By Steven K. Beckner

(MNI) – Should Federal Reserve policymakers decide that additional
monetary stimulus is needed at their June meeting — and that is not a
foregone conclusion — there is substantial sentiment for perpetuating
the soon-to-expire “Maturity Extension Program” or “Operation Twist.”

The alternative would be a third round of large-scale asset
purchases or “quantitative easing” (QE3), but there are those on the
Fed’s policymaking Federal Open Market Committee who see disadvantages
to doing so.

In Operation Twist, a $400 billion program due to expire on June
30, the Fed sells short-term U.S. Treasury securities from its portfolio
and uses the proceeds to buy long-term securities, resulting in no net
change in the Fed’s balance sheet or the supply of reserves.

By contrast, with outright quantitative easing, the Fed creates
reserves and expands the balance sheet.

QE3 is usually seen as a more aggressive way of injecting monetary
stimulus. But in terms of pushing down long-term interest rates, which
would be the main objective, many at the Fed believe there is not a
great deal of difference in impact between Operation Twist and QE3.

Indeed, internal estimates are that the $600 billion QE2, conducted
between Nov. 3, 2010 and June 30, 2011, and the $400 billion Operation
Twist, which began on Sept. 21, 2011 and concludes June 30, 2012, have
roughly the same impact on yields — 50-75 basis points.

If that is the case, then it might be better to continue the
maturity extension program and avoid the costs of another round of
large-scale asset purchases, it is felt.

Those costs include:

— potential losses on an enlarged securities portfolio if and when
yields rise and prices fall;

— the risk of feeding the perception that the Fed is working hand
in glove with the Treasury to finance deficit spending and monetize the
debt;

— the risk of alarming elements of the public, the legislature and
Wall Street already concerned about the longer term inflationary
implications of an expanded balance sheet — perhaps inflaming inflation
expectations, and

— compounding the difficulty of eventually executing an exit
strategy — shrinking the already huge balance sheet when the time comes
to remove monetary accommodation.

QE3 is not being ruled out, but the thinking in some quarters is
that it might be better to hold it in reserve in case economic and
financial conditions worsen and/or the Fed runs out of short and
medium-term assets it can sell to finance long-term securities
purchases.

The chief drawback of the maturity extension program is its
built-in limitations. At the conclusion of Operation Twist, the Fed will
have only about $200 billion in short-term Treasuries (dated three years
or less) to sell. However, the FOMC could decide to augment that amount
by authorizing the New York Fed to sell securities with remaining
maturities between three and six years.

Another option, which could be taken unilaterally or in conjunction
with a prolonged Twist program, would be to further revise the FOMC’s
“forward guidance.” The FOMC could delay the expected “lift-off” date
for federal funds rate hikes beyond late 2014.

But there would surely be resistance to doing that.

Alternatively, the FOMC could replace the “calendar date” with some
sort of “reaction function” — for instance wording conveying that the
Fed will hold the funds rate near zero until unemployment fell closer
the FOMC’s long-run projection of 5.2% to 6% unless inflation were to
run persistently above the 2% target.

Fed Vice Chairman Janet Yellen’s communications subcommittee has
been working along those general lines, but it may be difficult to
achieve consensus on such a revamped forward guidance in the near-term.

Another off-beat stimulus method that has gotten some attention not
long ago is so-called “sterilized quantitative easing” in which the Fed
would borrow short-term, via reverse repurchase agreements, to finance
long-term purchases. But MNI understands this is not under serious
consideration at this time. Among other concerns, it is feared that this
would backfire by putting undue upward pressure on the short end of the
yield curve.

Cutting the rate of interest the Fed pays on excess reserves has
been mentioned in the past, but has largely been dismissed as a
realistic option.

Quite possibly, the FOMC may choose to do nothing. It should
not be presumed that the FOMC will decide to inject additional stimulus
on June 20.

Depending on the complexion of economic and financial conditions on
June 20, the FOMC could well decide that it has already done enough by
holding the funds rate near zero since December 2008 and by buying more
than $2 trillion in bonds.

Fed Chairman Ben Bernanke, among others, has said that allowing
Operation Twist to expire would likely have only “minimal” effects on
yields. So the FOMC is not likely to put a new easing program in place
solely out of fear of an impending spike in yields.

The FOMC could content itself with simply maintaining its existing
policies of rolling over maturing Treasury securities into new issues
and of reinvesting principal payments on all agency debt and agency
mortgage-backed securities in the System Open Market Account in agency
mortgage-backed securities to prevent any passive shrinkage of the
balance sheet.

The FOMC could then argue that it is continuing to run a “highly
accommodative” monetary policy despite the expiration of Operation
Twist; that the economy is recovering, albeit slowly, with gradually
declining unemployment, and that American banks are strong enough to
withstand European shocks.

However, depending on how economic and financial conditions look on
June 20, the FOMC may feel forced to do something more.

The FOMC is “prepared” to take more balance sheet actions, as
Bernanke made clear after the April 25 FOMC meeting. He said the FOMC
“will not hesitate” to act if need be.

Of course, saying the FOMC is “prepared” is not the same thing as
saying it is poised to act. Certain conditions will need to be in place
for most policymakers to back additional easing.

MNI quoted officials on May 14 as saying the odds of additional
easing “could increase considerably to the extent that Europe’s debt
crisis reintensifies and threatens to worsen U.S. financial conditions
and undermine economic growth … . It would take more than a European
financial crisis by itself to induce the FOMC to launch QE3, however.
Policymakers would also need to see a combination of slower growth,
disappointing employment numbers and confirmation that inflation is
subsiding as the FOMC has been predicting e.”

New York Federal Reserve Bank William Dudley largely echoed those
conditions last week: “If the economy were to slow so that we were no
longer making material progress toward full employment, the downside
risks to growth were to increase sharply, or if deflation risks were to
climb materially, then the benefits of further accommodation would
increase in my estimation and this could tilt the balance toward
additional easing.”

By the time of the June 19-20 meeting, when FOMC participants will
revise their economic projections and funds rate forecasts, the
committee will have additional economic data, notably the May employment
report, in hand. And it will have seen how much further the
fast-changing European situation has deteriorated.

Whether to do more easing, how and by how much is likely to be a
tough judgment call.

** MNI **

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