By Neil Irwin
Washington Post Staff Writer
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.
Buying Treasurys is a purer exercise of the Fed's money-creation power. The purchases would lower the long-term rate on Treasury bonds, which in turn should pull down interest rates across the economy. Also, the Treasury bond market is huge, so the Fed would have leeway to intervene without crowding out private buyers.
One downside: If it buys Treasurys, the Fed could be accused of "monetizing the debt," or printing money to fund large budget deficits. There is a risk that global investors could lose confidence in the Fed's independence and not trust the central bank to step back from future bond purchases. That could cause a rise in interest rates and in expectations of inflation, undermining the effectiveness of the new easing.
The second option would be to buy mortgage-backed securities from Fannie and Freddie. One upside is that it would stimulate the troubled housing market by targeting mortgage rates directly. That said, mortgage rates have fallen dramatically in recent months, with little apparent benefit to the housing market, so further declines might not make much difference.
There are two downsides to the second strategy. First, it would put the Fed in the position of favoring housing over other sectors. Second, the market for mortgage securities has been slow to return to normal. If the Fed gets back in, it might delay the return of private funding and thus be counterproductive.4. Cut the interest rateon excess reserves?
Since summer, Fed officials have discussed cutting the rate they pay banks on reserves parked at the Fed as a tool to boost the economy. It works like this: For money banks keep at the Fed beyond their regulatory minimums, they are currently paid 0.25 percent interest. The Fed could cut that rate to close to zero, and then banks would have a bit more incentive to do something useful with that cash, such as lending it to clients.
But this would not be a panacea. Banks are parking money at the Fed because they want it to be very safe and readily available should they need it. So money that they no longer keep at the Fed banks would most likely pour into other ultra-safe, short-term investments, such as Treasury bills. That would not create much of an economic bounce, though at the margins it would reduce interest rates across the economy and have some mild benefit on growth.
That economic benefit, however, could prompt technical problems in the money markets caused by the decline of rates closer to zero. Still, the central bank would likely consider cutting the interest rate on excess reserves in conjunction with bond purchases.