Some Comments on the FOMC Statement

The FOMC statement on Tuesday indicated that the Fed now thinks the economy is weaker than previously thought. In view of this, the Fed has committed to keeping its balance sheet roughly the same size by reinvesting the proceeds of principal payments of the securities it acquired during the financial crisis in Treasuries, mainly those with a maturities ranging from two to ten years.

Given the uncertainty about the outlook for the economy and prices, it is no surprise that the Fed decided to take this middle course. Those who think the risk of deflation and another recession (or worse) is serious, such as Paul Krugman, argue that the Fed should expand its balance sheet. There is, however, no consensus about this among economists, and some are worried if the Fed acts too aggressively to forestall potential deflation, we will get unacceptable rates of inflation instead. While many commenters on this sound awfully sure of themselves, the fact is that no one really knows what the Fed should do.

The stock market fell significantly on Wednesday, the day after the FOMC announcement. The common explanation is that this was in reaction to the Fed’s more pessimistic outlook on the economy. Well maybe, but I am skeptical of most explanations of daily stock market moves. You can always find some news item to “explain” the move after the fact. No one does a comprehensive survey asking the sellers of securities why they sold or the buyers why they bought on a particular day.  

For anyone paying attention, there was no need for the Fed to verify that the economy was stalling, nor was it any surprise that that the Fed was concerned about it. If the market had gone up, the explanation would likely have been that the Fed was optimistic enough about the economy that it considered it unnecessary to increase the size of its balance sheet at this time. As a thought experiment, one might consider what the likely market reaction would have been if the Fed had decided not to reinvest principal payments or had decided to increase the monetary base by expanding its balance sheet.  It is not so easy before the fact.

As to how the FOMC announcement may affect the Treasury, the Fed’s purchases will affect the maturity structure of marketable Treasury securities held by the public (excluding the Federal Reserve Banks). My guess is that Treasury will not alter its current debt management strategy in light of this, but, at some point, maybe Treasury debt managers need to think about this, since the Fed’s holdings of private securities are quite large.

Also, the Treasury should consider why it is issuing Treasury bills and depositing the proceeds into the supplementary financing program account at the Fed. As of Wednesday, there was almost $200 billion in this Treasury account at the Fed. The reason for this program was to help the Fed reduce the amount of reserves held by the banks at a time when the Fed’s holdings of Treasury securities that it could sell had declined. But with the Fed’s holdings of Treasuries increasing as the principal balance of the private securities it holds decreases, the question arises why this program is still necessary. (I have expressed concerns about this program on this blog.)