1. Change in balance sheet composition. This policy option is the single most likely step at this week’s meeting, in our view. It has been dubbed a new “Operation Twist” after a similar Fed program in the 1960s. We believe the Fed will announce outright sales of short-term Treasuries coupled with purchases of longer-term Treasuries in order to lengthen the average maturity of its securities portfolio. Minutes from the August FOMC meeting signaled that active turnover of the balance sheet—sales and purchases—was the option under consideration, rather than the smaller and more passive step of reinvesting ongoing purchases related to MBS reinvestment further out the curve (though this would likely accompany the “twist”). If the FOMC announced only a shift in the maturity of MBS reinvestment flows we would consider it a significantly smaller-than-expected ease.

While an announcement along these lines appears very likely, we still see considerable uncertainty about the precise size and composition of the “twist”. The Fed owns $266bn Treasury notes and bonds that mature before the end of June 2013—over the period during which it has signaled to keep rates exceptionally low—and another $232bn that mature over the following year. We expect the Fed to sell some portion of these holdings—perhaps $300bn or so—and purchase securities with 7 to 30 years remaining maturity (we believe the purchases will likely have the same face value as the sales, even if dollar cost differs, because of the way the Fed has traditionally accounted for its security holdings). The total amount of sales and the maturity composition will determine total amount of duration risk likely to be removed from the private sector. We expect the “twist” to amount to net purchases of $300-400bn 10-year equivalents (i.e. the same amount of duration risk as $300-400bn of the current 10-year note).

For more detail and conceptual background on how the twist could work, see our two earlier articles on this policy option (“For More Easing, Will Fed Go Big or Go Long?” US Daily, August 15, 2011 and “Doing the Twist.” US Daily, September 8, 2011).

2. Cut in interest on excess reserves (IOER) rate. Although it is a much closer call, we also believe the FOMC will announce a cut in the IOER rate—the rate the Fed pays banks for their excess reserve deposits. As discussed in an earlier US Daily, the decision comes down to a cost/benefit calculation, and to date the Fed has implicitly decided that the modest potential benefits from an IOER cut have been outweighed by potential costs and risks. The costs of this option mostly relate to money market functioning: 1) it could impair the normal functioning of the federal funds market 2) lower rates may interact in perverse ways with deposit insurance fees and 3) an IOER cut could make it challenging for money market mutual funds to cover their operating costs (for more details, see “Revisiting the Rate on Reserves.” US Daily, September 13, 2011).

Despite several potential costs and/or risks associated with cutting the IOER rate, we believe a majority of the committee could support it. While the benefit in terms of monetary stimulus would be small, it would complement the Fed’s other easing actions—the 2013 commitment language and the “twist”—and could aid communication. Moreover, many of the problems associated with an IOER cut are longer-term in nature. Having signaled that it is likely to keep rates low for at least two years, the Fed may put little weight on these concerns. In order to mitigate some of the associated costs, we believe the committee would cut to 0.1% instead of zero.

3. Change communication about policy objectives. Another policy option that has received increased attention lately would tie the FOMC’s rate commitment language more closely to economic conditions, in order to bring greater clarity to the central bank’s goals and intentions. For example, Chicago Fed President Evans has proposed a commitment to keep the federal funds rate at its current level until the unemployment rate has fallen to 7%-7.5%, provided core inflation does not exceed 3%. The Wall Street Journal reported this morning that Chairman Bernanke has asked Presidents Evans and Plosser and Vice Chair Yellen to explore the idea further, but that “the issue about clarifying goals is unlikely to be resolved at this week's meetings, if at all, because of the wide range of views at the Fed about how to proceed” (“Fed Ponders Jobs, Inflation Targets.” September 19, 2011).

Avoiding a banking system implosion after an EZ exit would entail, unfortunately, the imposition of Argentine-style measures—such as bank holidays (deposit freeze) and capital controls—to prevent a disorderly fallout realistically, lots of collateral damage would occur, but this could be managed and limited. Banks could be recapitalized by the government through the issuance of recapitalization bonds while this recapitalization would initially increase public debt, the reduction in public debt from a significant default would give some fiscal margin to achieve such recapitalization. 


As for the rest of Europe, he's confident that a Greek default can be done in an orderly, negotiated manner that doesn't cause huge ripple effects.

We doubt the rest of Europe feels so sure about that.