By Vincent R. Reinhart Tuesday, July 20, 2010
The calls have picked up in frequency and urgency for the Federal Reserve to ease the stance of monetary policy. No doubt, such urgings will be particularly pronounced at Federal Reserve Chairman Ben Bernanke’s appearance before congressional committees this week. Despite the bluster for the cameras, however, the senators and representatives are not likely to be successful in prodding action.
A job requirement when I worked at the Fed was to sit stoically behind the Fed chairman as he delivered his semiannual testimony on monetary policy. Not once in my dozens of trips to Capitol Hill did I hear an elected official ask two obvious and important questions about policy setting. First, how has the economy changed in the six months since the last policy report? Second, what has the Fed done about it?
Those are hard questions for the current Fed chairman. Over the first half of 2010, the economy has grown only sluggishly so that gains in private payroll have not been sufficient to make meaningful progress in lowering unemployment. And inflation has fallen further below the range Fed officials previously identified as consistent with price stability.
Meanwhile, the Fed’s policy rate is unchanged, near but above zero, the Fed’s balance sheet is about the same size, and reserves in the banking system have fallen.
Bernanke’s response almost surely will be that the Fed has done all that will likely work. An aphorism often heard in the depth of the financial crisis in 2008 and 2009 is that there are no atheists in a foxhole. Policy makers were willing to try various unconventional actions, including lending to institutions through new facilities and buying assets they never bought before, on the hope of supporting a collapsing economy. When markets are strained and private-sector participants have pulled back, official action can have considerable traction in affecting the prices and yields of financial instruments.
Belief borne of battle does not always survive peacetime. As markets have improved and investors returned to trading, Fed officials probably hold that unconventional action would not move prices much. The Fed’s balance sheet may be big, but the private sector has more resources and a greater assertiveness in determining the prices of securities.
If so, then the Fed’s only policy lever on financial markets and the broader economy is its federal funds rate target. Bernanke and company will no doubt vigorously assert that they have done all that can be done in their current setting of the funds rate and communication about future action. The Fed funds rate is currently at the rock-bottom level of zero to one-quarter percent.
When there is no way to go lower, the only question left is how long to remain at that low level. Market participants’ understanding of the Fed’s answer to that question affects longer-term interest rates and all other financial prices. Through its various statements, the Fed has made it clear that the funds rate will remain low as long as the economy is performing poorly. Thus, as readings on spending and unemployment have proved disappointing over the past six months, private-sector economists have pushed further into the future when they expect policy tightening. In the mathematics of markets, taking out future tightening works the same as easing currently. Thus, monetary policy has been expansionary of late, helping to offset economic weakness.
But this modest contribution to growth is unlikely to reinvigorate spending. The next available weapon in the Fed’s arsenal is the direct purchase of securities. The Fed has bought marketable debt before and to good effect. Indeed, its program of purchasing Treasury, agency, and mortgage-backed securities only ended this spring. In total, the Fed added $1.25 trillion of long-term debt to its portfolio, which helped pull mortgage rates lower and keep its balance sheet from otherwise shrinking.
Lower market interest rates from renewed Fed purchases would encourage households and firms to spend. In addition, an expanding central bank balance sheet would blunt the upward pressure on the foreign exchange value of the dollar. This would shift some of the responsibility to keep the world economy going to our trading partners.
A Fed purchase program could be made to depend on the economic outlook in a manner similar to its interest-rate setting decision. That is, as long as the outlook is subpar and inflation headed down, the central bank would purchase a certain amount of government and mortgage-related securities between its regularly scheduled meetings. As a consequence, market participants would recognize that it was not an open-ended promise to monetize the federal debt.
Most likely, the improvement in financial markets thus far this year implies the effect on yields would not be as dramatic as when the Fed stepped in last at a time of great stress. But the action would push in the right direction so as to be helpful given near-term economic conditions.
Even a quick scan of the direction of the global political winds should add a special sense of urgency to the Fed’s decision-making process. Voters around the world are angry about big government deficits and huge debt loads. Retrenchment has already begun in earnest in Europe. Despite the Obama administration’s reluctance to embrace this particular change, the odds strongly favor fiscal restraint in the next few years here at home.
The economic cookbook pairs fiscal tightness with monetary laxity. If fiscal restraint emerges when the fed funds rate remains at zero, then additional monetary ease would have to take an unconventional form—buying assets. It would take a brave Fed chairman to announce new purchases of Treasury securities when the federal government is trying to restrict the volume of their sales so as to retain the confidence of investors. But if a Fed purchase program were already in place and had a track record in support of the general economy, the appropriate policy coordination could come off without a hitch.
A Fed program of buying longer-term securities is the right policy for now and makes the right policy more likely in the future.
Vincent Reinhart is a resident scholar at the American Enterprise Institute.
Image by Rob Green/Bergman Group.