Federal Reserve's shift in policy doesn't change its basic outlook

Chairman Ben S. Bernanke and other leaders at the Fed still see a gradual recovery underway.
Chairman Ben S. Bernanke and other leaders at the Fed still see a gradual recovery underway. (Mahmood Fazal/bloomberg News)
  Enlarge Photo    
By Neil Irwin
Washington Post Staff Writer
Wednesday, August 18, 2010

After the Federal Reserve's policy meeting last week, the drumbeat on Wall Street and among some economists for bold new steps to strengthen the economy got louder.

Don't hold your breath.

The Fed's move last week to make its monetary policy more supportive of growth was a reversal after a year in which the central bank backed away from unconventional steps to stimulate the economy.

Although last week's action reflects a deepening concern at the Fed over the sluggish pace of growth, policymakers remain reluctant to undertake broader efforts to stimulate the economy, viewing their policy tools as uncertain to be effective.

Fed officials would only make more aggressive moves to support the economy -- namely, purchasing hundreds of billions of dollars of Treasury bonds and other securities -- if conditions deteriorate enough to change their view that a gradual and self-sustaining economic recovery is underway. The bar is higher, according to economists and others who closely study the Fed, than many in the financial markets have assumed.

"This is a modest shift in policy, not a big one," said Peter Hooper, chief U.S. economist for Deutsche Bank. "Only if things change to the point that they no longer expect the economy to be on track in the longer term will it be time to pull out the big guns, because they don't think they have very big guns left anyway."

Last week, the Fed's policymaking committee said the central bank will buy bonds to replace mortgage securities that get paid off, effectively freezing its balance sheet at its current size rather than allowing it to shrink as time passes. The action will keep long-term interest rates for mortgages, corporate loans and other forms of debt slightly lower than they otherwise would have been.

By Fed leaders' estimates, the action will lower long-term interest rates by less than a quarter of a percentage point, and possibly less. Fed officials also see the action as a way to signal to financial markets that they are serious about keeping low interest rates in place for a long time to come.

The decision was driven by a modest downgrade in the Fed leaders' forecast of growth for the second half of the year and revised data on growth that showed economic activity was further below its potential than had previously been thought.

What it was not driven by -- at least for most policymakers -- was an expectation that the economy is at risk for a cycle of falling prices known as deflation, or that a dip back into recession has much likelihood of happening.

Those fundamental views about the economy would have to change for the Fed to take more forceful steps to stimulate growth. While Fed Chairman Ben S. Bernanke and his closest allies on the policymaking committee are worried about the growth picture -- revisions to the second-quarter U.S. gross domestic product are expected to show that growth in late spring was significantly below 2 percent -- for now they view a continued, if unspectacular, expansion as the most likely outcome.

In a normal environment for monetary policy, the recent weakness in the economic data -- combined with very low inflation levels -- would likely warrant lowering the target federal funds interest rate, the Fed's main policy tool. But that rate is already near zero and can't be cut further.

Some economists outside the Fed -- and a handful inside it -- are advocating that the central bank respond to the weaker economic outlook by undertaking more unconventional efforts, such as resuming major asset purchases.

The Fed's leadership, however, has set the bar higher for using less-conventional measures than it has for using the better-understood federal funds rate. That's because policymakers aren't sure exactly how much impact, if any, buying $500 billion of Treasury bonds would have on the economy.

The effect is particularly unclear in an environment where long-term interest rates are already very low; it's not evident that 10-year Treasury bond rates, to which mortgage and other rates tend to be linked, could fall much below their current 2.63 percent level.

Asset purchases could even be counterproductive, if they lead investors to think that the Fed will continue printing money indefinitely to fund large U.S. budget deficits, driving up inflation expectations. Although some uptick in inflation expectations could be desirable for the economy, the exact influence is unpredictable and expectations could get out of control quickly.

But advocates of new bond purchases argue that the Fed is being too timid in the face of a rapidly weakening economy. Whereas during the depths of the financial crisis, Bernanke and his colleagues deployed dozens of untested, unpredictable tools to try to strengthen the economy and financial system, the Fed has now returned to a more cautious approach.

More bond purchases "may not be a perfect tool, but it's more of a psychological battle they need to win right now," said Julia Coronado, a U.S. economist at BNP Paribas. "You can't wait until a deflationary psychology to take hold. You have to act in advance of that and act aggressively. The risk of failure is not a reason not to act."

© 2010 The Washington Post Company