The Fed has not run out of options, as yet

 EmailPrint This Post Print This Post

This post is a guest contribution by Asha Bangalore, vice president and economist of The Northern Trust  Company.

The worst of the financial crisis is history, but the U.S. economy is still struggling to establish self-sustained economic growth. There is an ongoing debate among economists and policy advisors as to what is the best course – fiscal austerity or stimulus – to restore financial and economic tranquility. Discussions about the Fed’s options in the event of further weakening of economic conditions in a deflationary environment have also surfaced. There is no consensus on what is the most suitable route partly because the relatively more obvious and aggressive measures have already been implemented. Today’s focus is a checklist of the Fed’s options if economic conditions call for more creative programs to support economic activity.

Chairman Bernanke’s speech in May 2003 (Some thoughts on monetary policy in Japan) offers a few alternatives. The first option Bernanke lists is for a central bank to announce a “quantitative objective for prices”. The operational aspect of this strategy would be a central bank announcing its intention to restore the price level to the value it would have reached if prices had not fallen. An assumption of a moderate increase in prices would be necessary.

The motivation to mention this approach is the fact that the U.S. Consumer Price Index (CPI) has declined for three consecutive months. The Core CPI, which excludes food and energy, and the core CPI excluding homeowners’ equivalent rent are both indicating a decelerating trend, with the core CPI showing only a 0.9% increase on a year-to-year basis in June.

The Fed prefers the core personal consumption expenditure price index, which shows a slightly more reassuring picture (see Chart 2, June data will be published on August 3).

The main objective is to raise inflation expectations in order to reduce the debt burden of borrowers and break the deflationary psychology that could be holding back household purchases. There is no urgency to take this step in the U.S., as yet, but it is an alternative worthy of consideration, if necessary.

A second option is a marriage of monetary and fiscal policies to stimulate business activity and break the deflationary spiral. It would work in the following manner. All tax cuts/spending programs would be financed by issuing new government bonds. The next step would be that the Fed would purchase these bonds. The benefit of this action is that outstanding publicly held debt would be unchanged and future tax obligations would be left unchanged. Lest we forget that there is no free lunch, this road will lead to inflation, which what is the temporary goal. The Fed will have to engage in reversing this program at the appropriate juncture.

Third, the Fed could lower interest rate on excess reserves as it is often mentioned in recent monetary policy discussions. At the extreme, the Fed could also be creative like the Riksbank, the central bank of Sweden, and charge a fee if banks park excess reserves at the Fed, a nominal one. Banks did not earn interest on excess reserves not too long ago, which could be reinstated. Furthermore, this policy could be tied to tax breaks for banks. (Public outrage, given that banks are perceived in negative light following the bailout, should not be surprising.) The Fed could establish suitable loan-to-reserve ratios, when achieved, to earn tax breaks for banks or yield interest on excess reserves instead of zero or negative returns. The quality and type of loans and the recipients of these loans would have to be controlled to implement this program.

Fourth, the Fed could purchase additional Treasury securities or re-establish expired programs. The downside of this option is that the “bang for the buck” will be diluted because it will be a repeat story. In sum, there are other expansionary monetary policy avenues to consider.

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, July 30, 2010.

Did you enjoy this post? If so, click here to subscribe to updates to Investment Postcards from Cape Town by e-mail.

More on this topic (What's this?)
Anticipating The Rate Hike
Rising Interst Rates Historically A Positive For Equity Returns
You can't really see it on this chart so you'll have to trust me
Read more on Federal Reserve at Wikinvest
OverSeas Radio Network

1 comment to The Fed has not run out of options, as yet

Leave a Reply

You can use these HTML tags

<a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

  

  

  

Top 100 Financial Blogs

Recent Posts

Charts & Indexes

Gold Price (US$)

Don Coxe’s Weekly Webcast

Podcast – Dow Jones


One minute - every hour - weekdays
(requires Windows Media Player)
newsflashr network
National Debt Clock

Calendar of Posts

August 2010
MTWTFSS
« Jul Sep »
 1
2345678
9101112131415
16171819202122
23242526272829
3031 

Feed the Bull