Q+A-Some questions and answers on further Fed easing

CHICAGO Mon Aug 9, 2010 1:28pm EDT

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CHICAGO Aug 9 (Reuters) - Federal Reserve policymakers meeting on Tuesday will discuss whether the U.S. central bank should take further steps to boost the economy, and if so, how.

Here are some questions and answers about what more the U.S. central bank could do:

WHAT TOOLS DOES THE FED HAVE LEFT?

To reverse the worst downturn since the Great Depression and rescue the financial system from a paralyzing credit crisis, the Fed lowered its target rate for overnight lending between banks to near zero in December 2008, promised to keep rates ultra-low for an "extended period" and expanded available credit to banks by $1.7 trillion through purchases of mortgage-backed securities and long-term U.S. debt.

But there's still more the Fed could do, Chairman Ben Bernanke has said. The Fed could harden its commitment to keeping interest rates low for a prolonged period, cut the rate it pays on the reserves banks hold at the Fed in a bid to spur more lending, and either stop letting maturing securities run off of its balance sheet or make additional asset purchases.

WHICH TOOLS ARE MOST LIKELY TO BE DEPLOYED FIRST?

Traders and economists say they expect any early Fed moves to be largely symbolic -- even changing the language in its statement to reflect the softening of the economy could set up expectations for further easing.

Other "low-hanging fruit" includes lowering the interest it pays banks to keep their reserves at the Fed, which is now at 0.25 percent, or reinvesting the proceeds of maturing mortgage-backed bonds into new securities.

St. Louis Federal Reserve Bank President James Bullard has advocated buying more Treasuries to support the economy, but such a step is seen as less likely in the near term.

HOW EFFECTIVE WOULD EASING BE?

Any further moves may have limited impact, said Michael Feroli, an economist at JPMorgan Chase in New York.

"The investor community is expecting something from the Fed ... but the benefits are probably more limited than what most people in the investor community would like to admit," Feroli said.

Not only are short-term rates approaching zero, but the yield on the two-year note is about half a percentage point and the yield on the 10-year note is just over 2 percent. It's not clear that pushing yields even lower would spur lending.

The Fed could boost the effectiveness of any move by implementing other policies, such as introducing a penalty rate on reserves that banks keep at the Fed, or by other targeted measures to augment lending. But freeing up more cash for lending is only effective if there is demand for loans that otherwise is not being met, which some economists doubt.

WHAT WOULD THE IMPACT BE IN THE MARKETS?

"Even if they symbolically reinvest their portfolio and put it into Treasuries, I'm not sure if there's a huge effect on interest rates, but there is a big effect on the bond market," said Anil Kashyap, a professor at the University of Chicago's Booth School of Business.

Asset purchases would affect bond prices and yields, pushing longer-term rates like those on 10-year notes down closer to shorter-term rates, economists said.

WHAT ARE THE DRAWBACKS?

Buying more assets could hurt the Fed's credibility, Dallas Fed President Richard Fisher has warned, raising questions about whether the Fed is printing money to finance the massive U.S. budget deficit and debt, which could undermine confidence in the dollar and drive interest rates higher.

Strengthening the Fed's commitment to holding rates low could tie policymakers' hands if the economy shifts and the central bank sees the need to act quickly to tame inflation.

If Fed action does not spur the economy in the expected way, people could start to worry about the Fed's overall effectiveness, which in turn could hurt its ability to manage inflation expectations, economists said.

WHAT'S THE RISK OF DEFLATION OR A LIQUIDITY TRAP?

Some economists are worried that if the Fed floods markets with more liquidity, consumers and businesses will react not by borrowing and spending, but by holding back in hopes that already low rates and low prices will drop even further.

The Bank of Japan faced such a problem in the early part of the century when it embarked on its policy of quantitative easing. But economists point out that the BOJ only started such easing after deflation had already set in, limiting the effectiveness of its actions.

In the United States, prices are still rising, albeit at a slowing pace. Some economists argue that if the Fed acts, it will try to do so before inflation dips below zero.

HOW CLOSE ARE WE TO FURTHER EASING?

Most recent data signals a slowdown in the economic recovery, but many economists say that the Fed is likely to wait until there are more definitive warning signals before acting.

"Bernanke has not been running around with his hair on fire or trying to signal some big shift is imminent," University of Chicago's Kashyap said. "There's room to go ahead and ease, but I think they also believe they've already put in quite a bit of stimulus."

Signals that could trigger further Fed easing could include a run of zero or below-zero inflation, continuing worse news on the jobs and housing front, a shift in consumer expectations toward falling prices, or another bout of U.S. dollar strength and stock market declines, economists at TD Securities told investors in a note on Monday.

Still, futures traders are pricing in some chance that the Fed will push short-term interest rates lower in coming months, and are not fully pricing in an increase in the Fed's target rate for at least another year.

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