The Fed shouldn’t be getting into “allocating credit.”
The new Fed has trouble taking shape. The seven-member Board of Governors, which is at the core of the policy setting FOMC, has four vacant slots. President Trump’s nominee for one of those slots, Marvin Goodfriend, has been hung up in the Senate for months and appears to go nowhere. Two other nominees are currently trying to navigate the confirmation process: Michelle Bowman, a banking regulator from Kansas; and PIMCO executive Richard Clarida for the vice chairman slot.
Chairman Jerome Powell is a lawyer, not an economist. So for balance, the vice chair is going to be a tried-and-true economist. Clarida fits the bill. But when he testified before the Senate Banking Committee on Tuesday, his views seemed to be a mirror image of Powell’s views. And that’s why what Clarida said about mortgage-backed securities on the Fed’s balance sheet is so interesting – even if he doesn’t make it through the Senate confirmation process – because it likely shows the direction of Powell’s thinking as well.
First things first. Like Powell, Clarida said he “absolutely” supports the Fed’s normalization of interest rates and the balance sheet. Like Powell, he said that the normalized balance sheet should be “a lot smaller,” and that Powell’s suggestion of a range of $2.4 trillion to $2.9 trillion, down from its peak-level of $4.5 trillion, “makes sense.”
Like Powell, he said stock market volatility itself – that’s downward volatility, the only volatility that matters on Wall Street – shouldn’t determine the Fed’s policy decisions. On banking regulation too he mirrored Powell.
So in this sense, what he said about mortgage-backed securities on the Fed’s balance sheet is fascinating: The Fed should shed them entirely, down to zero.
Clarida explained that there are “benefits and costs” of QE, and that as more layers of QE were piled on, “the benefits of QE diminished and the costs went up.” And as vice chairman, he’d “have to take a serious look at the costs of QE.”
Then he was asked about “non-Treasury instruments, like mortgage-backed securities,” for QE – that the Fed, when selecting non-Treasury securities, would be getting into something that it shouldn’t, namely “allocating credit.”
“Yes, absolutely,” Clarida replied: “My preference would be for the Fed to end up with a Treasury-only portfolio.”
He then added that, “as a general proposition, my preference would be to have the balance sheet as much as possible in Treasury securities.”
Shedding MBS from the balance sheet entirely and keeping them off could have a big impact. Currently, the Fed holds $1.74 trillion of MBS. That’s about 26% of all residential mortgage-backed securities outstanding. The Fed is the elephant in the MBS room.
Over the years, given the magnitude, the Fed’s MBS purchases and holdings have been a big force in the mortgage market, helping to push down yields of residential MBS, and thereby helping to push down mortgage rates.
That Clarida is thinking about shedding them entirely appears to be unrelated to mortgage rates per se, and all about what types of decisions the Fed should stay out of – and in this case, that the Fed should stay out of “allocating credit,” which would give one type of private-sector bond a competitive advantage over other types that are not being selected.
This was perhaps also a veiled criticism of the ECB’s QE program, which very specifically and publicly is “allocating credit” by buying (in addition to government bonds) corporate bonds, asset-backed securities, and covered bonds. The individual corporate bonds the ECB has acquired can be viewed in its public data base. For a company, having its bonds acquired by the ECB is deemed a stamp of approval and has pushed the yields of those bonds, and thus the cost of borrowing, way down. In other words, the ECB decides on a daily basis that certain types of private-sector credits, such as bonds of specific companies, will get preferential treatment, and others will not.
Clarida seemed to be saying that the Fed shouldn’t get into these decisions of preferential treatment in the private sector, that at first it might be MBS, but then, like the ECB, the Fed might slither into other credits, such as corporate bonds. Hence, stick to Treasuries only. And given that he and Powell are on the same page on just about all other issues brought up, it’s likely that this view is shared as well.
The Treasury Department reported that foreign holdings of Treasury securities rose by $220 billion over the 12 months through March 31. Over the same period, the US gross national debt surged by $1.24 trillion. Japan systematically dumped US Treasuries while China hung on. So who bought those Treasuries? Read… But Who the Heck Bought the $1.2 trillion in New US Debt Over the Past 12 Months?
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