Tuesday, July 17, 2012

FOMC's new tools

FOMC Minutes (of the Meeting of June 19–20, 2012): - Several participants commented that it would be desirable to explore the possibility of developing new tools to promote moreaccommodative financial conditions and thereby support a stronger economic recovery.
This got a great deal of speculation going. What could be the "new tools"? Here are some possibilities:

1. Sterilized securities purchases: see item #2 in this post.

2. Sterilized securities purchases involving MBS: see this post for more detail.

3. Cutting rates on banks' excess reserves to zero. This is essentially what the ECB just did, resulting in negative yields for much of the stronger Eurozone government short term paper. It certainly has the potential of pushing the short end of the US curve deep into negative territory as well. Such a move may also have some unintended consequences such as weakening of the dollar, damaging the repo markets, and negatively impacting US money market funds.

4. Some have suggested that the Fed could potentially introduce a scheme similar to the UK’s cheap-funding-for-lending program. The Bank of England is putting in place a scheme to provide long-term funding to banks that commit to lend these funds to customers. In the US however there are legal restrictions that limit collateral types for any long-term lending by the Fed to residential (and some multifamily) mortgages. This program would therefore only work for banks who want to do more mortgage lending. It's not clear this approach would be helpful because lending in the US is not constrained by banks' funding needs but by risk aversion (and in some cases regulatory capital). This however would certainly qualify as a "new tool".

5. A commitment to hold the Fed Funds rate near zero for a defined (longer term) period. The current low rate statement is not a "pledge", just a forecast. An actual term pledge would involve a new approach. It's an interesting but a bit dangerous idea because it takes away the Fed's ability to raise rates in the near future in case of unexpected inflationary pressures.

6. An all-out "unsterilized" QE3: see item #3 in this post as to why such policy decision is unlikely at this juncture.

Other than this set of tools, it would be difficult for the Fed to implement another program under the current law (particularly with Dodd Frank in place). Some ideas thrown around such as the Fed lending to small businesses, issuing Fed bills to sterilize asset purchases, etc., would require the involvement/approval of the US Treasury. And that would create a prolonged political mess, something the Fed is likely to stay away from for now.

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