WASHINGTON, Aug 11 (Reuters) - The Federal Reserve’s renewed push toward monetary easing was meant to offer some clarity on its likely policy path.
But by pulling the U.S. central bank even deeper into uncharted territory, the Fed’s announcement on Tuesday has inadvertently heightened uncertainty in financial markets.
How effective will the unorthodox policies prove? What will the Fed do next? Will it bolster its Treasury bond purchases and, if so, how aggressively? What does the Fed know that we don’t?
All of these questions were swirling around on Wednesday as Fed watchers tried to make sense of what is arguably the central bank’s most important policy announcement since it first signaled the intention to buy assets in late 2008.
“People are more uncertain about how the committee views the outlook and how worried they are,” said Laurence Meyer, a former Fed board governor now at Macroeconomic Advisors. “And they’re really uncertain about what’s going to happen at the next meeting.”
The Federal Open Market Committee, the Fed’s policy-setting body, said it will begin using the proceeds from maturing mortgage bonds it acquired during the crisis to keep its holdings of domestic securities around $2 trillion.
It was a small but significant shift that fueled a sense of doubt in markets as trade data suggested U.S. second-quarter growth was softer than first believed and weak Chinese factory data added to worries of a global slowdown.
The Standard & Poor's 500 index slid 2.7 percent .SPX, while the dollar, often seen as a safe-haven from turbulence, was on track for its sharpest one-day gain since October 2008, when the financial crisis reached fever pitch. .DXY
The muddled outlook was reflected keenly in a Reuters poll of primary dealers conducted just after the Fed decision. The results found the big banks deeply divided on the issue of whether the central bank would return to outright Treasury bonds purchases. Of the 13 dealers that chimed in, five offered an unequivocal “yes,” two said “possibly,” another responded with “unlikely” and five said “no.” [FED/R]
Even the immediate impact of the Fed’s reinvestment decision was hard to gauge. Unlike Treasuries, which have a set maturity date, refinancings and home loan prepayments could affect the amount of mortgage backed securities rolling off the Fed’s balance sheet.
And then there is the matter of effectiveness. The new approach, which some in the market have labeled quantitative easing II or simply QE-lite, is fraught with dangers. Japan’s troubled experience with a two-decade long deflationary cycle despite similar efforts with unorthodox policies offers a cautionary tale.
For starters, there is significant doubt about whether incremental steps like the one taken this week will do anything to affect lending conditions.
A New York Fed study published in March indicated the Fed’s commitment to buy over $1.7 trillion in securities during the crisis earned it only about a 0.3 to 1 percentage point decline in benchmark market interest rates. That means any substantial easing effort would take big, sweeping figures to make a noticeable dent — perhaps another $1 trillion, according to estimates by Goldman Sachs economists.
It is also possible that further easing offers diminishing returns to scale, analysts say, requiring ever increasing amounts of funds to get a similar easing effect.
Many also point out that the fundamental problems plaguing the United States are high unemployment and weak consumer demand, neither of which can addressed directly with more credit. The ultimate fear, expressed prominently by St. Louis Fed President James Bullard earlier this month, is Japanese-style deflation where no amount of monetary stimulus is enough to propel growth.
“It’s not a lack of liquidity that’s holding the economy back,” said Michelle Girard, senior U.S. economist at RBS Securities in Stamford, Conn.
The case of Japan is instructive on this count. The Bank of Japan repeatedly tried to funnel cash into its banks in the hope of sparking a lending boom, with little success.
Back in 2003, Fed Chairman Ben Bernanke, then a Fed board governor, had an interesting suggestion for the BOJ: “explicit, though temporary, cooperation between the monetary and the fiscal authorities.”
Unfortunately, that is highly unlikely in the United States, where a bloated budget deficit has already become a major talking point for politicians looking to November’s congressional elections.
In its absence, the Fed is pretty much on its own. But the doubts about whether a fresh push into asset buying can stem the U.S. economy’s slide are rampant — even within the central bank itself.
“Like the BOJ, the Fed is unconvinced how effective quantitative easing can be,” said David Cohen, director of Asian economics forecasting at Action Economics in Singapore. “But they are under increased pressure as the economy faces the threat of deflation,”
Additional reporting by Rie Ishiguro in Tokyo