Study Suggests Shift in Fed Bond-Buying

JACKSON HOLE, Wyo. â€" A new study finds that the Federal Reserve should keep buying mortgage-backed securities even as it stops buying Treasury securities, and even as it sells off its existing holding of Treasuries and mortgage bonds.

The study supports the Fed’s basic argument that buying bonds can help the economy, but it argues that the Fed made crucial mistakes in creating its bond-buying program, and that the Fed is at risk of compounding those errors.

Buying mortgage bonds has a larger economic effect than buying Treasuries, according to the study by Arvind Krishnamurthy, an economist at Northwestern University, and Annette Vissing-Jorgensen, an economist at the University of California, Berkeley.

But they found little economic benefit in holding mortgage bonds or Treasuries, a basic element of the Fed’s stimulus campaign.

And they argued that the Fed was undermining itself by failing to articulate a clear plan for the purchases. The paper was presented Friday morning at the annual monetary policy conference here in Jackson Hole, Wyo., convened by the Federal Reserve Bank of Kansas City.

There is broad agreement among economists that asset purchases have helped to hold down long-term interest rates indirectly, by signaling to investors that the Fed is serious about its plans to hold down short-term interest rates.

There have been persistent questions, however, about the direct benefits of the purchases.

Professors Krishnamurthy and Vissing-Jorgensen argue that the Fed’s purchases of more than $2 trillion in Treasuries since the financial crisis have had “limited economic benefits.” The purchases have cut the government’s borrowing costs, but they found little evidence for the Fed’s assertion that that has reduced borrowing costs for businesses and consumers.

It follows that “cessation of Treasury purchases or a sale of Treasury bonds will have small negative macroeconomic effects.”

They argue that the Fed should focus instead on buying mortgage bonds. The two professors found in an influential 2011 paper that the Fed’s purchases of mortgage bonds in 2008 and 2009 did reduce the cost of mortgages.

In the new paper, they write that the Fed’s current round of purchases has also worked, but for a different reason.

The first round of Fed buying helped because the financial crisis had constrained the resources of traditional bond buyers, in effect creating a shortage of demand for mortgage bonds, forcing sellers to offer higher interest rates.

The second round, by contrast, has worked because the Fed is reducing the supply of bonds available for purchase.

In both cases, the authors write, the benefit of the purchases is mostly limited to the housing market.

“It does not, as the Fed proposes, work through broad channels such as affecting the term premium on all long-term bonds.”

Interestingly, it also follows from this logic that selling the Fed’s existing holdings of mortgage bonds won’t have much impact on borrowing costs, because that would not affect the supply of the current crop of mortgage bonds.

Referring to mortgage-backed securities, the study says: “We conclude that an exit should proceed in the following sequence: The Fed should first cease its purchases of Treasury bonds and then sell down its Treasury portfolio. Second, the Fed should sell its higher-coupon M.B.S. as this will have small effects on primary market mortgage rates. The last step in this sequence is that the Fed should cease its purchases of current-coupon M.B.S. as this tool is currently the most beneficial source of economic stimulus.”

Professors Krishnamurthy and Vissing-Jorgensen argue that the Fed should be as clear as possible about its plans for this exit.

One of the most important developments in monetary policy over the last generation is the conclusion that central banks can increase the power of their actions by talking about their goals, thereby shaping the expectations of investors.

The Fed has embraced this approach in its core business of adjusting short-term interest rates, declaring that it intends to keep rates near zero at least as long as the unemployment rate remains above 6.5 percent and inflation remains under control. But it has not offered similar clarity about its bond-buying plans.

Fed officials have said that they want to remain flexible because they are still learning about the costs and benefits of asset purchases. The new paper argues that this is a mistake; it says that clarity about quantitative easing is even more important because of the large role of expectations in determining long-term rates.

“It is imperative that central banks outline a framework for the use of LSAP,” the paper says, using the acronym for asset purchases favored by cognoscenti. “Without such a framework, investors do not know the conditions under which LSAPs will occur or will be unwound, which undercut the efficacy of policy targeted at long-term asset values.”

In English: If the Fed doesn’t explain what it’s doing, investors will assume the worst, and borrowing costs will rise as if the Fed is doing nothing.