Here’s a number to wake you up: As of last December, the Federal Reserve’s book of agency MBS equaled ten percent of U.S. GDP. Put another way by the head of the Fed’s trading desk earlier this week, the Fed owns about a third of fixed-income U.S. agency MBS and is looking to buy still more. Put my way, not his, the FRB is taking a very big bet that its back-door entry into U.S. housing finance will have its desired accommodative effect. I have my doubts about that, but I know two things based on this new insight into future FRB actions. First, when the U.S. central bank owns this much agency paper, Fannie and Freddie aren’t going to be privatized anytime soon, if ever. Second, the FRB is laying pipe to get as close as it can to a bigger, corporate-like balance sheet to redirect monetary policy in a troubling new way.
If there were ever any doubt about it, the FRB’s big book confirms that Fannie and Freddie are mortgage utilities propping up not just the thirty-year fixed-rate mortgages that have become the bedrock of “American dream” political expectations, but now also essential to the non-traditional monetary policy the FRB seems determined to pursue. Although Janet Yellen last week made it clear that the FRB is still figuring out how the post-crisis framework works – or doesn’t – it’s important to recall also that her Jackson Hole speech presaged a new balance-sheet policy akin to one recommended at that conference by former FRB Gov. Stein.
In this policy, the FRB amasses an even bigger balance sheet and uses an array of monetary-policy channels to bypass the increasingly dysfunctional interest-rate one still dependent on large banks even though much of the rest of the economy isn’t anymore. Reflecting significant limits on buying still more Treasuries and the agency debt that’s essentially a Treasury proxy, Ms. Yellen indicated that the FRB might ask Congress to let the FRB hold corporate debt and/or equity. However, in any Congress with more than a smattering of Republicans stuck in the odd corner, any legislation expanding the FRB’s authority to intervene in the U.S. economy is dead-duck DOA.
What to do? Here’s where agency MBS come into play. Although agency MBS have either a de jure USG guarantee (Ginnies) or a de facto one (Fannie and Freddie, where they take both credit and pre-payment risk from the financial market). They thus give the FRB additional tools beyond the signaling, market, and other channels through which the central bank’s portfolio is supposed to work. As the Fed official said on Wednesday, agency MBS act a lot like corporate debt from a monetary-policy point of view. He didn’t say it because it doesn’t need to be said, but they also do this with orders of magnitude of more liquidity due to the size of the TBA market and zero credit risk to boot.
Like a lot of Fed actions, this monetary-policy reasoning makes a lot of sense, but only if you consider it in the monetary-policy isolation chamber. Take it out into the real world for a walk and all sorts of worries show up.
First is the fact that, while the Fed isn’t wrong about the de facto GSE guarantee, more than a few folks at the Fed itself wish it were. The more the central bank treats GSE obligations as Treasuries by another name, the more Fannie and Freddie are wards of the state stuck in conservatorship limbo until the Fed tapers its $4.2 trillion (maybe plus) book or Congress pulls itself together. Don’t wait up.
Second is the fact – or at least I think it’s one – that the Fed’s holdings of agency MBS perpetuate a deep, liquid, and artificially-priced secondary market for thirty-year fixed-rate mortgages. With the USG government taking the credit risk and the Fed swallowing pre-payment hazard, mortgage rates will drop – indeed that is the Fed’s avowed reason for buying this stuff – but housing demand will also remain artificially high and unnaturally subsidized. If this is the course U. S. policy-makers want, fine (maybe), but it isn’t for the Fed to decide.
And, finally, if the FRB decides to use its balance sheet to new and larger purpose, what will it do with its other monetary-policy tools that still depend on large banks. Professor Stein says the FRB should happily dispense with them, relying henceforth on a big book that makes it not just central, but also a way-big bank. To put a floor on effective rates, he would dispense with IOER and rely solely on the RRP. A new FRB paper we analyzed earlier today explores this further, finding that IOER and the RRP work together but that the RRP is far more important. The RRP is of course a non-bank vehicle, meaning that the FRB with a big book and an RRP could in theory dispense with banks as engines of financial intermediation.
The Fed would of course still need GSEs for housing finance and maybe, as Mr. Stein concedes, a few regional and community banks around for the little stuff. Big banks would survive, but they would become essentially financial-market infrastructure. That’s a brave new world – one that warrants a lot of thought before we find ourselves suddenly in it after the FRB owns the U.S. mortgage-finance system.