What to expect today from the Fed

August 9, 2011

Today’s meeting of the Federal Reserve’s policy committee was supposed to be a sleepy one. As recently as three weeks ago, there was no real reason to expect any policy shifts.

Then, a slew of very weak economic data came out. And in the past three stock trading sessions, the wheels have come off the financial markets, with the Standard & Poor’s 500 index down 11.2 percent since Thursday’s close. The teeth-rattling volatility of late 2008 is back.

So what is the Fed going to do about it?

We’ll find out at 2:15 p.m., when it announces results of the one-day meeting. This might be the hardest test for Chairman Ben S. Bernanke and the Fed since the end of the financial crisis.

There are no good options remaining for the Fed. If Fed officials do nothing, they look out of touch and the government seems to be out of bullets. But the actions they might plausibly take probably wouldn’t do much to either soothe markets or boost the economy.

And central bankers are loath to seem to be responding to the latest ups and downs of financial markets. They’re supposed to keep their eye on the ball — in this case, the performance of the underlying economy.

At the same time, there is no way the collapsing stock market of the past few days won’t affect the real economy — and it won’t be for the better. Even before the latest volatility, there were signs that the U.S. economy was growing at a painfully slow pace, not even fast enough to bring down the unemployment.

Fed officials are also determining their next action based in part on inflation. Here, too, the latest market activity makes new action to ease monetary policy more plausible. Commodity prices, especially oil, have fallen in recent days (gold is the major exception). And inflation expectations, as measured in the bond market, have fallen sharply as well, though not to the low points they reached last summer when the Fed last weighed new easing.

So what might the Fed do today? Here is a menu of possibilities, from most likely to least likely.

- Indicate it is monitoring the situation closely and will take new actions if necessary. The language of the Fed’s statement is sure to acknowledge the recent deterioration of the economic outlook and the financial market volatility. At the very least, it will signal that the Fed is prepared to take new actions in the future if conditions warrant.

- Pledge to maintain a large balance sheet for a long time. Bernanke raised this possibility in recent congressional testimony. The Fed holds $2.65 trillion in Treasury and mortgage-related securities on its books, and the central bank could pledge to maintain the portfolio at a very large size for an “extended period,” or some other language to signal it won’t be selling off securities — and hence sucking money out of the economy — anytime soon.

- Put a specific time horizon on its low interest rate policies, large balance sheet, or both. The Fed could go one step further and specifically pledge to keep its policy of low interest rates in place through, say, 2013.

- Change the duration risk of the bond portfolio. The Fed could indicate it will shift its $2.65 trillion portfolio toward securities that mature in the more distant future, which could lower longer-term interest rates for home mortgages and other forms of lending.

- Cut the interest on excess reserves rate. The Fed currently pays banks 0.25 percent on money it parks at the central bank. It could cut that rate closer to zero, giving banks slightly more incentive to lend it out.

- QE3. This is the big one. The Fed could consider re-opening its program of buying Treasury bonds or other securities to try to increase the money supply. The last round of so-called quantitative easing ended June 30, and consisted of $600 billion in bond purchases.

A particularly dramatic step would be to make any new program open-ended, for example pledging to keep buying $75 billion to $100 billion in bonds each month, indefinitely, until conditions warrant stopping.

The Fed would be loath to make such a consequential decision on the fly, reacting to just a few days of market activity without its usual slow, careful deliberation. The decision to undertake the last round of quantitative easing was a three month affair: Bernanke discussed it in great detail in one speech in late August 2010, then in another in October, before the decision was finally made in November.

The Fed probably won’t pull out the big guns of QE3. As recently as Friday, when a so-so jobs report was released, it seemed completely out of the question. But the situation has seemed so dire since then that it has little choice but to at least consider the possibility.

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