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.