When you’re rattled by collateral, do the Fed taper talk

Bernanke and the Fed have opted to rein in asset purchases in favour of pure interest rate steering. In Duy’s opinion there are two possible reasons for this: one is that the Fed is aware of some sort of negative side-effect associated with asset purchases that it wishes to suspend, the other is that the body is getting uncomfortable with ongoing balance sheet expansion.

This is a fair observation. So let’s consider for a second that the motivation is really the first explanation. If it’s true that the Fed’s asset purchases are creating liquidity problems in the underlying — so much so that short squeezes are impeding daily market operations, causing settlement fails and negative repo rates — this leaves Bernanke in a tricky communication position.

For one, the mechanics of QE are not easy to explain to Congress, or the market — both of whom have become far too accustomed to the notion that QE equals pure money printing.

Second, to say “we have to suspend QE because there aren’t enough assets for us to purchase without us becoming the market” is to admit that the Fed’s most important tool — QE — is now broken, which risks freaking out the market completely.

Even if it’s not, it’s still important for the Fed to maintain the illusion that QE remains a viable option. If the illusion can be maintained, then communication and rate-steering alone may be sufficient to keep the market supported. If the illusion is shattered, it’s unlikely that inflation expectations will be easy to manage with words alone, opening the door to even more drastic policy shifts such as unsterilised money-printing, expanded asset purchases into Reits and ETFs (a la Japan) or something even more exotic.

So it’s better to pretend that the economy is strong enough to handle a taper, than to admit that the taper is the result of checkmated Fed.

via When you’re rattled by collateral, do the Fed taper talk | FT Alphaville.

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