By Steven K. Beckner

(MNI) – “However, the way in which the FOMC implemented asset
purchases differed in important ways from the manner in which it has
historically adjusted the federal funds rate,” Brian Sack, head of the
New York Federal Reserve Bank’s open market desk, added, before
outlining some of the key design issues:

* “First, should the balance sheet be adjusted in relatively
continuous but smaller steps, or in infrequent but large increments? The
earlier round of asset purchases involved the latter approach, which
caused the market response to be concentrated in several days on which
significant announcements were made. That might have been appropriate in
circumstances when substantial and front-loaded policy surprises had
benefits, but different approaches may be warranted in other
circumstances. Indeed, it contrasts with the manner in which the FOMC
has historically adjusted the federal funds rate, which has typically
involved incremental changes to the policy instrument.

* “Second, how responsive should the balance sheet be to economic
conditions? Historically, the FOMC has determined the federal funds
target rate based on the Committee’s assessment of the outlook for
economic growth and inflation. If changes in the balance sheet are now
acting as a substitute for changes in the federal funds rate, then one
might expect balance sheet decisions to also be governed to a large
extent by the evolution of the FOMC’s economic forecasts.

* “Third, how persistent should movements in the balance sheet be?
An important feature of traditional monetary policy is that movements in
the federal funds rate are not quickly reversed, which makes them more
influential on broader financial conditions. A change that was expected
to be transitory would instead move conditions very little. For similar
reasons, one could argue that movements in the balance sheet should have
some persistence in order to be more effective.

* “Fourth, to what extent should the FOMC communicate about the
likely path of the balance sheet? The FOMC often communicates about the
path of the federal funds rate or provides other forward-looking
information that allows market participants to anticipate that path.
This anticipation of policy actions is beneficial, as it brings forward
their effects and thus helps to stabilize the economy. For the same
reason, providing information about the likely course of the balance
sheet could be desirable.

* “Fifth, how much flexibility should the FOMC retain to change its
policy approach? The original asset purchase programs specified the
amount and distribution of purchases well in advance. However, the FOMC
would be learning about the costs and benefits of its balance sheet
changes as it implemented a new program. This might call for some
flexibility to be incorporated into the program, providing some
discretion to change course as market conditions evolve and as more is
learned about the instrument.”

At its Aug. 10 meeting, the FOMC instructed the open market desk to
reinvest proceeds of maturing mortgage backed securities in longer term
Treasury securities to prevent the balance sheet from shrinking, and the
New York Fed announced at the time that its objective would be to keep
the balance sheet from falling below the then-prevailing $2.054
trillion.

Sack portrayed this as a rare instance of balance sheet targeting.

“This is a notable development by itself, as the directive from the
FOMC now involved two targeted variables — the target range for the
federal funds rate, and the target size for its asset holdings,” he
commented.

Noting that the New York Fed has been buying $27 billion of
Treasuries per month, he said, “we expect that pace to bump up to around
$30 billion for the next several months.”

“Looking further ahead, we currently project that the cumulative
amount of principal payments on agency debt and agency MBS through 2011
will be somewhat higher than the estimates provided at the August FOMC
meeting,” he said.

Sack said the market impact of the reinvestment purchases “will be
tied to the amount of duration risk that such purchases encompass. Thus,
the composition of purchases across maturities will be quite important
in governing the effects on financial conditions.”

The open market desk has followed the pattern of purchases that was
implemented in the earlier Treasury purchase program, with purchases
concentrated in nominal Treasury securities with remaining maturities
between 2 and 10 years.

“The average duration of the securities purchased is expected to be
just over 5 years, although the exact realized outcome will depend on
the offers that we receive in our operations,” Sack said. “Under this
approach, the purchases will remove a considerable amount of duration
from the market relative to what the market would have held without
reinvestments by the Federal Reserve.”

In deciding to reinvest maturing MBS in Treasuries, Sack said “one
crucial consideration was whether purchasing Treasury securities would
have an effect on longer-term interest rates comparable with that of
purchasing MBS.” He said his view was that “the effects would be
similar, because purchasing longer-term Treasury securities removes as
much duration risk from the market as purchasing current-coupon MBS.”

Leaving the door open to future purchases of MBS, as well as
Treasuries, Sack said that “purchasing MBS also removes prepayment risk
from the market.”

“If the market were to begin having trouble digesting that
prepayment risk, the spread between MBS rates and Treasury yields could
widen,” he said. “A significant widening of MBS spreads to Treasuries,
whether due to this or other factors, could affect policymakers’
decisions about which assets to purchase.”

“The Chairman’s speech in Jackson Hole and the August FOMC minutes
both indicated that reinvesting in MBS rather than Treasury securities
might become desirable if market conditions were to change,” he noted.

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** Market News International **

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