Gross and Rosenberg: QE3 will see interest rate caps

Yesterday, when discussing what QE3 could look like, I highlighted the 2002 remarks by then Federal Reserve Board Governor Ben Bernanke before the National Economists Club in Washington, D.C.. Bernanke was outlining what the Fed could do in a zero interest rate environment to promote economic activity. I indicated that the FOMC has already considered offering unlimited quantitative easing to target specific interest rates during the second round of quantitative easing. I believe the Fed will do this in QE3, and apparently Bill Gross and David Rosenberg do as well. While a QE3 is still a way’s off – probably not until 2012 – it makes sense to think about how it will be conducted.

The crucial passage pertaining to quantitative easing in a zero interest rate environment is below. Bernanke stated:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Today, Pimco offered up the same thinking on Twitter:

My understanding about what Gross believes is that the Fed could see QE3 "guaranteeing" a 2 year or 3 year yield at a certain level—say 50 basis points. Moreover, the Fed would not necessarily have to buy any Treasuries to defend this target. Gross understands that the private sector “would do it” for the Fed via the language and confidence in the "guarantee". In fact, I was tipped off last night that “it worked on long bonds in the 40s as his speech indicates.” The same individual also tipped me off that “the helicopter speech has been reemphasized as recently a 8/2010 at Jackson Hole”. So it is clear that Bernanke will do this if the economy is near or in recession.

I think this point about not having to buy any securities despite offering to defend the rate with an unlimited supply of liquidity is significant. We have mentioned this in passing before regarding the Fed’s defense of the Fed Funds rate.

Scott Fullwiler wrote me:

The Fed and other central banks actually don’t change the qty of rbs when they want to change the interest rate target. Under pre-Lehmann operating procedures (that set the target rate above the rate paid on rbs) the demand for rbs is VERY interest inelastic at the qty banks desire to hold to settle payments and meet rr. The Fed essentially just announces a new target, and stands ready to "defend" the target via repos/reverse repos if the mkt doesn’t move to the new rate.

Market discipline for fiscal imprudence and the term structure of interest rates

The same approach can be taken anywhere on the Treasury curve. As I said in the term-structure post:

I think this is significant when thinking about bond market vigilantes and the like. But the key takeaway from the Japanese experience is the one I just outlined: sovereign central banks control short-term rates in the currency they issue and through the term structure, they also have some control over longer-term rates. When there is slack in the economy, there is only so far the bond market vigilantes can go. I’m not saying rates can’t rise. I’m saying that that rise is capped if an economy is in a balance sheet recession.

Despite the talk of financial repression, savvy market participants like Bill Gross know the Fed has this power to ‘artificially’ suppress rates. I would argue it is the knowledge that the Fed is able to do so that has people talking about financial repression. Of course, savers don’t have a ‘right’ to a specific rate of return. But, rates are going to be held below what the market would dictate. if you are a fixed income investor in the United States, the only reason to invest in Treasuries then is to benefit from the price appreciation associated with yield suppression that interest rate caps would involve. A better bet is to find yield elsewhere – in high quality, high dividend shares, in corporate bonds or in government bonds in economies that offer a better yield and macroeconomic backdrop. And this is exactly why Gross is looking elsewhere to get bond yield.

Will this policy be a ‘free lunch’? Raghuram Rajan says no and I agree. Savers are the first casualty. But, more importantly, so are consumer balance sheets. Releveraging is exactly what is desired by these kinds of policies both on the monetary and fiscal side. Larry Summers said it well when he quipped:

that the central objective of national economic policy until sustained recovery is firmly established must be increasing… borrowing and lending

The jobs crisis is not just about demand

If the rate of return is artificially suppressed, you are probably going to get an underinvestment in capital in the sectors where you want it because marginal debtors and marginal projects will be favoured. That leads to malinvestment and longer-term economic underperformance. We have seen over the past generation that the distributional effects of monetary policy are much larger than mainstream economists estimate and ultimately end up in crisis.

My take: the US savings rate will remain low because of the skew in favour of debtors. With private sector debt levels still high, that means future US recessions will be events of extreme levels of private sector deleveraging and public sector deficits

Gross: Savers to Be Disadvantaged for Years

David Rosenberg is on to this as well. According to Zero Hedge, in reference to the legendary Operation Twist, he noted today:

There is certainly nothing preventing the Fed from targeting the 10-year Treasury-note any more than the Fed funds rate. But the funds rate is already near zero and as such there is no incremental move there that can benefit the economy. But targeting the 10-year note in much the same fashion is probably worth a try and if there is anything else we know about Ben Bernanke. It is that…

(i) he will be late, not early. So, by the time this comes the economy may well be back in recession, which in balance sheet cycles tend to occur every three years, so mark 2012 down in your calendar;

(ii) he is willing to be very aggressive when the time comes — he has certainly proven that. Back in 2007 or 2008 for that matter, who believed that short rates were going to vanish entirely and that the Fed would be buying assets by early 2009?

Now it is doubtful that the Fed would ever target the long bond. In fact, the Fed may even want it to be higher in yield to ease the pressure on radically underfunded pension funds. While the Fed can either target its balance sheet, which it has been doing with these QE measures, or target interest rates, it cannot do both at the same time. So the next ‘QE’ will not be called ‘QE’ but rather something else — maybe Operation Twist 2 (072 — you heard it here first).

My sense is that this will not be called quantitative easing or credit easing or anything like that. Those terms are dead because they are now politically radioactive. But operationally, the policy will be the same. This time the Fed will target price instead of quantity.

P.S. – The Fed is likely to soft peddle this policy change because of comments from people like former Atlanta Fed President William Ford questioning Can the Fed Go Bankrupt? The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Eventually people will be forced to accept this – and the term structure will flatten further and further out the curve. That’s how Japan got to a 1% 10-year yield because expectations of zero rate policy continued to lengthen in time.

Peter Diamond, the Nobel prize winner who withdrew his nomination for the Fed, would probably have supported this, judging from his prior statements. In a recess appointment to fill his post, we will probably get a like-minded official. So there is a great likelihood that we are going to see an increasing number of people at the Fed in favour of these policies going forward and fewer people like Plosser or Hoenig.

In my view, the only thing that can force the hand of a central bank is persistent and embedded inflation. Look at the BoE with a headline rate of inflation of 4.5% and a policy rate of 0.5%. If you are a British retiree living on fixed income, you are extremely unhappy. But low rates will continue like this for a good clip (5-10 years at least). Welcome to the new normal.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.


  1. fresnodan says:

    This Disqus commenting thing is the most annoying thing in the world – I wonder if the lack of comments is due to people leaving in frustration…

    Anyway, if the drop in private borrowing is true as asserted below
    maybe it explains the lack of affect of QE.
    Of course, when you consider that Bernanke thought that he understood that “subprime” was contained, should we really be surprized when there are these unforeseen circumstances? 
    With exchange rates, CDS’s, CDO’s, leverage, and all manner of deriviatives, does anybody truly think that the relationship to the economy is as quaint as it was in 1955???

  2. Anonymous says:

    This Disqus commenting thing is the most annoying thing in the world – I wonder if the lack of comments is due to people leaving in frustration…

    Anyway, if the drop in private borrowing is true as asserted below
    maybe it explains the lack of affect of QE.
    Of course, when you consider that Bernanke thought that he understood that “subprime” was contained, should we really be surprized when there are these unforeseen circumstances? 
    With exchange rates, CDS’s, CDO’s, leverage, and all manner of deriviatives, does anybody truly think that the relationship to the economy is as quaint as it was in 1955???

  3. Jason Frey says:

    Gross realizes this after he sold most of his Treasuries?

    • Jason,

      I think Gross’ argument is that the risk/reward of accepting the negative real yields of Treasuries is inadequate. Therefore, he would rather buy other debt or even dabble in equities because he anticipates low to negative real yields for at least the next 5-10 years.

  4. Jason Frey says:

    Gross realizes this after he sold most of his Treasuries?

  5. haris07 says:

    Ed, Even if the Fed were to target (and were able to successfully target) low long term rates, so what? With weak economic data, 10 year has already broken below 3% now (and touched only 3.7% in the most recent move up). 2 year is at 0.4% (+/-). That hasn’t achoeved anything much (for example failed to revive the moribund housing sector) except encourage speculation. Why would Operation Twist (or QE3) which explicitly targets yields really achieve anything anyway? Said another way, 10 year JGB at 1% isn’t doing anything for them, why are we (and Bill Gross) and everyone else focused on this at all?

    • Haris,

      Agree 100%. People are expecting way too much from the Fed. Why would we have the Fed out manipulating rates unless it would actually do something? It’s clearly an act of desperation by people who think fine-tuning the economy can work. Of course, I think this kind of thing is dangerous and has unintended consequences. Isn’t this the same interventionist attitude toward economic policy which led to a bloated level of household debt in the first place? Personally, I am surprised that so many smart people who recognize the debt problem can still advocate this and not understand the connection.

      • haris07 says:

        Yes, I am very confused as to the level of analysis and hand wringing about the Fed doing this and that. Rosenberg, Bill Gross, everyone and their mother….when all it seems to do is pretty much nothing for the real economy. Anyway, that is the world we live in.

  6. Wirtschaftswunderjahre zurückbringt says:

    3% now (and touched only 3.7% in the most recent move up). 2 year is at 0.4% (+/-). That hasn’t achoeved anything


    I has achieved something that we seldom achieve. We can during this perhaps brief opportunity window now auction off lot of t-bonds or even 99 year treasuries that there seems to be a gigantic market for. Why not do it at low rates while we still can. With that kind of cash from bond auction our fearless leaders could give us a tax holiday for the next two years. That kind of tax cut from bond auction could propel our economy fast enough to locomotive an entire train of countries.

    Do you know how much tax our stupid rulers collect on each home construction? $90,000 for the typical home. Is that tax burden slowing our housing sector or is it bringing the entire World to a grinding halt?

    Think about it

  7. captain obvious says:

    I find the new insights regarding QE to “infinity” via interest rate caps very insightful and great cutting edge information. Thank you and mr gross and rosenberg for being out ahead of the curve in interpretting Ben B’s helicopter path.

    What i find rather silly in all of this is what i perceive as politcal correctness or extreme naiveness (perhaps due to following the herd or to remain “mainstream accepted” by assuming that the fed is doing this for “main street economy” i.e and then the follow ups ” why would fed continue to do this if it hasn’t turned around housing or job market..i.e most efficient way to help real economy? ….etc. Who the hell takes politicans/ financial sector mouthpieces (fed chairmen) at their word? i assume it is the politically correct stance and a way to remain “main stream accepted” but c’mon this is to 1. keep financial sector profitable 2. keep financial sector’s power and influence 3. keep real economy alive enough to service debt and keep income stream flowing to financial sector. I mean that is what made Ben B so attractive to wall street and tbtf’ that they used politcal leverage to bless him into fed chair….his keynesian money pumping pro creditor….pro bailout deep rooted beliefs.

    or do you Edward already see this?