The Federal Reserve’s monetary policy brain trust – the Federal Open Market Committee (FOMC) — meets again today, and after a month of disappointing economic news following June’s meeting, the financial world is eagerly waiting to hear news of what action the Fed will take to goose the economy.
At last month’s meeting, the Fed announced that it would continue its “operation twist” program of selling short-term U.S. government debt and buying up long-term bonds in an effort to reduce long-term interest rates. But since that time, an already infirm economy has showed further signs of weakness: Last week’s GDP numbers showed decelerating growth, and employment growth has proven unable do more than keep pace with population growth.
These poor numbers, along with public remarks from some members of the FOMC, have led market watchers to believe that more aggressive action from the central bank is forthcoming. On July 13th, the President of the Federal Reserve Bank of Atlanta, Dennis Lockhart, gave a speech explaining his stance towards further simulative bond buying, commonly known as quantitative easing (QE). In the speech, he outlined both the pros and cons of expanding the central bank’s balance sheet, but signaled that he is clearly willing to endorse another round of QE if economic conditions warrant:
“My support for the current stance of policy rests on a forecast that sees a step-up of output and employment growth by year-end and into 2013. If the economy continues on the track indicated by the most recent incoming data and information, that forecast will become untenable, as will the policy premises underlying it.”
This is classically opaque Fed-speak, but the gist is: If the economy is actually as bad as the most recent numbers indicate, then I’ll vote for more bond buying. This sentiment was echoed by Cleveland Fed President Sandra Pianalto as well a few days after Lockhart’s speech.
But there is also reason to believe that the Fed might take a different approach to QE this time around. An increasingly popular idea among economists and pundits is to make the next round of quantitative easing open-ended; that is, instead of purchasing a set dollar amount of treasury bonds or mortgage-backed securities, the Fed would state a policy goal — 5% nominal GDP growth, say — and commit to doing whatever it takes, for however long it takes, to achieve that goal. In an interview with the Financial Times, another member of the FOMC, San Francisco Fed President John Williams, lauded the merits of such a program. In the interview, Williams argued that such a program would work better because it would stop market participants from merely planning around the end date of a bond buying program, and get them thinking more long term.
Indeed, since the Federal Reserve has a theoretically unlimited ability to buy up treasury bonds and mortgage backed securities, a promise from it to create nominal GDP growth is very credible. And so an open-ended commitment to creating that kind of nominal GDP growth will force banks to lend now and businesses to spend now, lest their money be worth less tomorrow. While this is just one member of the FOMC, that even one member is publicly endorsing such a policy significantly raises the possibility that it will be implemented.
One additional policy change that might be considered is to lower the interest rate that the Fed pays banks for keeping their reserves at the central bank, currently at 0.25%. The ability to pay banks interest on excess reserves was granted to the Fed in 2008 so that it could more effectively calibrate interest rates, and so that it could implement an orderly unwinding of its balance sheet once a recovery had successfully taken hold. But recently the European Central Bank eliminated the interest it pays on reserves in order to spur bank lending, and the Danish Central Bank has started charging banks a fee to keep reserves with it. Princeton economist and former Fed vice chair Alan Blinder penned an op-ed in The Wall Street Journal advocating a similar measure, arguing that banks won’t start lending unless the Fed stops paying them interest on reserves. He writes that although the policy may not lead to more lending, it is certainly worth a try:
“Suppose the Fed cuts the IOER from 25 basis points to minus 25 basis points, and banks don’t lend one penny more. In that case, the Fed stops paying banks almost $4 billion a year in interest and, instead, starts collecting roughly equal fees from banks. That would be almost an $8 billion swing from banks to taxpayers. There are worse things.”
So will the Fed announce any of these measures after today and Wednesday’s meetings? The conventional wisdom says that more bond buying is unlikely until at least the September or November meetings, but dismal economic news and increased chatter from FOMC members means that central bank will probably not sit on its hands much longer.