5 We
anticipate that the average duration of our purchases will be just over
10 years, or nearly twice as long as that for the purchases conducted as
part of LSAP2.
Second, unlike an asset purchase program, the MEP has implications
for the amount of debt that the Treasury has to issue over the next
several years. As you know, when the Federal Reserve has maturing
holdings of Treasury securities, the proceeds are automatically rolled
over into newly issued securities at Treasury auctions. However, under
the MEP, we will have sold $400 billion of securities maturing through
June 2015. With these securities no longer being rolled over to the
Federal Reserve, the Treasury will have to issue a larger amount of debt
to private investors, thereby reintroducing duration risk into the
market. This consideration was another reason why the purchases in the
MEP had to involve very long-term securities, in order to ensure that
the program removed a meaningful amount of duration risk from the market
even after the Treasury’s issuance.
Third, the program requires the Desk to actively sell Treasury
securities maturing over the next three years. This element of the
program was not intended to put upward pressure on shorter-term Treasury
yields. Indeed, with the FOMC indicating that it anticipates that
economic conditions are likely to warrant the current level of the
federal funds rate through mid-2013, I would have expected the 2-year
Treasury yield to remain well anchored. However, there has been some
modest upward pressure on the 2-year Treasury yield since the FOMC
meeting-a development that the Desk will continue to monitor.
In terms of operations, the program is being carried out over the
FedTrade system, which allows participation by all primary dealers in a
competitive bidding process for their own accounts or on behalf of other
market participants. Operations to sell securities were designed to
essentially have the same structure as purchase operations, in that we
take bids across a range of securities and select those that appear most
attractive.6 To date, we believe that the execution of our operations
has gone well.
On the MBS Reinvestments
Let me now turn to the implementation of the other policy
initiative from the last meeting, the decision to shift our
reinvestments into agency MBS. As noted earlier, the intent of this
action was to help support conditions in mortgage markets. One factor
prompting this decision was the ongoing widening between secondary
market rates on MBS and Treasury yields, which was keeping mortgage
rates higher than they otherwise would have been. Previous
communications had highlighted that changes in market conditions,
including a widening of the MBS spread, could prompt the FOMC to shift
its reinvestments into MBS rather than Treasury securities.7
This decision came as a surprise to the markets, in part because
the FOMC had communicated that it seeks to return to a Treasury-only
portfolio over time. However, the move to a Treasury-only portfolio has
always been described as a longer-run objective, in contrast to
near-term policy decisions that are instead driven by economic and
financial developments that have implications for the FOMC’s ability to
meet its objectives.
In any event, the MBS spread should now reflect that the Federal
Reserve is active in this market. The Desk anticipates that the pace of
MBS purchases will run at around $25 billion over the next several
months. Beyond that horizon, the pace of MBS purchases will depend on
the evolution of refinancing activity, as governed by the path of
longer-term interest rates, housing activity, and other factors.
The MBS purchases are being conducted internally by the Desk over
the TradeWeb platform. As with our Treasury operations, the process for
transacting in MBS is structured to follow a competitive process across
primary dealers to ensure that we are receiving fair market prices for
the securities. To date, the purchases have gone smoothly, and market
liquidity seems to be quite good.
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