If the Fed takes action, what could it do to boost the economy?

July 25, 2012

Rumors that the Federal Reserve might take more steps to boost the stumbling U.S. economy are getting louder. Both the Wall Street Journal and the New York Times have reports today that central bank officials are "moving closer" to further action, though likely not until they meet in September.


Ben Bernanke (Credit: J. Scott Applewhite/AP)

But what could the Fed actually do? And would any of it be effective? The standard stimulus option, as Federal Reserve Chairman Ben Bernanke told Congress last week, would involve a third round of "quantitative easing," or QE3. The central bank would buy up more assets, such as mortgage-backed securities, in order to push down long-term interest rates and spur economic activity.

In June, Bernanke explained to members of Congress why he believed QE3 could jolt the economy. The program would, he said, reduce the cost of borrowing money for corporations, bring down mortgage rates even further, potentially boost the stock market “and therefore increase wealth effects for consumers” to spur more spending. Credit Suisse recently surveyed the academic research on the first two bouts of quantitative easing and found that QE and QE2 were effective at preventing deflation and raising the GDP, although economists differ on the exact numbers.

Still, some onlookers are skeptical. The Fed is already holding short-term interest rates near zero until 2014. And many credit channels remain clogged, as banks and lenders tighten their standards. So many small businesses and prospective home buyers are having trouble taking advantage of interest rates no matter how low they go.

Indeed, Bernanke himself has cautioned that “there may be some diminishing returns” to further quantitative easing. He has also maintained that the Fed can't nurse the economy back to health on its own. In June, he told lawmakers, “I’d be much more comfortable if Congress would take some of the burden from us.”

Yet with Congress unlikely to offer more stimulus, some economists have called for unconventional tactics from the Fed. Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics, has suggested that the Fed target a specific 30-year mortgage rate—say, 2.5 percent—for the next 12 months by buying up as many mortgage-backed securities as possible. (By contrast, under QE3, the Fed would buy a fixed number of assets and wouldn't target rates.) The idea is that this would encourage a rush into the housing market, which has recently shown signs of recovery.

Others have suggested the central bank raise its inflation target. Chicago Fed president Charles Evans has argued that the Fed should commit to keeping short-term rates at zero “until either the unemployment rate goes below 7 percent or the outlook for inflation over the medium term goes above 3 percent.” The logic goes like this: As the economy recovers, an uptick in inflation will likely follow (as, say, younger workers move out of their parents’ houses and rents rise). Right now, however, the Fed appears to be unwilling to let inflation rise above 2 percent. Evans said the Fed should make clear it won’t hit the brakes just because prices are rising, at least not until the recovery has firmly taken hold.

Yet Evans' ideas appear to be an unpopular view with the Federal Open Market Committee. According to the Journal report, the Fed is "[d]etermined to keep trying to get the economy going without causing inflation."

There's also the side question of how much urgency the Fed actually feels to act. Unemployment is now falling more slowly than the central bank expected when it issued its forecasts back in April. Here’s a relevant chart, courtesy of the Council on Foreign Relations:

When the Fed published its forecasts, it expected more jobs reports like April’s, which initially showed the economy adding 115,000 jobs new jobs. But that hasn’t happened. Instead, April got revised downward. May added just 69,000 new jobs. And the June jobs report came in at just 80,000. That’s well below the central bank’s predictions. Which means the Fed’s own numbers show the Fed failing to meet its dual mandate of keeping unemployment and inflation low.

On the other hand, Bernanke and other Fed officials are facing the daunting prospect of intervening in the U.S. economy during a close election. And, while the Fed was designed to be insulated from politics, Bernanke has faced plenty of criticism. In recent congressional hearings, Republicans have sharply warned the Fed chief to reject further stimulus, while Democrats have offered less countervailing pressure.

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