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Aug 01, 2012 04:22 PM IST | Source: CNBC

Here's what Fed may do instead of more QE

While the main question surrounding the Federal Reserve is whether it will enact another round of quantitative easing, the central bank may have a different caliber of weapon at the ready.

Here's what Fed may do instead of more QE

While the main question surrounding the Federal Reserve is whether it will enact another round of quantitative easing, the central bank may have a different caliber of weapon at the ready.


A version of the European-style Funding for Lending Scheme has emerged in some quarters as a possibility that would allow the Fed to stimulate the economy in a stealthier way than outright QE would provide.


The Bank of England already has undergone a similar program, and a close facsimile could happen in the US should Fed Chairman Ben Bernanke decide that the economy needs more liquidity in terms of bank-provided credit.


The plan works in a fairly simple manner: In the UK`s case, the BofE is lending short-term government bills to banks, which use the securities as collateral to borrow money from the central bank at a rock-bottom rate - about 0.25% - and then make loans.



Banks can borrow up to 5% of the value of their existing loan books, and the loans from the BofE are four years in duration.


The program is similar to something the Fed tried, with considerable success, during the financial crisis that exploded in 2008.


The Fed is meeting Tuesday and Wednesday and will deliver its policy statement at the conclusion.


"As well as offering clear incentives for UK commercial banks to boost their lending, one of the benefits of the scheme is that, as it only involves a temporary swap of securities, it won`t boost the overall size of the Bank of England`s balance sheet," Paul Ashworth, chief US economist at Capital Economics, said in a note to clients.


The Fed`s program was called the Term Asset-Backed Securities Loan Facility and allowed primary dealers to borrow Treasury bills from the Fed in exchange for depositing collateral.


Instituting a similar program would be somewhat challenging for the Fed.



For one, the Fed will be out of short-term debt when it wraps up its Operation Twist program by the end of the year. The Twist involves selling short-term debt and buying longer-term notes in an effort to drive down interest rates and spur risk assets.


Also, there are some legal questions over what type of collateral the Fed can accept if it cannot lend T-bills.


Finally, there`s the reality that bank lending actually is increasing at a 5% pace in the US, so critics might say the program isn`t really necessary.


The Fed also may want to avoid one provision of the British program in which it grants the low rates to banks on 5% of their entire loan books, not just new loans.


The latter obstacle was emphasized by Alan S. Blinder, professor of economics and public affairs at Princeton University and former Fed vice chairman, in a Wall Street Journal op-ed piece Wednesday.


Blinder thinks the Funding-for-Lending Scheme is at least worth investigating, reasoning "it just might work, and the US economy certainly could use a boost."


Ashworth, at Capital Economics, points out that if the Fed adopted the plan and extended the rate to 5% of current loans it would expand the central bank`s balance sheet another USD 300 billion, something unlikely to be popular among Washington lawmakers.


"Nevertheless, it would make sense at a time when the demand for credit appears to be rising and banks are still tightening lending standards for some types of loans," he said. "As it stands, an FLS is obviously only in the early planning stages. But it will be interesting to see whether the idea develops more support at the Fed."


Copyright 2011 cnbc.com

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