QE2: Not What The Market Is Expecting

If the FOMC were to move forward with an expansion of the balance sheet, it would presumably want to take into consideration the perspective gained from the asset purchases conducted from late 2008 to early 2010.  The FOMC would have to decide the extent to which a new purchase program would follow the approach from the earlier round of purchases.

An alternative approach would be to design a purchase program that shares more of the features of the FOMC’s adjustment of the federal funds rate in normal times.  After all, adjustments to the balance sheet are in many respects a substitute for changes in the federal funds rate.  Both instruments attempt to influence broader financial conditions in order to achieve a desired economic outcome.  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.  With this contrast in mind, I raise a set of policy questions that could be considered in designing a purchase program.

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.

– Brian Sacks, Executive Vice President, New York Federal Reserve, “Managing The Federal Reserve’s Balance Sheet”, October 4, Remarks at 2010 CFA Institute Fixed Income Management  Conference, Newport Beach, CA

Doug Kass brought my attention to this important speech by New York Fed Vice President Brian Sacks in a piece he wrote yesterday published on TheStreet.com titled “Kass: Fed Policy Pumps Asset Prices”.  But in his piece, Kass focuses on a secondary aspect of the speech.  Kass is amazed that Sacks admits that Fed policy is partly intended to prop up asset prices.  But regardless of whether Fed officials admit it or not, this has been obvious from the beginning.

What is important about Sacks’s speech is what it suggests about QE2.  The quote I lead this piece with is the crucial issue.  Sacks describes two alternative approaches to a new round of asset purchases.  The first would be “shock and awe” like QE1 when the Fed brought out the big guns and announced $1.8 trillion in asset purchases all at once.  This shocked the market and gave it a surge of adrenaline that propelled it.

The second approach would be a more “gradual” one.  As Sacks notes, in the past the Fed has influenced the credit markets through the Fed Funds Rate and it has generally chosen to make incremental changes.  In that respect, QE1 was a departure from the Fed’s standing practice.  The implication is that QE2 might be more gradual and conservative.  What exactly this entails I don’t know.

But it does suggest that if the market is expecting “shock and awe” from the Fed along the lines of what it did in 2009, it may be disappointed.