Does the Federal Reserve really think that another round of continued buying of long term Treasuries and mortgage-backed securities will provide a significant healing effect to the ailing economy? Isn’t it time to consider a different course of treatment where the “bang for the monetary buck” will be more significant?
Recently three Stanford professors (Joseph Grundfest, Mark Lemley and George Triantis) analyzed the effects if the Federal Reserve used its buying power to buy tax-exempt municipal bonds instead of just Treasury bonds and mortgage-backed securities as part of an overall quantitative easing strategy. The professors concluded that while the Fed’s current program of buying Treasury bonds and mortgage-backed securities is designed to keep long term interest rates low generally and mortgage rates low specifically, the impact on the economy is at best indirect. Lower mortgage rates will only affect those who actually qualify for a new loan or a refinancing, and the associated interest savings may or may not result in the desired stimulus effect.
By contrast, a Fed program aimed at municipal bonds would have a direct impact in terms of lowering the borrowing costs for states, cities, and counties, and thus reduce the need for tax increases and their negative impact on growth and allow for stimulative spending on employee salaries and infrastructure. It is impossible to argue with this logic.
I am not a professor, but a 25-plus year market practitioner. As a result, I’ve attempted to go beyond the qualitative benefits described by the professors and supplement them with the quantitative benefits associated with a “QE Muni” buying program. I’ve started with the assumption that the Fed buys $10 billion of long dated (i.e., 20-to-30-year term) tax-exempt bonds through secondary market operations. Clearly, it would be a paltry amount in comparison to the $40 billion being purchased per month in the mortgage market or the $45 billion of Treasury purchases as a part of QE3, but a significant amount in terms of the impact it would have on yields in the tax-exempt market. The positive effects would be numerous:
• Cities, states and other tax-exempt entities would be able to borrow at a lower cost. As a $10 billion buyer in the municipal market, the Fed would have an immediate impact on tax-exempt rates -- they would move dramatically lower relative to taxable rates. It’s reasonable to assume a 50 basis point reduction in long-term tax-exempt rates. With $300 billion of long term tax-exempt bond issuance annually, debt service costs to state and local governments (and related entities) across the market would be reduced by $1.5 billion annually. In effect, state and local governments would benefit from a major federal assistance program at no cost to federal taxpayers.
• The Fed would earn money for itself. Assuming an average yield of the tax-exempt purchases of 3.50% and funding the purchases by selling Treasuries with an equal duration, the Fed could easily earn incremental positive carry in the range of 150 basis points or $150 million per year. On a present value basis this would exceed $2 billion over the next 20 years. To the extent the Fed desires a “twist” (i.e., funding the purchases by selling shorter term securities), the immediate savings would increase as would the likely present value benefit.
• It would actually help with the federal deficit. A $10 billion purchase of tax-exempt bonds as described above would take $350 million of tax-exempt interest annually out of the hands of taxpayers. Assuming an effective marginal tax rate of 39.6%, this would result in “avoided tax benefit” annually of almost $140 million. I’m no expert on budgetary scoring, but clearly this should result in some deficit reduction benefit. On a present value basis over the life of the purchased bonds this would result in approximately $2 billion of avoided tax benefit.
• To the extent the buy back program has a lasting impact on tax-exempt yields, the economic benefits described above would be accrued in subsequent years as well and the total impact would be additive. In other words, take all of the benefits and savings described above and add additional savings of the same order for each year the program is in existence.
Does anyone get hurt by this program? No. Current holders of tax-exempt debt would probably see the value of their existing holdings rise as the related yields decline. On future purchases, these retail investors will either have to accept lower relative yields (more in line with historic averages) or be pushed into other investments such as equities, corporate bonds or small business investments.
In terms of the credit risk associated with owning a portfolio of municipal bonds, the Federal Reserve can easily manage this risk and it certainly would be less risky than a portfolio of mortgage-backed securities. Historically, BBB-rated municipal bonds have defaulted at a lower rate than AAA-rated corporate bonds.
While various other alternatives have been proffered over the past few months regarding limiting tax-exemption (i.e., lowering the maximum tax rate when computing tax-exempt interest or eliminating subsidies for Build America Bonds), a “QE Muni” program would result in significant immediate benefits from both a budgetary standpoint as well as to the state and local governments that rely upon the tax-exempt market to meet their financing needs.
If, as the professors suggest, quantitative easing is the medicine that the economy needs, maybe we should consider an alternative prescription rather than simply increasing the current dose.