Oct 5 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
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
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.
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.