Q+A-Will the Fed do more to help the economy?

Tue Oct 5, 2010 12:29pm EDT

Oct 5 (Reuters) - The U.S. Federal Reserve is mulling whether or not it should do more to spur a sluggish economic recovery and lift an inflation rate that is too low.

The Fed has already done a lot. It bought $1.7 trillion of mortgage-related and Treasury bonds after cutting benchmark interest rates to near zero to combat the financial crisis and help the economy pull out of a severe recession.

But given the economy's weak outlook, many analysts expect the Fed to embark upon another round of asset buying as early as its next meeting on Nov. 3-4 meeting. [FED/R]

WILL THE FED DO MORE TO SUPPORT THE ECONOMY?

Federal Reserve officials are still divided on whether or not to ease further.

William Dudley, the head of the Federal Reserve Bank of New York, said on Oct. 1 that more Fed action will likely be warranted if the outlook for employment and inflation does not improve.

Dudley's views, as the vice chair of the policy-setting Federal Open Market Committee, are seen as carrying more weight than other regional presidents. His view has been publicly shared by Chicago Fed President Charles Evans and Boston Fed President Eric Rosengren. [ID:nN01261676]

But some other Fed officials are not on the same page.

Charles Plosser, head of the Philadelphia Federal Reserve Bank, said on Sept. 29 that further Fed easing is unnecessary based on his outlook. And Dallas Fed President Richard Fisher has said in his view only another shock to the system would merit further easing.

WHAT DO FED OFFICIALS DISAGREE ON?

Federal Reserve Chairman Ben Bernanke has framed the debate on further easing in terms of a cost-benefit analysis.

This means there are many different fault lines along which Fed officials can disagree: on the outlook for the economy, the effectiveness of tools and the costs of using those tools. -- Economy: Officials differ on whether the recovery is merely working its way through a soft patch or whether the recovery is truly faltering and needs support.

-- Effectiveness: Regional Fed bank presidents, including Dudley and Rosengren, say purchases can stimulate the economy by lowering borrowing costs.

But Fisher has argued that regulatory and fiscal uncertainty -- not interest rates -- is hindering business activity, putting the ball in the government's court.

Some officials, including most vocally Minneapolis Fed President Narayana Kocherlakota, have argued that much of the unemployment problem is due to a skills mismatch, which monetary policy is not best placed to address. But others say this view is too pessimistic and that unemployment is primarily a demand problem, which the Fed can tackle.

-- Costs: Some Fed officials, including Plosser, have voiced concern about the possibility the Fed's credibility could be damaged if it launches fresh action and is not successful in lowering the unemployment rate.

He and others also worry about distorting markets and laying the groundwork for future inflation by complicating the Fed's eventual exit from its accommodative policies.

There is also a concern that some investors might interpret the Fed's purchases as a monetization of the debt.

Another cost is that purchases would further expose the Fed to interest rate risk.

Dudley, however, said in his Oct. 1 speech that the costs do not appear to be "prohibitive."

WHAT WOULD FED HOPE TO ACHIEVE WITH MORE EASING?

If the Fed resumed purchases of longer-term U.S. Treasury debt, it would hope to further drive down long-term borrowing costs to spur economic growth and to nudge up below-target inflation.

In part, the Fed would want to force investors to move into other, riskier, asset classes to impact a wide range of rates.

Lower U.S. borrowing costs could stimulate home buying and building, business investment and, ultimately, hiring.

The $1.7 trillion of purchases of securities lowered long-term borrowing costs by around half a percentage point, according to the Fed and other analysts.

Dudley estimated that $500 billion of purchases would likely have about the same impact as a 0.5 or 0.75 percentage point decline in the Fed's benchmark federal funds rate.

Further asset purchases could also raise inflation expectations and bolster confidence, by signaling to markets the Fed's commitment to tackling disinflationary pressures.

SMALL STEPS OR BIG BANG?

The New York Fed staffer charged with implementing Fed policy, Brian Sack, said on Oct. 4 that a smaller step program would enable the Fed to be more responsive to the evolving economic outlook. This, he said, would be similar to the way it has historically adjusted the benchmark federal funds rate.

Sack said the big upfront announcements -- which is what the Fed did in the first round of purchases -- may be more appropriate in circumstances where "substantial and front-loaded policy surprises had benefits, but different approaches may be warranted in different circumstances."

However, a risk is that the Fed will lose out on the full announcement effect on yields of a shock-and-awe announcement. [ID:nN04294462]

WILL THE FED BUY MORE MBS OR MORE TREASURIES?

Fed officials have said the Fed could buy more Treasuries or mortgage-backed securities.

Sack said there currently appears to be more room for the Fed to buy Treasuries without creating market distortions.

He said the Fed's System Open Market Account currently holds about 12 percent of the outstanding stock of Treasury coupon securities. There will also be plenty of supply, he said, with the Treasury expected to issue around $1.2 trillion over the next year.

If mortgage-backed securities cheapened significantly relative to Treasuries, this could affect the Fed's decision on what assets to buy, he said.

WHAT OTHER OPTIONS DOES THE FED HAVE?

The Fed could also clarify its intentions through its communications strategy. It could strengthen its pledge to keep rates low for an extended period.

Dudley suggested that the Fed could be more explicit about its inflation objective.

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