Four key questions if the Fed decides to stimulate the economy
Wednesday, September 29, 2010; 8:25 PM
The debate over new Federal Reserve efforts to boost the economy has rapidly shifted from "whether" to "how." Since Fed officials met last week and signaled they are open to new steps to try to strengthen the economy, chatter has flown around financial markets about the possibility of a major new infusion of cash, on the order of $1 trillion. Some of this talk is a little premature, as it is not a given that the Fed will take any action at its Nov. 2-3 meeting. If economic data come in surprisingly good over the coming weeks - or inflation shows signs of rising - the Fed might not intervene. But here is a guide to the key technical and strategic questions that Fed Chairman Ben S. Bernanke and other central bank leaders will need to resolve, should they choose to act, on how to stimulate growth by easing monetary policy.
1. How much 'quantitative easing'?
This is the biggest question. The strategy that Fed officials are most likely to pursue involves buying vast quantities of bonds on the open market - essentially increasing the money supply - to strengthen economic growth and get inflation closer to its annual target rate of 2 percent.
Such a strategy is called quantitative easing. Fed watchers refer to a possible new round of such easing as "QE2," since it would follow earlier bond purchases announced during the financial crisis.
But how many hundreds of billions of dollars? In its previous efforts to prop up the economy, the Fed expanded the size of its balance sheet from about $850 billion to about $2.3 trillion. That may have been a significant factor in ending the recession in June 2009. Still, the government was taking so many audacious steps to try to arrest the economy's free fall that it's hard to know exactly how much of a role QE1 played.
The economy isn't collapsing anymore, and the financial markets are functioning somewhat normally, even though growth is too slow to bring down joblessness. That means that new quantitative easing would offer less bang for the buck: Each $100 billion of new easing would produce less incremental improvement in the economy than it did during the crisis.
Bernanke addressed the issue in a speech last month but had no definitive answers. "The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool," he said. "However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses."
2. Shock-and-awe ordribs-and-drabs?
A closely related question is how the Fed would announce new easing measures. In the earlier rounds of major asset purchases, the Fed announced them in a few, dramatic steps (such as a March 2009 declaration that it would buy up to $1.25 trillion in mortgage-backed securities, among other actions).
That shock-and-awe strategy has some clear benefits. Interest rates respond rapidly to the initial announcement, and the Fed can then take its time actually making the purchases. A clear sign of commitment from the central bank creates a boost in financial markets and allows the economic benefits to begin flowing the moment the announcement is made.
However, St. Louis Fed President James Bullard has advocated having smaller purchases announced at each policy meeting, an approach that is gaining favor within the central bank. For example, at next month's meeting, Fed officials could announce, say, $200 billion in planned asset purchases. At their subsequent meeting in mid-December, they could announce another round of asset purchases, if economic data have continued to disappoint, or no additional purchases if the economy seems to be firming up.
With the dribs-and-drabs strategy, the Fed would lose the immediate benefits of shocking financial markets with an announced wall of money. But it would gain the flexibility to respond to economic conditions as they evolve.
3. Treasuries or mortgage-backed securities?
Further Fed easing would consist of buying assets. But which assets?
The two major choices - the assets that the Fed can buy using its standard legal authority, as opposed to invoking emergency lending provisions - are to buy U.S. Treasury bonds or housing-related debt issued by Fannie Mae and Freddie Mac. During the try-anything crisis response in 2009, the Fed did both. Here are the pros and cons of each.