What more can the Fed do now?
By Neil Irwin,
With the U.S. economy flatlining and at risk of falling into a new recession, the Federal Reserve lacks good tools to do much of anything about it — though that won’t necessarily stop the central bank from trying.
The Fed has a policy of ultra-low interest rates and other unconventional steps already in place to pump up the economy. But the central bank has declined to take any new actions to try to further loosen monetary policy this year, amid projections that economic growth will rebound in the second half of the year. But the most recent data has made those predictions look more doubtful.
Chairman Ben S. Bernanke and his colleagues do have options to try to address a new wave of weakness evident in recent data. It’s just that the tools that remain are either not particularly powerful or could exacerbate rising prices that have already pinched Americans this year — or both.
The Fed is holding its regular meeting on monetary policy next week, and leaders of the central bank will surely discuss the weakening outlook, whether they should do anything in response and what such a response might consist of. Their public statement following the meeting will likely reflect the worsening outlook for the economy, but they appear inclined not to make any policy changes until more evidence has become available and there has been more time to weigh it.
That discussion will take on particular urgency if a report on the job market Friday is particularly atrocious, which would be the third-straight month of disappointing job creation.
The Fed will be particularly attentive to any evidence that the weaker economy is pushing down prices across the economy. The central bank is more likely to take action if there is a risk of falling prices — or at least prices rising well below the central bank’s unofficial target of about 2 percent — than if inflation seems set to continue on the uncomfortably high trajectory it has been on through the first half of the year.
A slew of economic data in recent days has pointed to a flatlining of economic growth in the United States — and much of the world — as summer began. The most recent was a report Tuesday that personal consumption spending fell in June for the first time in almost two years. That followed the release of a key manufacturing survey Monday showing that the expansion in the nation’s factories came nearly to a halt in July, and gross domestic product data Friday that showed the economy grew at less than a 1 percent annual rate in the first half of the year.
The basic challenge for the Fed is this: It is charged by Congress with maintaining stable prices and maximum employment. But when those goals are in conflict with each other, that makes it hard to decide what to do. And right now, the nation seems to be losing ground on jobs, adding them too slowly to reduce unemployment. Yet prices are rising at about the 2 percent or so annual pace that the Fed considers to be stable. Anything the Fed does to try to address the weak job market may well cause inflation to rise above its leaders’ comfort level.
The policy changes the Fed might consider — as laid out by Bernanke in congressional testimony last month — would include committing to keeping the Fed’s policy of ultra-low interest rates and massive holdings of bonds on its balance sheet in place for a specific period of time. Currently, the Fed has pledged to keep its target for short-term interest rates very low for an “extended period” and has accumulated $2.7 trillion in assets through a strategy of “quantitative easing.”
But the Fed may be able to lower interest rates further across the economy — such as for home mortgages and corporate borrowing — if it announced that rates will stay low or its holdings will remain massive, or both, through some set date, such as 2013.
“There could more forward guidance on how long the policy accommodation could be put in place,” Charles Evans, president of the Federal Reserve Bank of Chicago, said last month.
However, that policy would also leave the Fed with its hands tied if inflation again emerges as a problem; already, the steep rise in fuel prices earlier in 2011 has pushed consumer prices to the high end of the range that the central bank considers acceptable.
Another modest idea Bernanke floated in July was of changing the “duration” of the bond holdings on its balance sheet. If it replaced Treasury bonds that are due to be paid off in three years, for example, with those that mature in seven years, then it might lower longer-term interest rates for other assets and strengthen the stock market. However, that change would leave the Fed at greater risk of incurring losses if rates rise in the future and the bonds fall in value.
Bernanke also suggested that the Fed could lower the interest rate it pays banks on reserves they park at the central bank. If banks were not earning the 0.25 percent they currently receive on their “excess reserves,” they might have greater incentive to loan the money out.
The final possibility Bernanke raised in his testimony would be an even bigger leap for the Fed than those options: another round of purchases of U.S. Treasury bonds made in a bid to expand the money supply. The last such round, known colloquially as QE2, or the second round of quantitative easing, consisted of $600 billion in purchases that ended just a month ago.
Bernanke and his colleagues are reluctant to take on a new round given that the last round had only limited benefits for the economy and was deeply controversial. But if the economic outlook keeps deteriorating with the speed it has over the past two weeks, QE3 will almost certainly become a bigger part of the Fed’s conversation.