Tuesday, August 10, 2010

Bernanke Is In His Helicopter, But What Does It Mean?

The New York Fed has just released details of how it will conduct the MBS reinvestment program. Key comments in the statement are:
On August 10, 2010, the Federal Open Market Committee directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (agency MBS) in longer-term Treasury securities. The most recent H.4.1 data release indicates that outright holdings of domestic securities in the System Open Market Account (SOMA) totaled $2.054 trillion as of August 4, 2010. The Desk will seek to maintain the face value of outright holdings of domestic securities in the SOMA at approximately this level....

In the middle of each month, the Desk will publish a tentative schedule of purchase operations expected to take place through the middle of the following month, as well as the anticipated total amount of purchases to be conducted over that period. The anticipated total amount of purchases will be calibrated to offset the amount of principal payments from agency debt and agency MBS expected to be received over that period. The announcement will occur shortly after the monthly releases of current MBS factors from Fannie Mae, Freddie Mac, and Ginnie Mae, allowing the Desk to anticipate the principal payments to be received by the SOMA portfolio over the period.

The first tentative schedule of purchase operations and the anticipated total amount of purchases to be conducted through the middle of September will be published tomorrow, August 11, at 3 p.m. The purchase schedule will include a list of operation dates, settlement dates, security types to be purchased (nominal coupons or TIPS), and a maturity date range of eligible issues for each scheduled operation. The Desk expects to begin purchasing Treasury securities under this policy on or around August 17.

The Desk will concentrate its purchases in the 2- to 10-year sector of the nominal Treasury curve, although purchases will occur across the nominal Treasury coupon and TIPS yield curves. The Desk will typically refrain from purchasing securities for which there is heightened demand or of which the SOMA already holds large concentrations.
The important points to keep in mind here are that although the Fed holds sizable quantities, make that very sizable ($2.04 trillion), most of the securities are 15 year and 30 year securities at original issue. This means most are not likely to be paid off for at least 5 years, probably much longer. Money to the Fed will flow as the result of refinancings and other prepayments.

B of A's Jeffrey Rosenberg is estimating that in the next 12 months $340 billion in MBS funds will be reinvested. If it does turn out to be this high. It could be very significant. This is roughly 17% of the total MBS instrument held by the Fed. It is also, and most important, equal to 4% of the money supply (M2). A 4% increase in the money supply, in and of itself is not enough to manipulate the economy into a pseudo-boom. However, it might be enough if the normal multiplier effect takes hold. Remember, if the Fed doesn't but directly from the Treasury in some kind of circle jerk to funnel money to Freddie and Fannie so that Freddie and Fannie give it right back to the Fed, and it doesn't appear that they are, then what the Fed is pumping into the system is super-money.

Back in the 1980's the super-momey multiplier was over 3, relative to M1. It crashed during the financial crisis, but was between 2 and 1.5 in the years before the crash.  M2 has tended to increase at a much more dramatic rate, but to keep things conservative let's assume that the multiplier is at the M1 rate of 2. This changes the growth rate from 4% to 8%  for M2 (Most likely more). This will start to have an impact on the economy in two ways. A pseudo, money manipulated boom will reignite and inflation will restart in earnest.

There is going to be a lot to watch over the next few weeks and months. First off,  in the months ahead we will be able to see how accurate Rosenberg's estimate of how much money the Fed will have to reinvest. If Rosenberg is correct, it will be roughly $30 billion per month. Second item to observe is to see if there is indeed a multiplier effect with the money the Fed adds. If Rosenberg is correct about prepayments, and the multiplier also does kick in, then we could be headed toward pseudo-boom inflation city.

One closing point I want to make is that some may ask, "Why this super-money could have such an impact now, when it didn't have such an impact on money supply when the Fed initially pumped these funds in?"  The answer comes by understanding the relationship between banks and the Fed during the initial purchases of the MBS instruments.  The Fed bought the MBS from the banks, but because the banks put these funds right back with the Fed as excess reserves, the funds never hit the system. HOWEVER, if the Fed goes out and buys Treasury paper in the open market, then there is going to be a bunch of non-banks, who for all practical purposes are going to be getting Fed checks (though there may be a bond dealer or two in the middle). Once this money is in the system, it's in the system. The bond seller will deposit the check with a bank and that bank may keep it as excess reserves, but the other side of that transaction is the depositor and that money is out in the system.

Bottom Line: Bernanke's tinkering and new tools are making things very complex and there are a lot of factors to watch. Further, it is not clear whether the multiplier effect will kick in with this money or whether banks will send these funds into excess reserves, which will dilute the impact, but not eliminate it.

Thus, at this point, this move has to be classified as jawboning in the sense that it is not a clear money supply booster as say a cut in the interest rate on excess reserves would be. That said, under perfect storm conditions, this move could be enough to result in double digit money growth. The mad scientist Bernanke has mixed a concoction that is bubbling, brewing and could very easily explode. Or another way to put it is that Bernanke is in his helicopter, he has filed a flight plan, but no one knows how much money he has taken in the helicopter. He doesn't even know, so buckle your seat belt, put your goggles on and as long term protection buy more gold.

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