Part II: Will The Fed Begin Selling MBS In The Near Future?

We've discussed this before and will probably have to discuss it again...

(Reuters) - The Federal Reserve should consider selling mortgage back securities (MBS) and buying U.S. Treasury debt, Richmond Federal Reserve Bank President Jeffrey Lacker said in an interview with Market News International on Friday.

Lacker is not currently a voting member of the Federal Open Market Committee that decides monetary policy.

Lacker had opposed the Fed's move to buy MBS, arguing in favor of buying only Treasury securities from the outset of the asset purchase program that the Fed introduced to deal with the 2008 financial crisis. And Lacker now argues that the Fed should systematically swap its MBS holdings for Treasury holdings in the open market, according to Market News International.

Through the end of March this year, the Fed had purchased $1.25 trillion of agency mortgage-backed securities and $175 billion of agency debt as part of a quantitative easing policy to lower mortgage rates and narrow rate spreads. Last year it completed $300 billion of longer term Treasury purchases.

Lacker's comments about exchanging MBS for Treasury securities came in the context of a larger discussion about the Fed's exit strategy.

The Fed could sell MBS and return to an "all-Treasuries" portfolio without changing its overall "quantitative easing" stance or putting much upward pressure on interest rates, Lacker said.

Lacker said there are "good arguments" for the Fed selling assets before it raises interest rates, but added it should only tighten monetary policy when economic growth is "strong enough and well enough established."

For now, Lacker said he is not ready to end the "extended period" of "exceptionally low" short-term rates which the FOMC reaffirmed at its most recent meeting in June.

In fact, Lacker said it is conceivable that the Fed might have to revert to expanding its balance sheet through asset purchases if the economic recovery falters, but said that is "unlikely." He acknowledged that downside risks to the outlook have risen, but doubted the economy is headed for a "double dip" back into recession. He also downplayed deflation risks.

The time for actual tightening has not yet arrived, he suggested.

"I think we're entering a period where it might be worthwhile thinking about changing that ("extended period") language, but I'm not there yet," he said.

The timing of policy firming is "obviously going to depend on the data," said Lacker, adding, "I'm going to look for a time when growth is strong enough and well enough established that higher interest rates -- higher real short-term rates -- will be warranted."

Distinguishing between changes in interest rates and changes in the size of the Fed balance sheet, Lacker said "the timing (of steps to exit from quantitative easing) relative to interest rate increases is an interesting question."

He went on to draw an another distinction -- between the size of the balance sheet and its composition.

"In my mind, I see a lot of good arguments for withdrawing quantitative easing before we begin raising our policy rate," he said. "Now, having said that, there is also a separate question of the composition of our balance sheet."

Noting that the Fed "tilted away from Treasuries by buying all these mortgage-backed securities" last year, Lacker said, "Conceivably we could begin moving back towards Treasury-only without changing the overall quantitative easing stance."

"I think one of the things on the table ought to be selling our mortgage-backed securities and, if it's not time to withdraw quantitative easing, investing the proceeds in Treasury securities."

Asked whether he has support on the FOMC for his proposal, Lacker replied, "Let me just say that that's something that ought to be on the table."

Other Fed officials, notably St. Louis Fed President James Bullard and Philadelphia Fed President Charles Plosser, have favored selling assets fairly soon and have argued for an all-Treasury portfolio, but have not specifically suggested selling MBS and putting the proceeds into Treasuries.

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I will say the same thing about this round of MBS sales rhetoric that I said about the Fed's first few attempts to breach the subject: selling MBS holdings in the near future would create a major supply and demand dislocation in the mortgage market and erode the value of the rest of their "buy and hold" portfolio. It doesn't make sense to execute or even seriously discuss an MBS sales strategy! Plus, although the first two mentions of MBS asset sales were offered by an FOMC voter (Bullard) and an alternate voter (Plosser),  the comments made on Friday were from a non-voting member of the Fed (until 2010), so we can automatically discount the headline.

I did however find it interesting that Lacker seems to be taking a step back from his optimistic perspective of economic reality. It's very odd that he went as far to imply he would support another round of quantitative easing (more TSY purchases).  Remember, Jeffrey Lacker has been an advocate of removing the "rates low for an extended period" verbiage from the FOMC statement and reducing the size of the Fed's balance sheet,  so hearing a generally HAWKISH Fed president shift his sentiment toward the bear camp should set off a few more "double dipper" alarm bells.