Morgan Stanley On What QE 2 Will Look Like

From Morgan Stanley:

How much will they buy? A wide range of options appear to be on the table, but based on the signals provided by Sack and other officials, it looks like the Fed is converging on a flexible approach that will involve a specified amount of buying (perhaps $100 billion) that would occur prior to the December FOMC meeting, with the amount scaled up or down from there at future meetings depending on economic and financial market conditions. Indeed, even a policymaker as dovish as Rosengren appears to favor such a gradualist approach. This pace of buying would be roughly in line with our estimated budget deficit ($1.15 trillion) for fiscal 2011. So, the Fed would be absorbing virtually all of the net new Treasury issuance as long as they maintained this pace of purchases.

Will the Fed continue to buy across the curve or will it focus its purchases at the long end of the market? This is a major source of uncertainty for the markets. We suspect that the Fed will stick with their current strategy of buying across the curve in order to maintain a 6- to 7-year average maturity of purchases. There are only about $550 billion of Treasuries outstanding with a remaining maturity of greater than 10 years. So, if the Fed were instead to concentrate its buying in this sector, it could have a powerful impact on long-term yields.

What about the 35% rule? The Fed has a self-imposed restriction that prohibits it from owning more than 35% of the outstanding amount of any individual Treasury security. But this rule can be waived at any time and thus does not represent a significant barrier to concentrated purchases.

Will they buy Treasuries only? Initially, the Fed is likely to stick to buying Treasuries, but over time it could scale into mortgage-backed securities. In particular, we suspect that the Fed may wind up targeting a gross amount of MBS holdings near $1 trillion. When the Fed surpassed this threshold in the first round of asset purchases, it appeared to trigger some significant dislocations in the MBS market.

What is the probability of an intermeeting move? From our standpoint, such action is unlikely but possible. The most obvious potential trigger is Friday's employment report. If the report is really bad (say, below 0 for private payrolls, for which we would assign about a 20% probability), then we would put the chance of an intermeeting move at about 33%. Combining these probabilities, we see maybe a 5-10% chance overall for an intermeeting move.

What will be the impact on the markets and the economy?
According to our trading desk, the market has already priced in a scenario close to the one we expect. And as we have highlighted previously, the economic impact associated with this type of monetary stimulus is likely to be quite modest. As evidence, we have cited results from a large-scale macroeconometric model maintained by Former Fed Governor Larry Meyer. For the past several decades, economists have recognized that such models are not particularly accurate when it comes to making short-term forecasts, but they are very useful for playing "What if?" games. Meyer's model is widely used in private and public policymaking circles for such simulations. Meyer estimated that a $2 trillion asset purchase program would 1) lower Treasury yields by 50bp, 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012, 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be "high-end estimates" because they don't take into account the unique nature of the current credit environment and the potential blockage of some of the normal transmission channels. Moreover, a relatively high probability of a resumption of asset purchases is already priced into the market, and thus a full 50bp response in Treasuries seems unlikely. In sum, there is good reason to believe that the pass-through benefits to the economy associated with a modest decline in Treasury yields will be quite limited.

Finally, what will be the long-run impact on inflation? There are several channels through which asset purchases could ultimately influence inflation. The most obvious would be if we are wrong about the economic impact and the program ultimately proves to be effective in stimulating growth - either in the US or globally - causing the economy to overheat before the Fed can unwind the stimulus. Also, there could be an impact on inflation arising from a significant elevation in inflation expectations. There has been a meaningful rise in market-based measures of inflation expectations in recent weeks as speculation regarding the resumption of Fed asset purchases has become more widespread. The Fed's actions could stir up some inflation via a decline in the dollar, but the trade-weighted value of the dollar stands about where it did at the start of the year, and many other countries appear to be engaged in policies aimed at achieving a competitive devaluation (or as former Fed and Treasury senior staffer Ted Truman terms it, "a competitive nonappreciation"). So it is hard to see the dollar moving enough to trigger a meaningful impact on domestic inflation.

The financial markets actually seem to be overly focused on what we consider some of the least likely transmission channels - namely, money supply and debt monetization. To date, the so-called money multiplier (the ratio of a monetary aggregate, such as M-2, to the monetary base) has declined by about the same amount that the monetary base has risen, leaving the money supply little changed by the expansion of the Fed's balance sheet. This reflects the fact that almost all of the excess bank reserves created by the Fed's balance sheet expansion have wound up being held in bank reserve accounts at the Fed (earning 25bp). Even a hard-core monetarist should not fear inflationary consequences from this type of balance sheet expansion until the money multiplier begins to normalize. Similarly, the debt monetization channel seems a little hazy. The Fed always monetizes a share of Treasury borrowing, and the current level of monetization is unusually low. Even $1 trillion of buying over the next year would leave the Fed's holdings of Treasuries within the historical range


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