The efficacy of this effort is the subject of significant debate, even internally within the FOMC. Some who question the efficacy, including myself, note that the effect of our purchasing MBS and driving down mortgage rates has certainly assisted a robust recovery in housing, and with it, construction jobs and manufacturing and transportation of materials that go into homes… [T]he Fed’s muscling of the yield curve has brought what has been a 30-year-long bond market rally to a crescendo…

Counteracting whatever benefits one can trace to the Fed’s unorthodox policies are some obvious costs. First, savers and others who rely on retirement monies invested in short-maturity fixed-income investments, such as bank CDs and Treasury bills, have seen their income evaporate while the rich and the quick, the big money players of Wall Street have become richer still.

Second, the standard return assumptions of 7.5 to 8 percent for retirement pools, as you well know, have been dashed (though I have always felt they were already calculated on an imaginary and politically convenient basis rather than a realistic one).

Third, accompanying the Fed’s growing balance sheet we have seen a dramatic expansion in the monetary base—the sum of reserves and currency. A basic understanding of demand-pull inflation is “too much money chasing too few goods.” Thus, the excess, currently nondeployed money could prove the kindling of an inflationary conflagration unless the Fed is nimble in managing its effect as it works its way into the economy’s production and consumption of goods and services.

A corollary of reining in this massive monetary stimulus in a timely manner is that financial markets may have become too accustomed to what some have depicted as a Fed “put.” Some have come to expect the Fed to keep the markets levitating indefinitely. This distorts the pricing of financial assets, encourages lazy analysis and can set the groundwork for serious misallocation of capital.

…

Whereas before, our portfolio consisted primarily of instantly tradable short-term Treasury paper, now we hold almost none; our portfolio consists primarily of longer-term Treasuries and MBS. Without delving into the various details and adjustments that could be made (such as considerations of assets readily available for purchase by the Fed), we now hold roughly 20 percent of the stock and continue to buy more than 25 percent of the gross issuance of Treasury notes and bonds. Further, we hold more than 25 percent of MBS outstanding and continue to take down more than 30 percent of gross new MBS issuance. Also, our current rate of MBS purchases far outpaces the net monthly supply of MBS.

The point is: We own a significant slice of these critical markets. This is, indeed, something of a Gordian Knot…

There is no Alexander to simply slice the complex knot that we have created with our rounds of QE. Instead, when the right time comes, we must carefully remove the program's pole pin and gingerly unwind it so as not to prompt market havoc. For starters though, we need to stop building upon the knot. For this reason, I have advocated that we socialize the idea of the inevitability of our dialing back and eventually ending our LSAPs. In June, I argued for the Chairman to signal this possibility at his last press conference and at last week’s meeting suggested that we should gird our loins to make our first move this fall. We shall see if that recommendation obtains with the majority of the Committee.

But these calculations may underestimate the true magnitude of the problem. A funding ratio of 75 percent equates to an assumption of an 8 percent average annual return on the portfolio of investments. It's fair to ask whether this is a realistic assumption given current forecasts of the economic and financial environment. Arguably not.

Using this optimistic 8 percent return assumption, public state and municipal pension funds have an $800 billion funding gap to fill. Using a lower, more realistic return assumption (such as the longer-term rate on U.S. Treasuries) implies a $3 trillion to $4 trillion funding gap. You might call this "the other debt problem" in the United States.

Well, Mr. Chairman, the essence of making the market discipline approach work is that the counterparties, investors, and creditors be sophisticated and able to evaluate the investments that they're undertaking.  In the case of a pension fund, the pension fund manager has a fiduciary duty to make investments which are appropriate for the risk return needs of that fund.  So if that fiduciary manager has sufficient sophistication to use some of these things, that perhaps is OK.  But in most cases, I think that pension funds should probably not, you know, go heavily into these types of instruments {hedge funds}.

From Q&A session

It wasn’t too long ago that the markets were fretting about underfunded liabilities of pension plans. Recent equity market rallies around the world have mitigated that risk. Pension fund managers now have ample opportunities to secure some of their long-term funding needs in the higher quality tranches of the bond market. The 30-year Treasury bond yields 4.84 percent. If my math is right, this means someone can buy so-called stripped bonds that mature in 2037 at $100 for 25 cents on the dollar, thus matching every dollar of their long-term liabilities for a quarter. Of course, prudent fund managers would only do that if they were confident that the Fed would continue to protect the purchasing power of those strips. If we continue to contain inflation, they will—strengthening the financial security of American workers.

Changes in the management of and accounting for pension funds are a third possible source of a declining term premium. Reforms proposed in the United States, Europe, and elsewhere are widely expected to encourage pension funds to be more fully funded and to take steps to better match the duration of their assets and liabilities. Together with the increased need of aging populations in the industrial countries to prepare for retirement, these changes may have increased the demand for longer-maturity securities. We have seen little direct evidence to date of sizable pension-fund portfolio shifts toward long-duration bonds, at least in the United States. But judging from anecdotal reports, bond investors might be attaching significant odds to scenarios in which pension funds tilt the composition of their portfolios toward such assets substantially over time.

The demographic shifts underway in the major economies seem to have contributed to an increase in demand for longer-dated fixed income assets to fund growing pension liabilities, and these shifts have been reinforced by actual and anticipated changes in the regulations that affect pension fund managers. These changes may have operated to push up the price and lower the yield on longer maturity bonds, but the effect of these changes seems likely to be small in comparison to the changes in the behavior of forward interest rates.