Central Banks

Tuesday, April 16, 2019 - 10:51

MNI INTERVIEW:Fed To Buy Bills, Add Flexibility If Output Sags

--Repeating Story Initially Sent at 7:50 ET/11:50 GMT Tuesday

WASHINGTON (MNI) - The Federal Reserve wants to boost its holdings of short-term Treasury bills to give itself flexibility to stimulate growth in another downturn, but officials are wary of moving too quickly for fear of distorting markets, Philadelphia Fed economist Roc Armenter told MNI.

Owning more bills would allow the Fed to quickly reinvest maturing proceeds into longer-term debt to stimulate markets, a la 2011's Operation Twist, in which the Fed sold $400 billion of short-dated bonds and bought longer-term Treasuries to lower long-term rates and encourage people to invest in riskier assets.

It would also permit the option, if necessary, of more quickly shrinking the Fed's balance sheet -- by not replacing shorter-term securities as they expire, Armenter said.

He stressed that the Fed would not invest solely in bills, because it still wants to ensure an ample supply of on-the-run securities in the market and limit the central bank's impact on the yield curve.

"The question is how to weight neutrality against flexibility," he said. "All these neutrality considerations put a speed limit on how fast the composition of the balance sheet can change."

After calling an end to the reduction of its balance sheet in September, the Fed is now assessing the point at which it should once again purchase securities so that reserves remain steady as its liabilities, mainly currency in circulation, grow. Fed staff economists continue to study the option of introducing a standing repo facility to lower bank demand for reserves, Armenter said.


FOMC members are looking to normalize the long-run composition of the balance sheet, which now excludes bills. Over time, officials intend to move to a Treasuries-only portfolio, though the Fed still holds $1.6 trillion of mortgage-backed securities, some of which were just acquired and won't mature for 30 years.

The average weighted maturity of the Fed's Treasury holdings is around 92 months, compared to 69 months for all Treasury debt outstanding and the pre-crisis average of 40 months. Even just comparing notes and bonds, the average maturity of the Fed's holdings is one to two years longer than the outstanding universe of notes and bonds, Armenter said.

Shortening the duration of the Treasury portfolio more gradually means it will take a long time for the portfolio to converge to something closer to the universe outstanding, and the longer it takes, the "more likely that something happens before 'normal' is achieved in composition terms," Armenter said.

"Rates are not very far from zero, so if we were to face a recession, there's a good likelihood that rates will go back to zero and committee will consider balance sheet policies, and of course that will delay normalization."


On the flip side, a very aggressive policy of bills purchases will interfere with market functioning and "might even raise a bit of uncertainty about which securities we buy and which ones we sell," Armenter said. The Fed's buying more short-dated securities could result in a material reduction of supply to private investors, and if the Treasury does not ramp up issuances in response, it could even result in bill shortages.

The FOMC "wants to keep things gradual and predictable" above all else, he said, and that extends to shedding MBS.

Beginning in October, up to $20 billion per month of agency debt and MBS principal payments will be reinvested in Treasuries in proportions matching the outstanding Treasuries market, the FOMC announced last month. In addition, some MBS will be paid down earlier as borrowers move or refinance loans to take advantage of lower mortgage rates.

But on the whole, MBS are "not going to go away very fast," Armenter said. "There is a limited appetite (among FOMC members) to be aggressive in selling MBS," as the process involves repackaging the securities and risks hurting the somewhat fragile housing market.

--MNI London Bureau; +44 203 865 3829; email: jason.webb@marketnews.com


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