An Alternative To The Fed Forward Guidance

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I hesitate to write this piece, because I think doing this would be a bad thing.  Then again, I don’t believe that most of the jawboning done by the Fed is useful.

So let the Fed put its money where its mouth is, and, hey, improve its asset-liability match in the process.  After all, over the last five years, the Fed discovered that they have an asset side of their balance sheet.  They decide that they can try to twist the Treasury curve, lowering long rates, and stimulate the housing market via QE.

But aside from monetizing debt, which often leads to serious inflation, QE has not shown much potency to do anything good.  Thus the Fed thinks that enhanced guidance will be the tool to use to breathe life into this over-leveraged economy.  A possible example: “We promise not to raise the Fed funds rate until 2017.”

Deeds, not words, I say.  I challenge the Fed to do the following: Offer multiple tenors (maturities) of Fed funds.  At present, Fed Funds is an overnight rate.  Offer 1, 3 and 6-month Fed funds.  Offer 1, 2, 3, 5, and 10-year Fed funds.  Give the banks the ability to lock in funds for lending or investing for longer amounts of time.  Create the Fed funds yield curve.

Rather than merely promise that Fed funds will remain low for so many years, offer banks a way to have a guarantee of low Fed funds rates for that time period.  That would be powerful.  Whether it would be powerful for good is another matter.  Personally, I doubt it would be good, and I think the same of enhanced guidance.

In doing this, the Fed might realize that they have a liability side of the balance sheet, and one that does not have a zero duration.  If they have long term assets, why not long term liabilities?

Sigh.  In the old days it was easy.  The Fed did not have an over-leveraged economy, and so they invested in short-dated Treasuries, and adjusted Fed funds as their major policy lever.  Open market operations took care of the rest.

Introducing long term liabilities to the Fed means that policy accommodation can no longer be removed instantly.  The longer dated Fed funds would only shift as it matures.  It would give strength to monetary policy in the short run, but weaken it in the long run.  But hey, we are a short-run society, so why should we care?  Bleed our grandchildren dry, and have the great-grandchildren ready to be bled for our good.

Eventually we have to question why we are pursuing policies that harm the long-run in order to goose the short-run. Once we start doing that, we might be on the road to maturity, even if it means we get a severe recession, or even a depression.  The “greatest generation” was the greatest because of character formed out of depression and war.  Sad that they sucked the blood of their grandchildren via Social Security and Medicare.  We live with the results of their short-term thinking.

By David Merkel, CFA of Aleph Blog

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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