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Assignment 7

Assignment 7

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Published by Antoine Gara

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Published by: Antoine Gara on Nov 01, 2010
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Antoine GaraAssignment 72.1 Years Later, QE 2.0 BeginsAfter an unsurprisingly soft advance third quarter GDP report of 2.0 percentgrowth, the market now ponders how the Federal Open Market Committee’s statement of a second round of monetary easing on November 3
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will differ in scope from the firstround pursued during the heat of the credit crisis.With core inflation running below 1 percent and unemployment above 9.5 percent, Friday’s GDP report shows a continued need for policymakers to quicken a slowrecovery in business investment and discretionary consumer spending. A sizeableincrease in consumption by individuals and corresponding spending by business is stillrequired for the economy to return to growth rates that lift prices and employment; dual parts of the Federal Reserve mandate. In a recent speech, William Dudley, president of the New York Fed stated that “viewed through the lens of the Federal Reserve’s dualmandate – the pursuit of the highest level of employment consistent with price stability – the current situation is wholly unsatisfactory.”Since the target interest rate of balances that are traded between institutionsholding reserves at the Fed is close to zero and guidance states that rates will stay low for an extended period, the Federal Open Market Committee must now decide how to act inexigent times to help money into risk assets and accelerate spending plans.In its Open Market Operations, the Federal Reserve can restore risk taking wheneconomic conditions or confidence is deteriorating by buying government securities or  private credits in exchange for new dollar liabilities. These actions called quantitative andcredit easing respectively adds a large buyer of risk assets, narrowing spreads to the pointthat it is possible or appropriate for other buyers to follow suit.According to Michael Cloherty, Head of US Rates Strategy at RBC, the Fed in its November 3
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statement will begin an open-ended operation of roughly 1 trillion dollarsof treasury purchases paced at 85 billion dollars a month for at least a year. He sees mostFed buying between the 4-year and the 10-year treasury and minimal purchases of the 30-year, mirroring its allocation of mortgage repayments into treasuries. According to a
 
Bloomberg report of Fed purchases tracked by Barclays, the Fed has reinvested 62.3 billion dollars of MBS repayments into treasuries, with 3.85 percent going into 20 to 30-year treasuries.The question is whether quantitative easing through treasury purchases can movemoney into the risk assets that will accelerate inflation, spending and hiring decisionswithin the United States. Since Fed Chairman Bernanke broached a second round of easing in Jackson Hole last August, equity markets have rallied 9.5 percent and the dollar index has dropped 7 percent.A recent report by Bloomberg Economist Michael McDonough showed that 6months after the 2008-9 round of credit easing, purchases of credit instruments by theFed were highly correlated with gains in emerging market assets and less to US assets.According to Michael Cloherty at RBC, the correlation is logical because overseasinvestors hold roughly half of all treasury assets. A move into emerging market equitiesand currencies therefore reflects a natural flow of funds into higher yielding assets.In an phone-interview, Michael Pond Co-Head of US Rates Strategy at BarclaysCapital judges easing to work if it moves people into the assets that raise equity prices,household net worth and eventually discretionary spending. In this sense, he thinks, “theFed should certainly be concerned if the move into risk assets doesn’t increase UShousehold net worth, but instead, emerging market household net worth.” He is alsoconcerned that quantitative easing might not be the most direct tool to lower borrowingcosts to homeowners and businesses.If, after easing, credit spreads widen, he sees that “the Fed might look to moveinto other markets.” These uncertainties, along with the chance that recovery comesquicker than expected, belie expectations that the Fed wants flexibility and will make anopen ended statement on November 3
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. Friday’s GDP report did not change the argumentfor Fed easing. According to Mr. Pond, “if core inflation had increased it might have been a signal not to rush on easing, but core PCE increased 0.8% demonstratingcontinued low inflation, keeping the need for easing unchanged.”Open-ended language will also be used by the FOMC to describe inflationexpectations according to Lyle Gramley, Senior Economist at Potomac Research Groupand former Federal Reserve Board Governor. Although “the Fed is not ready to talk 

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