QE MUNI BUYING – A GAME CHANGER?

Yesterday Ed Harrison at Credit Writedowns pointed out an article on Bloomberg by David Blachflower, a former member of the Bank of England’s Monetary Policy Committee, and a professor of economics at Dartmouth College.  Blanchflower says the following VERY important statement with regards to QE (via Bloomberg):

“What will they buy? They are limited to only federally insured paper, which includes Treasuries and mortgage-backed securities insured by Fannie Mae and Freddie Mac. But they are also allowed to buy short-term municipal bonds, and given the difficulties faced by state and local governments, this may well be the route they choose, at least for some of the quantitative easing. Even if the Fed wanted to, it couldn’t buy other securities, such as corporate bonds, as it would require Congress’s approval, which won’t happen anytime soon.”

This is potentially significant.  The ramifications here are different than if the Fed is buying treasuries or MBS.  That is merely an asset swap.  It doesn’t alter private sector net financial assets.  Buying munis, on the other hand, potentially could.  What this would be, in essence, is a bond buying program similar to what the ECB is doing in Europe.  They become the market maker of sorts in the muni market and ensure bids.  This would reduce interest rates (funding costs) and could potentially change the outlook for state budgets.  But this is the key.  The states would have to materially alter their budgets in order to benefit.

Of course, this is all speculation.  There is no confirmation that the Fed is even considering this, but the fact that Blanchflower is discussing it means it’s probably on the table.  The key here, is at the state level.  This is not the same as the Treasury writing cheques to the states.  The states would have to make a decision to issue more debt – in essence, they would have to make the opposite decision that the European states have made.  Given the current bent towards austerity I find it hard to believe that the states would do this. This also assumes that the muni portion of QE would be large enough to actually make a dent in the economy.

Lots of speculation here, but perhaps Mr. Bernanke has a better grasp on this situation than I previously assumed.  My guess is a muni announcement would be on the small side (with treasury purchases making up the majority of the purchases) and that the states will continue down the path of austerity.  But it’s all speculation at this point.