A darkening US economic outlook is forcing Federal Reserve officials to dig ever deeper into an already depleted policy toolkit and consider measures until recently deemed too radical. A new US downturn could prompt policymakers to take the aggressive step of setting specific economic guideposts for the direction of interest rates.
August jobs data pointed to a labour market teetering on the edge of recession, and investors are looking for the Fed to take some sort of action in September – probably an additional further effort to push down long-term interest rates. But if things get worse, baby steps in the direction of further easing might not do the trick, pushing the central bank to be even bolder.
An approach that sets explicit targets for economic conditions would serve the twin goals of increasing transparency about the aims of policy and requiring only a verbal commitment rather than outright asset purchases, which have proven controversial. “The next step would be to outline criteria, numerical targets for unemployment and inflation,” said Mark Gertler, an economics professor at New York University who has been a consultant to the New York Federal Reserve Bank.
Such a measure could help the economy by temporarily allowing greater inflation, reducing the debt burden of businesses and consumers and giving them added incentive to spend by pushing the dollar down.
“Where they can be most effective is to signal to the markets how fast they are going to let the recovery go before they raise rates,” said Gertler.
Minutes from the Fed’s last meeting on August 9 suggested officials were already considering such a shift last month, even before the economic data took another turn for the worse.
“In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate,” the minutes said.
BEN IN A BOX:
Chicago Fed President Charles Evans has actively campaigned for a price-level target, and in interviews this week suggested the central bank should allow inflation to rise as high as 3 per cent in order to spur employment.
But if Fed Chairman Ben Bernanke opts for that route, he is likely to face opposition from more-hawkish policymakers who fear inflation, once rising, could get out of control.
Even those who are not anxious about inflation might worry the move would unnecessarily box the Fed into trying to achieve a specific level of unemployment, when central bankers do not have full control of the variables affecting the labor market. Economists widely agree the level of full employment that is consistent with non-inflationary growth can vary over time.
“This idea has come up, I was a bit cautious about it,” Dennis Lockhart, the president of the Atlanta Fed, told reporters this week.
Last month, the Fed took the unprecedented step of saying it expected to keep interest rates near zero for at least another two years, an effort to put downward pressure on long-term borrowing costs. However, the economy continues to look sickly. The prospect of a renewed downturn appeared heightened after the government said on Friday that the US job market failed to add jobs last month for the first time in nearly a year, while the unemployment rate remained stuck at 9.1 per cent.
Against that backdrop, the Fed could begin to ponder employing even some of the more controversial policy options left in its toolbox.
BRACING FOR A TWIST:
What will the Fed do in the very near term? Many analysts are expecting some sort of fresh policy announcement at the Fed’s next meeting on September 20-21. Expectations of action grew last week when Bernanke announced that the meeting, originally scheduled for one day, was being expanded to two to allow more time for officials to discuss their options. “I am expecting them in some way to talk about extending the maturity of their holdings,” said Dana Saporta, economist at Credit Suisse. “For Bernanke to announce that there is a two-day meeting coming up at which options will be actively discussed and then to announce the status quo at the end does not seem likely to me.”
For its next easing step, the Fed would almost certainly seek to tilt its bond portfolio toward longer-dated maturities to try to put more downward pressure on long-term interest rates. It is unclear, however, exactly how the Fed might shift its portfolio.
The more modest way to do this would be to simply reinvest proceeds from maturing bonds it holds into longer-dated issues. Another way, akin to a 1961 policy known as Operation Twist, would involve actively selling securities of short duration to buy longer-term ones.
Both approaches have been actively discussed. Neither is likely to have a major economic impact, but they could bolster market psychology at a fragile time, buying policymakers time to debate more aggressive measures. Analysts at Keefe, Bruyette and Woods even see the possibility that the Fed might eventually try to complement new efforts on housing from the administration of President Barack Obama with a new mortgage stimulus of its own. “Down the road,” they said in a research note, “we would not rule out the Fed employing a modified Operation Twist that would involve reinvesting the proceeds of maturing Treasuries into mortgage-backed securities or even selling short-dated Treasuries to buy MBS.”
