Potential Costs of Asset Purchases

The Trading Desk at the New York Fed implements monetary policy on behalf of the Federal Open Market Committee (FOMC). Primary dealers are select banks and securities broker-dealers that trade U.S. government and select other securities with the New York Fed; they are trading counterparties in the implementation of monetary policy.

The primary dealers are surveyed prior to each FOMC meeting, and the survey results help the FOMC evaluate market expectations about economic, financial, and monetary developments. The questions on the survey change to reflect topics discussed in FOMC statements, meeting minutes, and FOMC member speeches. The January 2013 survey included the following question:

The minutes of the December FOMC meeting stated that while almost all members viewed the asset purchase program begun in September as having been effective and supportive of growth, they also generally saw that, "The potential costs could rise as the size of the balance sheet increased." Please rate the potential costs cited according to your current assessment of their importance in determining the size, pace, and composition of asset purchases going forward. (5 = very important, 1 = not important).

Here's a tabulation of the results from 21 primary dealers, provided by the New York Fed:

Most of the dealers rate an increase in inflation expectations as a low to medium risk of the Fed's asset purchases. In a speech on March 27, Eric Rosengren of the Boston Fed noted that "Most of the original critics of LSAPs voiced concerns over the potential impact on inflation and inflation expectations. However, the expansion of the Federal Reserve’s balance sheet began in 2008 and five years later we currently have a PCE inflation rate of 1.2 percent, well below our 2 percent target. As the years have passed and inflation has remained stable, this criticism has become more muted."

The second potential cost is "impairment of future implementation of monetary policy." Most of the dealers are at least moderately concerned about this, with 10 rating it at 4 or 5.  Sandra Pianalto of the Cleveland Fed expressed this concern in her speech, also on March 27, saying that "should inflationary pressures emerge, there is the risk that the Federal Reserve's ability to respond could be complicated by the size and composition of our balance sheet. We have developed tools to remove monetary policy accommodation when the time comes to do so, and we have even tested them on a small scale, so that we will be ready to use them. We have planned carefully, but we are in uncharted territory."

Most seem to agree that the effect on Federal Reserve net income is not an important cost of the asset purchases. There is moderate to high concern about effects on market functioning. Simon Potter, Executive Vice President of the New York Fed, explains this concern and how the Fed is addressing it:

There is a finite supply of Treasury securities and agency MBS available to purchase, in terms of both total outstanding amount and how much is available for purchase in the market at any given time. If the Federal Reserve were to become too dominant a buyer or holder, it could reduce the tradable supply of these securities and discourage trading among market participants, leading to diminished liquidity and price discovery. A significant deterioration in liquidity could lead investors to demand a premium for transacting in these markets, ultimately raising borrowing costs and undermining the program’s policy goal. 

With this concern in mind, the Desk closely monitors how our implementation of asset purchases impacts financial market functioning. In particular, we follow measures of market activity, such as trading volumes, bid-ask spreads, trade sizes, quote sizes, financing costs, and settlement fails, as well as other indicators. We also monitor indicators related to our operations, which can provide some direct insight into potential market functioning issues. These include the prices at which we can execute in comparison with prevailing market quotes, the extent and concentration of dealer participation in operations, and the ease of settlement of our MBS purchases... Based on these types of measures, our operations are going smoothly and market liquidity is holding up well. 

In addition to this monitoring, we have developed active policies to help prevent market dysfunction as a result of our operations. In the Treasury market, the Desk ceases purchases of a specific security once SOMA holdings of that security reach 70 percent of the outstanding stock. In addition, when SOMA holdings of a specific issue exceed 30 percent of outstanding securities, the Desk limits the rate at which it acquires new holdings of that issue based on a predetermined, graduated schedule.

Potential costs to financial stability are also seen as fairly important by the dealers, although a substantial minority (6 out of 21) rate this problem as just a 2. Fed officials are also divided on this issue. Rosengren expressed the less-worried position:

Some observers have noted that stock prices have risen quite substantially...Make no mistake, this would pose a financial stability problem if stock prices had significantly outstripped likely earnings – particularly if those investing in stocks had become highly leveraged and were particularly susceptible to a reversal in share prices... While share prices have risen, so have operating earnings. And while there has been some increase in the ratio, it remains well below the 20-year average. 

Other observers have noted that residential real estate prices have risen significantly in some markets, and that this could pose a financial stability problem. Since homes are normally purchased with significant debt, a rapid increase in prices could risk a repeat of the problems of the past decade...While housing prices have risen in many markets recently, they remain well below their peak prices. Furthermore, if one compares an index of house prices to a rent index (shown in Figure 6), assessing whether the values of homes are approximately in line with the services that housing provides, as reflected in rental rates, house prices have now fallen enough that this ratio is back to where it was in 1993, well before the run-up in house prices. 

Another area of potential concern has been the increase in high-yield bond issuance... Firms with high-yield bonds are refinancing those bonds, much like many homeowners have refinanced their houses. This refinancing improves the cash flow of companies and makes them more able to weather shocks. However, if these yields are low because investors are bidding aggressively for such bonds, reaching or over-reaching for higher yields in a low interest rate environment, then one would expect to see high-yield bond rates fall more than relatively safe rates, reflecting the strong desire to take on more of this debt at lower yields, despite its higher risk....The spread between high-yield bonds and 10-year Treasury securities is currently a little below the average spread over nearly two decades.That means that high-yield rates have fallen approximately in line with the rates on safe assets, implying stable rather than significantly diminished compensation for risk.

Last week, the Fed decided to continue its $85 billion per month of asset purchases. Charles Evans of the Chicago Fed said that "At the moment, it is not even a close call" that the benefits of continuing the asset purchases outweigh the costs.