MORGAN
NORTH
STANLEY
RESEARCH
AMERICA
US Economics Team
Morgan Stanley & Co. Incorporated
Richard Berner
Richard.Berner@morganstanley.com
David Greenlaw
David.Greenlaw@morganstanley.com
Ted Wieseman
September 8, 2010
US Economics
Ted.Wieseman@morganstanley.com
David Cho
David.Cho@morganstanley.com
What Can Ben Do?
Fed officials have recently outlined three specific
stimulus measures that could be used should the need
arise: 1) purchase more securities, 2) commit to lower
policy rates for longer, and 3) reduce the interest rate on
bank reserves.
The problem is that these options do not pack much
of a punch. In particular, pushing Treasury yields even
lower, when 10-year yields are already near 2.50% and
the mortgage refi pipeline is clogged, doesn’t really
accomplish much.
Opportunity to reduce real yields on mortgage debt
to sub-normal levels. Additional purchases of MBS
could provide significant stimulus, especially if they were
combined with implementation of a streamlined
refinancing program.
The Fed may consider purchasing other private,
non-mortgage debt. One additional option would be to
purchase other types of securities in order to have a
more direct impact on financial conditions. The Fed is
legally prohibited from purchasing most forms of private
debt, but there are ways around this restriction.
More stimulus is unlikely at September FOMC
meeting. The August employment report was hardly a
blockbuster, but it appeared to show sufficient signs of
progress to keep the Fed from implementing additional
monetary stimulus at the September 21 FOMC meeting.
But officials are likely to spend much of the session
debating the pros and cons of the various stimulus
options so that they can be ready to act should future
data prove disappointing.
For important disclosures, refer to the
Disclosures Section, located at the end of
this report.
MORGAN
STANLEY
RESEARCH
September 8, 2010
US Economics
What Can Ben Do?
David Greenlaw (New York)
that more Treasury buying would accomplish much, and thus
we doubt that additional easing efforts would stop there.
We continue to believe the US economy has entered a rough
patch that will prove to be temporary and that the Fed will be
back in exit strategy mode in 2011. Our basic view seems to be
shared by most members of the FOMC. However, downside
risks are evident for the near term, and as a result the Fed has
shifted their focus from exiting to the possibility of doing more.
Exhibit 1
Additional stimulus measures under consideration. In
recent months, Fed officials have outlined three specific
stimulus measures that could be used should the need arise.
They are: 1) purchase more securities, 2) commit to lower
policy rates for longer, and 3) reduce the interest rate on bank
reserves. The problem, as former Fed Vice Chair Alan Blinder
outlined in a recent Wall Street Journal op-ed, is that the
stimulus options the Fed has highlighted are not all that great
(see “The Fed Is Running Low on Ammo,” WSJ, August 29,
2010). Pushing Treasury yields lower — when 10-year yields
are already near 2.50% and the mortgage refi pipeline is
clogged — doesn’t really accomplish much. Indeed, we were
disappointed that Fed Chairman Bernanke’s Jackson Hole
speech did not include any new ideas. This omission
suggested that either the Fed has not yet come up with
anything else or the other options being explored are deemed
to be not yet fit for public consumption.
Purchasing Treasuries is not the only route to QE. As we
have pointed out previously, Bernanke believes that monetary
stimulus is all about the impact on interest rates (see our note:
“Now that the Dust Has Settled,” August 13). That’s one
reason why we believe the market’s focus on “quantitative
easing” is somewhat misplaced. Many investors appear to
define QE as central bank purchases of government debt —
even though 1) the term actually refers to stimulus provided by
the creation of excess bank reserves (together with the
associated impact on the monetary base) and 2) the Fed
entered into its current QE regime several months before it
started buying Treasuries or mortgage-backed securities
(MBS).
Real 30-Year Fixed Mortgage Rates
12
Real 30-Year Fixed
Mortgage Rate (Percent)
8
4
0
-4
71
74
77
80
83
86
89
92
95
98
01
04
07
10
Note: Real Yield equals Nominal less Yr/Yr Change in Core CPI. Shaded areas indicate
recession.
Source: MS calculation based on Freddie Mac and BLS data
Yields on mortgage debt have room to fall. In his Jackson
Hole speech, Bernanke noted that he relied on a “portfolio
balance” transmission channel whereby Fed purchases of
Treasuries would improve financial conditions by reducing
yields across the entire fixed income asset class. But there are
reasons to be skeptical of this model — especially when
Treasury yields are already so low. Indeed, even though the
Fed purchased more than $1.5 trillion of Treasuries and
government-guaranteed debt as part of the Large-Scale Asset
Purchase program (LSAP), real yields on mortgages and
corporate debt are holding close to normal levels (see Exhibits
1 and 2). That is where we see the real opportunity: There
should be plenty of room to provide stimulus by reducing yields
on mortgages and private debt to sub-normal levels. In
addition, the bang for the buck would be greatly enhanced if
policymakers were to combine additional purchases of MBS
with implementation of a streamlined refi program, along the
lines we described in our “Slam Dunk Stimulus” note published
on July 27, 2010.
Still, the signals from Bernanke and other officials suggest that
the first step toward additional monetary easing – should we
reach that point – would be to buy more Treasuries. That’s the
approach they are following for now in reinvesting the cash
flows from principal repayments of MBS. However, we doubt
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MORGAN
STANLEY
RESEARCH
September 8, 2010
US Economics
Exhibit 2
Real BAA Corporate Bond Yields
12
Real Baa Corporate
Bond Yield (Percent)
10
8
6
4
2
0
-2
58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Note: Real Yield equals Nominal less Yr/Yr Change in Core CPI. Shaded areas indicate
recession.
Source: MS calculation based on Federal Reserve H.15 and BLS data
Other pundits (including Alan Blinder) have also suggested that
the Fed could get creative by buying private sector debt, such
as corporate bonds or asset-backed securities. However, the
Fed is legally prohibited from purchasing most forms of private
debt. In 2004, Fed staffers David Small and Jim Clouse
published a detailed analysis of this issue (see “The Scope of
Monetary Policy Actions Authorized Under the Federal
Reserve Act” July 19, 2004). The legal issues involved are
quite opaque — for example, the Small/Clouse paper is 44
pages long and has 76 footnotes. Moreover, many of the
publications they reference (54 in all) date from the early 1900s.
Exhibit 3 contains a summary of the assets the Fed is
authorized to purchase based on the analysis of Small/Clouse.
Exhibit 3
Types of Financial Assets That May be Purchased
by the Federal Reserve
US Treasury securities
US agency securities (including securities guaranteed by US agencies)
Cable transfers
Bankers' acceptances
Bills of exchange
State & Local Government Obligations
Foreign Government Debt
Gold
Note: Some securities are subject to maturity limitations and other restrictions.
Source: “The Scope of Monetary Policy Actions Authorized Under the Federal Reserve Act”
July 19, 2004, by David Small and Jim Clouse.
Small/Clouse also identify the types of assets that the Fed is
explicitly not authorized to purchase. These include: corporate
bonds, commercial paper, mortgages, equity and land (other
than Federal Reserve premises). However, there are ways to
get around these restrictions. In particular, the Fed has relied
on its so-called 13(3) authority to create a financing vehicle for
private securities — as opposed to purchasing the securities
outright. (Note: Section 13(3) of the Federal Reserve Act
permits the Fed, in unusual and exigent circumstances, to
extend credit to individuals, partnerships and corporations.)
For example, relying on 13(3) authority, the Fed established
the Term Asset-Backed Loan Facility (TALF) as a means of
supporting the asset-backed securities market. Under the
TALF, the Fed provides non-recourse funding to any eligible
borrower who posts adequate collateral. The Fed also relied
on $4 billion of TARP funds provided by the Treasury to
capitalize the TALF.
The Commercial Paper Funding Facility (CPFF) is another
example of a program established by the Fed during the
financial crisis in which they were able to work around
restrictions on the purchase of commercial paper. The CPFF
provided a liquidity backstop to issuers of commercial paper
through a special purpose funding vehicle (SPV). The SPV
purchased commercial paper from eligible issuers using
financing provided by the Federal Reserve Bank of NY. In the
case of the CPFF, there was no TARP contribution from
Treasury and thus all credit extended by the Fed was with full
recourse to the SPV and secured by all the assets of the SPV.
Obviously, the Fed is getting pretty close to the edges of its
authority in establishing vehicles such as the TALF and the
CPFF, and this is one of the reasons that policymakers were
anxious to close down the programs as soon as market
conditions allowed. Moreover, the creation of similar programs
going forward will be complicated by the lack of available
funding from the TARP. Under the recently enacted
Dodd-Frank regulatory reform legislation, the TARP cannot
incur obligations for any new program that was not initiated
prior to June 25, 2010. Moreover, authority to make any
commitments whatsoever under the TARP will expire in
October 2010.
Given these constraints, the Fed is going to have to be
especially creative if they want to implement real monetary
stimulus that will have a meaningful impact on financial
conditions. The August employment report was hardly a
blockbuster, but it appeared to show sufficient signs of
progress toward a labor market recovery to keep the Fed from
implementing additional monetary stimulus at the September
21 FOMC meeting. Yet officials are likely to spend much of the
session debating the pros and cons of the various stimulus
options, so that they can be ready to act should future data
prove disappointing. We will be anxious to see if officials
expand their menu of stimulus options on the heels of this
3
MORGAN
STANLEY
RESEARCH
September 8, 2010
US Economics
meeting. Clearly, this stands in stark contrast to the FOMC’s
intense focus on exit strategy that prevailed up until only a few
months ago.
Finally, we should note that there are actually two ways to
reduce real private borrowing rates — raise inflation or cut
nominal yields. But, at Jackson Hole, Bernanke indicated there
was “no support” for an initiative aimed at increasing the
FOMC’s medium-term inflation goals above the levels
consistent with price stability.
4
MORGAN
STANLEY
RESEARCH
September 8, 2010
US Economics
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