Will the US Federal Reserve, which earlier this month signaled it will keep rates near zero for the next two years to support a foundering recovery, see fit to do even more to bring the economy out of its funk?
That is the question on investors' minds as they await Fed Chairman Ben Bernanke's speech on Friday in Jackson Hole, Wyoming, where last year he gave the first sign the central bank was preparing for a new bond-buying program designed to boost the economy.
The Fed had already cut short-term interest rates to near zero in December 2008. By June 2011, when the Fed's second bond-buying program ended, it had purchased a total of USD 2.3 trillion in assets to support economic activity.
Even so, growth slowed sharply in the first half of the year, and recent manufacturing surveys give scant hope of a quick turnaround this quarter. With inflation well above what it was last year, officials say the bar for doing even more this year is high, and indeed the Fed's Aug. 9 decision to extend its
low-rate pledge for another two years drew three dissents.
But officials maintain the Fed still has arrows in its quiver, should conditions warrant using them.
What could the Fed do?
- It could return to what appears to have been its most potent conventional tool, another round of large-scale asset purchases. Most analysts see this as an aggressive move and possible only if conditions worsen significantly.
- More likely is the smaller move of deliberately restocking its balance sheet to emphasize longer maturities, pushing longer-term interest rates even lower.
- The Fed could also cement its commitment to easy money by promising to keep its much-expanded balance sheet large for an extended period, similar to the promise it made earlier this month on short-term rates.
- Other less-likely options include setting explicit targets for inflation or price levels, to strengthen confidence that the Fed won't let inflation get out of hand; and lowering the interest rate it pays banks on excess reserves, forcing them to lend the money to obtain higher rates of return.
How might the Fed go about rebalancing its portfolio?
- Use proceeds from maturing mortgage-backed bonds and Treasuries to buy longer-end securities. An analysis from TD Securities suggests that this option could result in the purchase of as much as USD $500 billion in longer-term assets over the next 15 months, nearly as much as the Fed's second round of outright bond buys.
- Finance the purchase of long-end securities with the sale of short-end securities. This approach could allow the Fed to rebalance its portfolio more quickly than by simply replacing maturing securities, while at the same time keeping its balance sheet steady.
- Buy long-end securities and neutralize the excess liquidity created by simultaneously draining bank reserves. Doing so could reduce inflation worries by keeping abundant reserves in check.
What would the Fed hope to accomplish with rebalancing?
- Encourage risk-taking: moving to longer maturities could push down interest rates for longer-dated securities and spur investors to take on riskier assets, such as stocks.
- Lower interest rates: by weighting the Fed's portfolio to longer-dated maturities, the Fed would be pushing down longer term rates even more, encouraging borrowing and hopefully, spending, investing and hiring.
What prevents the Fed from moving more aggressively?
- Inflation worries: after the Fed's USD 600 billion second round of quantitative easing, or QE2, as it became known, commodity and energy prices soared worldwide. The Fed was blamed for fueling inflation, although Chairman Ben Bernanke and other economists argued that rising demand around the world was the principal cause of rising prices.
Even so, US inflation is now near the Fed's preferred level of 2% or a bit below, depending on the gauge. When the Fed launched QE2, inflation was near record lows.
Bernanke has said that higher US inflation is one restraint on Fed willingness to ease policy.
- Political pressures: the Fed was savaged at home as well as abroad for QE2. US lawmakers took it to task for risking inflation and proposed narrowing its mandate to focus only on price stability, not on growth.
While the cental bank has over the years established a reputation for political independence, the risk of stoking further anti-Fed sentiment on Capitol Hill could give policymakers pause. Republican presidential hopeful Texas Governor Rick Perry said earlier this month he would consider further Fed bond-buying "treasonous."
- Effectiveness questions: although a study by Fed economists said large-scale asset programs lowered rates on 10-year Treasury bills by between 0.30 of a percentage point and 1 percentage point, impact is a subject of heated debate.
Detractors point to the continued struggles of the economy - which grew at less than a 1% annualized rate in the first half of the year - as signs of quantitative easing's limitations. Supporters counter that without the bond buying, things would have been worse.
- Policy fatigue: after Fed purchases of near USD 1.4 trillion worth of mortgage-related debt and USD 900 billion of Treasury securities, many wonder whether additional bond buying would have diminished effect.
Furthermore, some Fed officials believe that despite stumbles, the recovery is on track and that the Fed's next step should be tightening, not further easing.
- Difficult exit: critics worry that when the recovery begins to gain traction, the Fed will have difficulty shrinking its balance sheet from its current USD 2.9 trillion size, let alone a larger one. Failure to reverse easy money policies in time could ignite inflation and plunge the economy into a fresh crisis.
Fed officials say they have the tools in place to tighten monetary policy even with a bloated balance sheet. However, the reversal of quantitative easing on such a large scale has never been undertaken before.
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