FED´s GAMBLE GRAPHS NOV REUTERS

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the fed’s big gamble
The Federal Reserve’s latest effort to bolster the U.S. economy -- a new, $600 billion round of buying U.S. government debt -- takes it deeper into uncharted waters

REUTERS/JASON REED

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HE FED'S LATEST MOVE is aimed at lowering borrowing costs even further for consumers and businesses, who are still suffering the effects of the Great Recession, thereby giving a boost to the U.S. recovery. Some worry that this may not be enough and the Fed may have to spend yet more money if it is to make a big dent in the

unemployment rate, at nearly 10 percent, and stave off deflation. But others warn that this second round of so-called quantitative easing is a dangerous gamble by the world’s most powerful central bank, one that could cause a spike in inflation and put the credibility of the dollar at risk without delivering much growth.

China, other developing powerhouses and even Germany have criticized the United States for the impact of its economic policies on currencies around the world. President Barack Obama can expect more protests when he attends a summit of leaders from the Group of 20 big economies in Seoul, South Korea on Nov. 11-12.

november 2010

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“steePeNiNg tRade” baCK iN VOgUe
by Emily fliTTER AND JENNifER AblAN neW YorK, nov. 3

Fed officials: Doves, Hawks or Centrists
A rating of where policymakers stand on a scale of 1 to 5, with 1 representing those most likely

The Federal Reserve's to support a further aggressive easing of monetary policy and 5 those most likely to oppose one. message on Wednesday Dove Dovish Hawkish Hawk Centrist was essentially this: Fed official (Title) 1 2 3 4 5 it plans to revive the Ben Bernanke (Chairman) economy by stoking Janet Yellen (Vice Chair) inflation. The result, for Kevin Warsh (Governor) bond investors, will be Elizabeth Duke (Governor) Daniel Tarullo (Governor) a dramatically steeper Sarah Raskin (Governor) yield curve. Eric Rosengren (Boston President) By some measures, William Dudley (New York President) the Fed's buying Charles Plosser (Philadelphia President) program was more than Sandra Pianalto (Cleveland President) markets expected. The Jeffrey Lacker (Richmond President) new round of easing, Dennis Lockhart (Atlanta President) on top of reinvesting its Charles Evans (Chicago President) previous round, means James Bullard (St. Louis President) it will purchase $850 Narayana Kocherlakota (Minneapolis President) billion in Treasuries by Thomas Hoenig (Kansas City President) Richard Fisher (Dallas President) the middle of 2011. Average That is more than half of the $1.3 trillion in debt Source: Thomson Reuters Reuters Graphic/van Tsui the U.S. government is expected to issue for the Reuters graphic/Van Tsui whole year. "It is hard to find value in a 30-year asset The Fed is trying to prevent a slide in yield and time to maturity -- will get steeper. inflation from turning into a deflationary spiral The slope of the yield curve represents the sub-4.0 percent if the Fed is running a proof falling wages, growth and business activity, sum of the market's expectations of future growth and ultra pro-inflation regime. The market is, in effect, saying the Fed will win -real interest rates and inflation. even if it triggers rapid price increases. When the curve steepens, the most or it will get its inflation," Baker said. "The Fed is actively pursuing a pro-inflation A steeper yield curve helps banks earn stance," said Bret Barker, portfolio manager advantageous maturity range is the shortintermediate sector, which is also where the more money on loans they make. Banks can with the TCW Group. borrow at low rates and make long-term However, the move did not impress Fed is buying. With the Fed focusing on the 2- to 10- loans at high yields. everyone. With the average maturity of the In contrast to the selloff at the long end, new purchases between five and six years, year part of the yield curve, the investment longer-dated bonds took a beating after the trade for the remainder of the year is the intermediate maturities such as five- and announcement. The 30-year bond tumbled "steepening trade," said Tom Sowanick, chief seven-year Treasury notes rallied. Rick Klingman, managing director of Treasury investment officer of OmniVest in Princeton, more than two points in price. trading at BNP Paribas in New York, said fiveThe long bond's performance was abysmal New Jersey. A steepening trade uses derivatives that year yields could go as low as 1 percent from compared with intermediate maturities, or the 1.12 percent currently. Seven-year yields could belly of the yield curve, which are expected will pay off as the yield curve steepens. The difference between 10-year yields and get down to 1.65 percent from their lateto benefit most from the Fed buying. The difference between the yields of five-year 30-year yields also hit its widest level on record. Wednesday level of 1.82 percent. But he cautioned that the time frame for Treasury notes and 30-year Treasury bonds Investors said it may take a lot more selling for increased to an all-time high of 294 basis points. yields on 30-year bonds to rise to attractive that movement was hard to predict, and Rising yields for longer dated bonds mean levels. The long bond was yielding 4.04 percent many factors could interfere with the yields' march lower. that the yield curve -- the relation between at the end of Wednesday's session.
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fed gOes big aNd bOld bUt maY fall flat

bOND bUyER: U.S. Chairman of the Federal reserve ben bernanke delivers opening remarks at a Federal reserve System symposium on “mortgage and the Future of Housing Finance” in Arlington, virginia. october 25, 2010. REUTERS/Jim yOUNG

Emily KAiSER AND mARK fElSENThAl WASHInGTon, nov 3

factbox
behind Chairman Ben Bernanke despite the cacophony of voices heard before this meeting. The Fed said the economic recovery "continues to be slow," which was somewhat less gloomy than in its Sept. 21 statement when it said the recovery "has slowed in recent months." Indeed, recent readings on manufacturing and consumer spending have been slightly better than expected. The bind for the Fed, however, is that this strength has not been reflected in the two categories that count under its dual mandate -- employment and inflation. The new buying program has a finite end of June 2011, but the Fed said it was open to adjustments depending on the path of recovery, giving it some wiggle room to go even bigger should the economy falter. The New York Fed said the $600 billion, combined with an ongoing program to reinvest maturing securities, meant the grand total could reach $900 billion, or $110 billion per month. The Fed said it will buy $600 billion of Treasuries between now and June 2011 -- or $75 billion a month. It is also continuing to reinvest the maturing proceeds of its first round of mortgage-related and Treasury buying. That's another $250 to $300 billion between now and June. The Fed said it will regularly review the pace of purchases and size of the program and will adjust it as needed. The purchases will be more focused on the 4-7 year range than the first round of purchases (see graphic). The Fed said it is temporarily relaxing its limit of not owning more than 35 percent of any one issue, but holdings will only rise modestly above that levle. The New York Fed plans to publish its monthly schedule for Treasury purchases on Nov. 10 at 2 p.m. EST (1900 GMT) . 3 4

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HE U.S. FEDERAL RESERVE'S second round of money printing looks larger at first glance than many on Wall Street had anticipated, but concerns lingered that it would not accomplish much. The pledge to buy an additional $600 billion in long-term Treasury bonds by the middle of next year was slightly larger than the median expectation of $500 billion in a Reuters poll. But this would work out to about $75 billion a month, which was a smaller monthly amount of new purchases than many analysts had expected. Stock investors greeted the news with indifference, which may simply reflect the fact that the Fed clearly telegraphed this move and markets had priced it in. What may be troubling for Fed officials is that the program's success relies in part on markets strengthening, so the ho-hum response blunts the impact. Kansas City Fed President Thomas Hoenig remained the lone dissenter, suggesting that the core of the committee remains united

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q&A
a PRimeR ON qUaNtitatiVe easiNg
WhAT iS QE2?
QE2 is market jargon for the second big round of Fed long-term asset purchases -also known as quantitative easing. In essence the Fed is printing money and buying government debt, hoping to drive down borrowing costs further after having already cut benchmark U.S. interest rates to near zero. The Fed said it will buy another $600 billion of Treasury bonds as part of this program between now and June next year. That's on top of the $250 billion to $300 billion that the Fed is going to reinvest from maturing debt from its first round of quantitative easing over that period. The Fed earlier bought $1.7 trillion of mortgage-related and Treasury debt.

Why DOES ThE fED ThiNK iT NEEDED TO DO mORE?
The Fed thinks the unemployment rate is too high and inflation is "somewhat low" relative to what it deems consistent with its dual mandate of price stability and full employment over the long run. There's also the worry that slowing inflation could ultimately slide into an economically troubling deflation, a sustained period of falling prices that could deter consumers from spending and businesses from investing.

hOW lONG Will ThE pROGRAm lAST?
The Fed says it will buy the $600 billion by the end of the second quarter of 2011 -- or about $75 billion a month.

DiSSENTER: Kansas City Federal reserve President Thomas Hoenig speaks regarding “ending Government bailouts” at the American economic Association Conference in Atlanta, Georgia January 5, 2010. REUTERS/TAmi chAppEll

hOW Will iT WORK?
Fed officials disagree on how it will work and how effective it will be. Some officials say it will primarily work by lowering yields on U.S. Treasuries, pushing investors into more risky assets in a move that will lower rates more widely. Lower U.S. borrowing costs could stimulate home buying and building, business investment and, ultimately, hiring. Other officials say further asset purchases could work primarily by raising inflation expectations and bolstering confidence by signaling to markets the Fed's commitment not to let prices fall.

WhAT ARE SOmE cONcERNS AbOUT ThE pROGRAm?
Some Fed officials, including Philadelphia Fed President Charles Plosser, have voiced concern about the possibility the Fed's credibility could be damaged if it launches fresh action and is not successful in lowering the unemployment rate. He and others also worry about distorting markets and laying the groundwork for future inflation by complicating the Fed's eventual exit from its accommodative policies. There is also a concern that some investors might interpret the Fed's purchases as a monetization -- or inflating away -- of the national debt.

WhAT ARE ThE GlObAl implicATiONS Of ThE pROGRAm?
Expectations of fresh bond buying by the Fed have pushed investors overseas in search of higher returns in recent weeks, weakening the U.S. dollar. This flood of capital has driven up asset prices in emerging markets and strengthened other currencies.

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Fed’s purchases of Treasuries by maturities
The Federal Reserve pulled the trigger on a second round of Treasury purchases, committing to buy $600 billion more in government bonds by the middle of next year.
Quantitative easing 1 (QE1) purchase share of bonds by maturity - % 1 year to 2 years 2 years to 3 years 3 years to 4 years 4 years to 6.5 years 6.5 years to 10 years 10 years to 17 years 17 years to 30 years TIPS Quantitative easing 2 (QE2) purchase share of bonds by maturity - % 1.5 years to 2.5 years 2.5 years to 4 years 4.5 years to 5 years 5.5 years to 7 years 7 years to 10 years 10 years to 17 years 17 years to 30 years TIPS 0
Source: Thomson Reuters Reuters graphic/Van Tsui

03/11/10

5

10

15

20

25

oPINIoN

eNteR the eRa Of deValUatiON
JAmES SAfT neW YorK, nov. 3 E’VE ENTERED A NEW era in global financial markets: the U.S. is intentionally devaluing the dollar. For the United States, which has long espoused a strong dollar but in reality had a policy of benign neglect, this is the equivalent of pushing the big red eject button in the jet cockpit: something big is going to happen and we will have to see how it will work out. The Federal Reserve’s pledge to purchase $600 billion of longer-dated Treasuries between now and the end of the second quarter of next year, and reinvest $250-300 billion in the same period, means the central bank will be buying up $110 billion a month in Treasuries and creating a like amount of new money out of the ether. Perhaps the principal way quantitative easing will boost the economy, the Fed hopes, is by lowering effective interest rates, enticing investors to move into riskier assets, some of which may generate inflation and jobs. As well there is the wealth effect; the old canard of spending more because your retirement account and house have gone up in nominal terms. The bald fact, though, is that by turning on the printing presses the Fed will drive down the value of the dollar absent a similar move in another currency. Much of the new investment created by quantitative easing will be made not in the United States but will be money borrowed in the United States, exchanged into a foreign currency, probably in emerging markets, and invested overseas. That will drive the dollar down, which will help to make U.S. industry more competitive. There you have it; competitive devaluation, a beggar-thy-neighbor policy. It is not much of a lever, but it is one of the few which the Fed has left to pull. Don’t expect anyone from the Fed or the Treasury to tell you this in simple declarative sentences, but it’s true nonetheless. A currency war blossoming into a trade war has to be one of the outside but significant risks of 2011. If global growth can recover significantly this may be averted, but this is far from promised. The second and maybe more important risk is that the U.S., having lost control over its own monetary policy many years ago due to recycling of capital by the Chinese, now loses control of its currency. Like going broke, this can happen little by little and then all of a sudden. The alternative is that QE is not terribly successful in improving U.S. growth but does touch off a round of speculative investment elsewhere, investments that make returns in a shrinking dollar look worse day by day. Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for. 5 2

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INstaNt vIews

slightlY UNdeRwhelmed
JOSEph bATTipAGliA oF STIFeL nICoLAUS
They’re basically saying the economy is still too soft, it’s not generating new jobs growth, there is a risk of deflation . . .So this is the path we’re going to go down, risks be damned.
fOllOW ThE lEADER: Traders in the S&P 500 options pit at the Chicago board of Trade signal orders shortly after the Federal reserve’s decision to leave short-term interest rates untouched. Chicago, Illinois. november 3, 2010. REUTERS/fRANK pOlich

RichARD fRANUlOvich oF WeSTPAC
I don’t think the Fed overdelivered… beyond June, there’s nothing, there no outlook. I am slightly underwhelmed. The dollar did sell off, but I don’t think this spike in the euro has legs.

CLICK TO WATCH REUTERS REPORTER DAN BURNS, OR VISIT HTTP://LINK.REUTERS.COM/GAW53Q

bREAKiNG viEWS: beRNaNKe’s bONd sPRee Raises mORe RisK thaN RewaRd
by mARTiN hUTchiNSON WASHInGTon, nov 3 employment. However buying Treasuries and relying on interest rate movements to stimulate growth is a very inefficient means of funding small businesses, where most American jobs are created, as banks have so many other ways to achieve higher returns. Indeed, it's possible that much of the excess money flowing through the system will flow into the global --not regional -economy, increasing commodity prices and inflation in overheated markets. Petrobras chief Jose Sergio Gabrielli remarked on CNBC, immediately following the announcement, that "more liquidity is good for Petrobras." For one thing, it increases oil prices. But that's hardly the purpose of the exercise. U.S. banks' commercial and industrial loans, including those to small businesses, fell by a quarter from their 2008 peak to around $1.2 trillion in the week ending Oct 20. An injection into that market, perhaps by purchasing sub-participations in banks' business loan portfolios, would require special authorization. But it would attack the problem directly -- and would arguably be less inflationary to the global economy. For sure, it's not an easy solution -- but it's time for the authorities to get creative, not destructive.

JASON bRADy oF THornbUrG InveSTmenT mAnAGemenT
Clearly they had to do something. It’s possible some of the positive economic data we’ve seen softened it a touch. My real question is how is this really helping, how much additional benefit is there of lowering rates? Maybe the thing they doing is not about lower rates but forestalling the potential for higher rates.

T

he Federal Reserve's latest bond-buying spree is one inefficient -- even dangerous -- way to create jobs. The announcement that it will buy $600 billion of Treasuries over the next eight months was well signaled, so it did not move markets much. But the liquidity it will add to the international monetary system is very likely to flow into commodity speculation and overheated emerging markets. Pointing a smaller money hose directly at small business would have been more effective and less risky. The Federal Open Market Committee's proposal involves bond purchases at the rate of $110 billion per month until June 2011, of which $35 billion monthly would consist of reinvestment purchases, as previously announced. Excluding that recycled money, the buying represents about 72 percent of the Treasury's funding needs during the period, based on the government's 200910 funding pattern. That's not quite Weimar Republic levels of money-printing, but it brings attendant dangers nonetheless. The FOMC statement makes clear that the purpose of these purchases is to promote a stronger U.S. economic recovery, consistent with the Fed's mandate of fostering full

JEffREy pRiTchARD oF ALTAveST WorLDWIDe TrADInG
This is going to be supportive for gold in the long run. You may not see it right now but we should see highs before the end of this year. If you’re a company and you’re looking to get a return, you’re not going to the bond market.

JEff KlEiNTOp oF LPL FInAnCIAL
This provides the market with additional clarity. It now knows the size of the purchases, how long they’re going to take place and the pace at which the Fed is going to conduct it. The question is whether this is enough. The consensus was $500 billion over the next six months or so. This is just a little bit ahead. The gap between disappointment and surprise is so narrow, but I think they may have threaded that gap with what they announced here.

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made iN ameRiCa, imPORted bY asia
by AlAN WhEATlEy beIJInG nov 3 In a reversal of the trade flows that have so unbalanced the global economy, some of the dollars that the Federal Reserve is expected to start minting soon to buy U.S. Treasury bonds will wash up on Asia's shores, presenting a headache for policymakers already fretting about rising inflationary pressure. Resentment in emerging markets about the global spillover effects of easier U.S. monetary policy is likely to hang over next week's summit of the Group of 20 leading economies in Seoul. "What will happen with another round of quantitative easing by the Fed? It's creating inflation, alright. Just not necessarily in the U.S., but on the other side of the globe," said Frederic Neumann, an economist with HSBC in Hong Kong. In fact, a lot of investors are counting on the Fed to succeed where the Bank of Japan has long failed and generate inflation at home. U.S. core inflation of 0.8 percent is lower than it has been since the early 1960s, but asset managers have been snapping up Treasury Inflation Protected Securities and other hedges against rising prices. On the face of it, though, worries of inflation in the developed world any time soon are akin to a malnourished man refusing to eat more for fear of growing obese. In a world of substantial excess capacity, high unemployment and tightening fiscal policy, inflation is likely to remain low in rich countries, the International Monetary Fund said in its latest World Economic Outlook, published last month. It saw deflation as a more pertinent threat and projected that excess supply in the United States and the euro zone would not be used up until 2014. "For high inflation to emerge, there would have to be multiple shocks, including a sudden move to financial or trade protectionism that would undo much of the integration of markets that has taken place over iNTERESTiNG EXchANGE: The Fed’s decision could have some undesirable effects on inflation in Asia. november 1, 2010. REUTERS/pETAR KUJUNDZic recent decades. Such a latter camp," he said. "If there are spillovers scenario seems remote," the IMF said. Indeed, without significantly stronger financial into countries that are already on the verge of and structural policies, potential output in rich overheating, then domestic policymakers are economies is likely to remain appreciably below going to tighten more than they otherwise would." pre-crisis trends, the IMF said. While politicians focus on the nominal rate And, it added, any mistakes by governments in rolling back public deficits could cause a of the yuan against the dollar, China's higher long period of deflation or low inflation and inflation rate is already pushing up the economically more important real exchange disappointing economic growth. Jan Hatzius, chief U.S. economist at rate. Indeed, Bank of America Merrill Lynch last Goldman Sachs, said there was so much slack in the economy that U.S. interest rates might week nudged up its forecast for inflation across emerging Asia in 2011 to 4.0 percent from 3.3 stay close to zero for several years. Speaking in Beijing this week, Hatzius said percent and said rising bond yields suggested the impact of more Fed quantitative easing investors were already on the scent. "This highlights one of the great ironies would be benign for Europe, where growth is weak, because it would let monetary of QE2: it creates inflation in the region that least needs it," economists T.J. Bond and conditions stay looser for longer. "But in some parts of the world, it causes Marcella Chow said in a report. more problems. And Asia is probably in the

GRAphic

hawKs aNd dOVes fight it OUt
consensus fell into place at the Fed in favor of a second round of purchases of U.S. government debt to stimulate the economy in recent weeks, with a number of officials firming their support or showing more openness toward easing. Supporters of more quantitative easing, labeled doves, include Fed presidents in

A

For an interactive map of where policy makers stand click here http:

http://r.reuters.com/ryv97p

New York, Chicago and Boston. Several see a very low inflation rate, lack of momentum in the economy and worries over deflation. Other Fed officials have reluctantly come around to the idea of more easing, though some have outright warned such a move was dangerous and unlikely to fix the U.S. jobless problem. 7 5

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Fed explores ways to support economy
Here are some of the steps open to the Fed a support a flagging economy. Here are some steps the Fed could pursue to supporttoflagging economy characterized by low inflation and high unemployment.
TREASURY PURCHASES The Fed looks set to launch a new The Fed launched a new program to purchase U.S. Treasury program to purchase U.S. bonds, althought the scope and Treasury bonds. pace of such purchases remains unclear. Advocates of further Treasury purchases believe a greater effort is needed to boost business and consumer demand. INFLATION TARGET The U.S. central bank may choose to set an explicit inflation target in conjunction with a policy of asset purchases. The goal would be to clearly communicate to both the public and financial markets that policymakers are committed to getting inflation back up to more comfortable levels. LOW RATES LANGUAGE The Fed has said it could offer further stimulus to the economy by bolstering its commitment to keeping interest rates low for an extended period. This would force market participants to price in lower longterm borrowing costs, and prompt some investors to buy riskier assets as they seek higher returns. PRICE LEVEL, GDP TARGETING Price-level targeting takes inflation targeting one step further. By targeting a specific price level, the Fed would promise to generate above-target inflation at times when inflation is slowing or prices falling in order to play catch-up. Like an inflation target, a price-level target could help lift inflation expectations. SHOOT FOR HIGHER INFLATION Staff at the International Monetary Fund and a number of other prominent economists have argued the Fed should consider shooting for inflation above 2 percent as a way to raise price expectations and induce consumers and businesses to go out and spend. This approach is seen as problematic within the Fed.
Source: Thomson Reuters Reuters graphic/Van Tsui

Fed balance sheet - $ - trillion 2.5 Agency debt 2.0 1.5 1.0 0.5 Treasuries MBS 0.0 2005 2006 2007 2008 2009 2010 Treasury breakeven rates - percent

3 2 1 0

-1 2009

5-year 10-year 2010

4 3 2 1

Treasuries vs. benchmark rate - percent

0 2009

10-year Treasury Federal funds target rate 2010

Inflation - Core PCE prices Index value Percent change, y-o-y 3.5 Price level target 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2005 2006 2007 2008 2009 2010 12 9 6 3 0 -3 -6 Joblessness and inflation - percent

112 110 108 106 104 102 100 98

2002

Unemployment rate CPI yoy change 2004 2006 2008

02/11/10

2010

cOvER phOTO: The Federal reserve building in Washington, January 26, 2010. REUTERS/JASON REED

FOR MORE INFORMATION CONTACT: wILLIaM scHoMbeRG, ecoNoMIcs edItoR, aMeRIcas +1 646 223 6194 [email protected] tIM aHMaNN, ecoNoMIcs edItoR, wasHINGtoN +1 202 898 8370 [email protected] PedRo da costa, +1 202 354 5820 [email protected]

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