Stock Turmoil Draws Attention to the Fed
As Market Seeks Stability, Investors Look for Board's Reaction to Grim News
August 10, 2011 (International Herald Tribune) Its chairman has held the U.S. Federal Reserve steady since June, saying that he wanted to judge the economy's health for a while before making any changes. Since then, indicators have been grim.
The U.S. Federal Reserve is back in the spotlight, with investors anxiously wondering whether the central bank will end a two-month hiatus Tuesday and announce new measures to support the economy.
Under its chairman, Ben S. Bernanke, the Fed has pushed the boundaries of its authority and defied opposition during its unprecedented four-year campaign to rescue the financial system and revive the economy.
As the Fed's policy-making board convened Tuesday, with the gains of the past two years slipping away and the government focused on getting smaller, the looming question was whether Mr. Bernanke and his lieutenants were willing to press deeper into uncharted waters.
Mr. Bernanke has held the Fed steady since June, saying that he wanted to judge the health of the economy for several months before considering any additional measures.
But the news since then has been uniformly grim. The government reported that the economy had grown at an annual rate of only 0.8 percent in the first half of the year. The number of people with jobs is shrinking. Governments at all levels are cutting spending. The stock market has plunged, so vast amounts of household wealth have evaporated. And investors once again are fleeing Bank of America and Citigroup, rescued at such a heavy cost only two years ago.
Close watchers of the central bank had expected that this meeting in August would pass quietly, with difficult decisions deferred until the autumn. But just as happened last summer, the moment is rising to meet the Fed.
"I think that they should reconsider their judgment" to wait, said Joseph E. Gagnon, a former Federal Reserve official and now a scholar at the Peterson Institute for International Economics. Mr. Gagnon said that Mr. Bernanke, who has said publicly that he is reluctant to act, was right to fear the consequences. "He is expressing the angst of a sailor in uncharted waters, in which he's right," he said, "but you have to weigh that against the very real cost in unemployment."
The Fed keeps its eyes on the medium term, like a driver steering a car down a highway, because its actions affect the economy only gradually. Donald L. Kohn, who stepped down as the Fed's vice chairman last year, said the recent setbacks had nonetheless been significant, because they had reduced the trajectory of growth, making it more likely that the Fed would need to act.
"To the extent that you thought fiscal policy was in a tightening mode, you'd factor that into your forecast," said Mr. Kohn, now a fellow at the Brookings Institution. "And to the extent that you thought the stock market was reducing the country's wealth, the cost of credit for marginal borrowers was rising, you would want to factor those into your forecast and into your monetary policy decisions."
The Fed has held its benchmark short-term interest rate near zero since December 2008, flooding the financial system with the nearest thing to free money. The central bank also has amassed a portfolio of $2.9 trillion in Treasury securities and mortgage-backed securities, driving down long-term interest rates by accepting low rates, and pushing investors into stocks and other riskier assets.
A number of independent studies have concluded that the asset purchases gave the economy a modest but meaningful lift by reducing rates, an argument that can be summarized in the simple observation that stocks climbed after the most recent round of purchases was announced in August of last year. The purchase of $600 billion in securities was completed in June; and now the market is falling.
Most public attention has focused on the possibility that the Fed will renew its asset purchases, the most drastic option available to the central bank, but also the one it has said is the most unlikely.
There are even reasons to think a new round of asset purchases could be more potent. Because rates already are low, a similar reduction in rates would be larger in percentage terms. Also, the first round of purchases presumably plucked Treasury securities from the hands of those most willing to sell. The remaining holders are likely to demand a better deal, driving down rates more.
But some members of the Federal Open Markets Committee have said that they do not support additional purchases, expressing concern that the extensive portfolio will interfere with the central bank's ability to control inflation when the economy strengthens.
Instead, the Fed is more likely to begin any renewed aid campaign with smaller gestures.
The most basic measure available to the Fed is to promise that it will keep interest rates near zero for at least six months, or a year, or some other specified period. The central bank has promised after each of its meetings since late 2008 to keep interest rates near zero "for an extended period." Earlier this year, Mr. Bernanke said that each renewal of that promise meant there would be no changes for at least a few months. A promise with a more distant expiration date would reduce uncertainty about at least one aspect of the economy.
The Fed also could make a similar commitment for the first time regarding its huge investment portfolio. Selling assets removes money from circulation, tightening monetary conditions, so a promise to maintain the portfolio for a certain number of months would have a similar effect. Moreover, the Fed has said it will start to sell assets before raising interest rates, so a promise about the portfolio also would extend the Fed's commitment to maintain low rates.
Another available option would be to maintain the size of the portfolio, but to shift its composition toward bonds with longer terms. The Fed initially was reluctant to do this because those bonds would take longer to disappear naturally, but that concern may have been eased by the board's affirmative decision eventually to shrink its portfolio through asset sales.
None of these options is likely to speed growth significantly. Economists generally agree that the economy is suffering from a lack of demand. The Fed can provide lots of money at low cost, but it cannot persuade companies to build new factories unless they think there will be a market for their products. And it cannot persuade consumers to spend money on those products if they do not have jobs, or if they have already borrowed more money than they can afford to repay.
"I don't think any of these things would have a huge effect on rates," Mr. Kohn said. "Could they help to reduce the cost of capital and ease financial conditions? Sure, and that would help encourage spending. But I think the major problem here is that people don't want to spend, and that's about confidence in the economy and the government."