FT Alphaville " The pros and cons of the Fed's three options Nothing was decided in the March 13 FOMC statement, though it did include the Fed's cautious recognition that the prospects for the US economy had improved since the start of the year. But the minutes from the meeting, set to be released on Tuesday at 2pm EST, are likely to scrutinised carefully for any discussion of what the Fed might do next. Our own guess is that we won't learn much, as even the dove-ish members probably want to wait a little while to better judge the resilience of the labour market's improvement this year. Whatever the case, Carl Lantz of Credit Suisse has a helpful overview of the pros and cons of the Fed's options for when Operation Twist expires at the end of June. Pros The benefit of the Fed reverting back to outright reserve creation is that it would providefor greater stimulus than could be achieved through maturity extension, as it wouldn't be limited by the assets available to sell. It would also better enable the FOMC to target the most relevant borrowing rates. In its maturity extension program, the limited volume of saleable assets prompted the Fedto direct a greater proportion of its purchases into the long end than had been the case inQE1 or QE2 in order to achieve similar duration extraction. In contrast, without similar constraints, the Fed could focus its purchases where it would most impact borrowing costs, despite less efficient duration extraction. Balance sheet expansion would most directly allow the Fed to target assistance to the mortgage market by creating incremental net demand... Cons The main drawback of outright QE is the reaction that it would elicit from monetarists about the potential impact of a further increase in excess reserves on inflation. The Fed largely discounts any impact of higher reserve levels on inflation in the current environment and has emphasized its capability to keep this cash in its hands even as the economy recovers through its TDF (term deposit facility), RRPs (reverse repos), and adjustments to IOER (interest on excess reserves). Nonetheless, inflation expectations are a psychological phenomenon that can be self fulfilling,so if enough people believe reserves will feed inflation, it could happen despite any fundamental cause. 2 - Sterilised QE The benefits of a sterilized purchase program would be essentially the same as QE3. The one additional benefit is the fact that it would not raise the alarm bells of monetarists concerned about another increase in reserves. One drawback of sterilizing a portion of QE would be the impact on front-end rates. ... Sterilization would likely dampen the positive impact of the Fed's MBS purchasescompared to outright transactions because potential increases in short-term rates would reduce carry. ... The primary drawback is the potential hit to Fed credibility. Chairman Bernanke and other influential FOMC members have long expressed confidence that the current level of reserves is not an issue and that draining them in the future will not present a problem. To now arbitrarily sterilize a portion of excess reserves would seem to contradict that view and lend credence to those concerned about reserve levels. Indeed, we discussed in our March 9 weekly the fact that sterilization would largely represent window dressing, as the draining tools are unlikely to be sufficient to suck out all the reserves. As such, any further increases in excess reserves should further complicate the Fed's eventual need to drain, whether or not the purchases are sterilized. We'd hasten to add that despite all the talk about what sterilised QE would look like, it's unclear how seriously it's being considered within the Fed. In our opinion, sterilised QE would also be as much about easing strains in money markets by providing additional collateral against which yield-hungry money market funds could engage in reverse repos. 3 - Extending Twist First, it would avoid the potential policy mistake of withdrawing stimulus prematurely. Second, given that it is the status quo, it would not really represent a change in policy and could be used to push off a directional decision until after the November elections. Third, it should be relatively uncontroversial, as it seems to be viewed as more of a technical operation by the political class. Taken together, an extension of twist would likely fly under the political radar whilecontinuing to support longer-term rates until after the elections. Another potential direction the Fed could take with twist would be to extend it in a hybridized fashion, selling short-dated Treasuries, but reinvesting the proceeds into a combination of Treasuries and agency MBS. The main benefit of this hybrid approach would be the targeted support to mortgage rates that Fed officials appear anxious to provide, while still remaining relatively innocuous to monetarists. The drawback to either form of twist is the fact that there are limited quantities of assets to sell to support the purchases. If the Fed desired to be more impactful than its maturity extension program has been, an extension is unlikely to be sufficient. Another complication is the impacton the front end of the coupon curve of such a high volume of Fed selling. Since the implementation of Twist, the 2-year Treasury spread to OIS immediately widened in anticipation of front-end sales. The spread would likely widen further upon an extension. There is, of course, a fourth option: let Twist expire and do nothing to replace it. Barring an extraordinary acceleration in the recovery during Q2, this remains unlikely. This entry was posted by Cardiff Garcia on Tuesday, April 3rd, 2012 at 18:48 and is filed under Capital markets. Tagged with FOMC, FOMC minutes, qe, sterilised QE.