What the Fed Could Do
The Fed Is Running Low on Ammo: You may have noticed that the complexion of the U.S. economy has turned a bit sallow of late.... Chairman Ben Bernanke has told the world that the Fed is not out of ammunition. It still has easing options, should it need to deploy them. The good news is that he's right. The bad news is that the Fed has already spent its most powerful ammunition; only the weak stuff is left.... Let's examine....
From exit to re-entry. The first easing option is to create even more bank reserves by purchasing even more assets—what everyone now calls "quantitative easing." The FOMC took a baby step in that direction at its last meeting by announcing that it would no longer let its balance sheet shrink as its holdings of mortgage-backed securities (MBS) mature and are paid off. Instead, it will reinvest the proceeds in Treasury securities.... When the Fed buys private-sector assets like MBS it is trying to shrink interest rate spreads over Treasurys—and thereby to lower private-sector borrowing rates such as home mortgage rates—by bidding up the prices of private assets, and so lowering their yields. Judged by this criterion, the MBS purchase program was pretty successful. But when the Fed buys long-dated Treasury securities it is trying to flatten the yield curve instead.... Now put the two together. By reducing its holdings of MBS and increasing its holdings of Treasurys, the Fed de-emphasizes shrinking risk spreads and emphasizes flattening the yield curve. That strikes me as a bad deal for the economy because the real problem has been high risk spreads, not high Treasury bond rates.
If the FOMC is serious about re-entry into quantitative easing, it should buy private assets, not Treasurys. Which assets? The reflexive answer is: more MBS. But with mortgage rates already so low, how much further can they fall? And would slightly lower rates revive the lifeless housing market? To give quantitative easing more punch, the Fed may have to devise imaginative ways to purchase diversified bundles of assets like corporate bonds, syndicated loans, small business loans and credit-card receivables. Serious technical difficulties beset any efforts to do so without favoring some private interests over others. And the political difficulties may be even more severe. So the Fed will go there only with great reluctance.
What's in a word? The FOMC has been telling us repeatedly since March 2009 that the federal-funds rate will remain between zero and 25 basis points "for an extended period."... The Fed's second option for easing is to adopt new language that implies an even longer-lasting commitment to a near-zero funds rate. Frankly, I'm dubious there is much mileage here....
Interest on reserves. In October 2008, the Fed acquired the power to pay interest on the balances that banks hold on reserve at the Fed. It has been using that power ever since, with the interest rate on reserves now at 25 basis points. Puny, yes, but not compared to the yields on Treasury bills, federal funds, or checking accounts. And at that puny interest rate, banks are voluntarily holding about $1 trillion of excess reserves. So the third easing option is to cut the interest rate on reserves in order to induce bankers to disgorge some of them.... How about minus 25 basis points? That may sound crazy, but central bank balances can pay negative rates of interest. It's happened.... [S]uppose some fraction of the $1 trillion in excess reserves was to find its way into lending. Even if it's only 10%, that would boost bank lending by 3%-4%. Better than nothing.
A fourth way out. There is a fourth weapon, which the Fed chairman has not mentioned: easing up on healthy banks that are willing to make loans.... It would probably do some good, maybe even a lot, if word came down from on high that some modest loan losses are not sinful, but rather a normal part of the lending business.
So that's the menu. The Fed had better study it carefully, for if the economy doesn't perk up, it will soon be time to fire the weak ammunition.