New Fed Policy, old policy, right one, wrong one?

New Fed Policy?

Same old Fed policy?

The Fed has a new plan. It’s to do something then to blunt the impact of what it has done. Is this better than doing nothing? Or is nothing better than more of this too clever-by-half seemingly sophisticated Fed fiddling?

The plan is to allow the Fed to continue to buy long term securities (Treasuries or mortgage paper) even if oil prices rise. To blunt the impact of the stimulus from reserve creation the Fed would do matched sales (reverse repos) an operation in which the Fed takes out the same reserves it just put in with the long-term securities purchase. The Fed gets an interest bearing loan secured by market paper from its dealers in the short term markets and ‘presto-chango’ nothing has happened with reserves. Well something has happened but not with reserves. The amount of reserves in play remains the same. There are fewer long term securities and more short-dated paper for the dealers. It looks a lot like Operation-Twist with an extra twist (actually one twist fewer). So maybe since this is lacking part of the twist operation we should call it ‘operation twit’ and lose the ‘S’? Just a thought…

In the Fed’s Operation Twist its focus is on two different securities on the treasury yield curve one long-dated, the other short. The Fed buys the long term security and sells the short one trying to ‘twist’ the yield curve lower.  For this new operation the Fed would use one Treasury security (or mortgage bond) and a short term collateralized loan. As with Op Twist there would be no reserve impact.

On balance there would seem to be some yield curve effects from an operation of this kind. The Fed would be taking duration and perhaps some credit risk out of the market. But the Fed blunts the reserve effect the same as it does with Twist. And since the reverse RP’s can be rolled over (or not) the Fed gains a mechanism it can use to manage reserve effects if it wants to.

What is odd about this operation is that it is another way for the Fed to try and stimulate the economy. This new plan comes at a time that the economy is doing better. The reverse RP would be just be another thing to get in the way of the Fed when it finally needed to shrink its balance sheet. This is also to say that the long term security purchase envisioned by the Fed goes in the wrong direction if the economy is improving. But this plan tells of the Fed’s biggest fear. It is not yet dealing with the idea of shrinking its balance sheet.   

With Bernanke having just testified before the Senate and the House committees and with the take-away having been that he did not seem too eager to do another QE, it is odd that the Fed would come up with another Operation-Twist type of transaction.

With the economy doing better it is still possible that there will be some unexpected backsliding. But is a real unravel the biggest risk? The big issue we know the Fed has to prepare for is to shrink its balance sheet and this proposal goes in the other direction.

At the end of the day, the Fed is doing everything it can to convince us that it is willing to stay easy for a long time and that it has many different options for policy to help the economy. But it is doing very little to convince us that good times are just around the corner.

As the Fed makes further preparations for never ending sluggish growth, the economy is doing better. Job growth has picked up. The Non MFG ISM just this week has been quite strong. And unit labor costs are now rising more than they have in some time gaining 2.8% Q/Q annualized on the back of gaining 3.9% in Q3. We have to go back to Q3 and Q4 of 2008 to find two stronger quarters for ULC growth. But those quarters saw falling productivity push up ULC. We are seeing ULC rise in the face of still growing productivity.  ULC are up by 3.1% yr/yr the highest since Q4 2008. Still, the Fed’s focus has been on how it could do more to stimulate the economy.

The rise in unit labor costs has economists buzzing if not anyone else. Job growth has picked up and yet, the unemployment rate is still very high. Still, we are getting these wage pressures. Some are wondering if the NAIRU unemployment rate might be higher than the 5.5% the Fed talks about. It’s possible.

But this ULC/productivity report is a reminder that the economy does not conform to stereo-type views of it. We have had stagflation (low growth and with high unemployment and high inflation). Just because the economy has slack does not mean it cannot create some price pressures. Some theory might say that it can’t but the fact of it is that it is happening. We are making policy in the real world. This appearance of elevated labor costs will be something to watch very closely; it’s not a development that would have the Fed expanding its balance sheet further. But that is still the way that Fed policy tilts. Is the Fed getting behind the curve? If this keeps up, that question will asked more often.