St. Louis Fed economist wonders if central bank policies create conflict

The Federal Reserve‘s commitment to purchase long-term Treasury securities and the central bank’s habit of communicating its intentions for the future of the federal funds rate creates a potential conflict, according to one economist at the Federal Reserve Bank of St. Louis. As the Federal Open Market Committee prepares to meet Tuesday for the final time this year, Daniel Thornton, vice president and economic adviser at the St. Louis Fed, said the Fed has attempted to reduce long-term interest rates by providing forward guidance and undertaking quantitative easing. But the former assumes a high degree of substitution across the maturity structure, while the latter assumes a low degree, according to Thornton. “The FOMC could reduce uncertainty and greatly improve its communication and transparency by clearly stating why it is pursuing both of these approaches simultaneously,” he said. He pointed to a opinion put forth in late September by Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, that suggests QE2 represents “another form of forward guidance about the fed funds rate.” Thornton said this is because longer-term securities inherently have more interest-rate risk than shorter-term bonds, as their price changes more in conjunction with changes in the interest rate set by the FOMC. “By holding a relatively large quantity of longer-term securities, the Fed would suffer a larger capital loss if it raised interest rates,” Thornton said. “From this perspective, the large-scale purchase of longer-term securities could be seen as a commitment device, designed to enhance the effectiveness of the FOMC’s forward guidance policy.” Prior to the Fed’s decision to purchase another $600 billion of longer-term Treasury securities in early November, Thornton questioned the need of the so-called QE2, wondering if banks will simply hold onto the funds rather than boosting lending. Other officials at Fed districts across the country also believe the effects of QE2 will be muted because the benefits don’t outweigh the costs and the markets are functioning much better than they have in a few years. Write to Jason Philyaw.