Will the Fed’s unconventional monetary policy work?
Out of conventional ammunition, the Fed uses its balance-sheet to battle the slump
CENTRAL bankers ordinarily strive to be boring. But these are not ordinary times. On December 16th the Federal Reserve unveiled a three-part assault on America’s slump that lit up the news wires like a pyrotechnic display.
From The Economist print edition
The Fed’s policy panel, the Federal Open Market Committee (FOMC), announced that it had cut its target for the federal funds rate to between zero and 0.25%, the lowest on record; it indicated it would stay there “for some time”; and having used up its conventional monetary firepower, it promised an unconventional strategy, such as the buying of mortgage-related securities and, possibly, Treasuries to lower long-term borrowing costs.
There was in fact less novelty than first met the eye. The actual funds rate, which is charged on excess reserves banks lend to each other overnight, had already fallen to below 0.2% (see chart), well below target, in part because the banking system is awash with unneeded reserves. (The FOMC is now aiming at a range rather than a level because of the difficulty of hitting the latter.) The Fed had already announced plans to buy up to $100 billion of debt directly issued by Fannie Mae and Freddie Mac, the now-nationalised mortgage agencies, and $500 billion of their mortgage-backed securities (MBSs). Ben Bernanke, the Fed’s chairman, had said Treasury purchases were under consideration.
But drowning out the specifics was the thundering tone of the Fed’s long statement. “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” it said.
Unconventional monetary policy is often called “quantitative easing” because its effect is felt through the quantity rather than the cost of credit. Through an array of lending programmes, the Fed’s balance-sheet has soared from below $900 billion to more than $2 trillion, and is about to grow further.
Will these tactics work? In an exhaustive study of unconventional monetary-policy options in 2000, five Fed staff economists concluded, “These tools have their limitations, and there is considerable uncertainty regarding their likely effectiveness.” The impact of the Fed’s actions to date even on short-term interbank rates is inconclusive; its ability to influence much larger, globally integrated bond markets is even less certain. Still, Vincent Reinhart, who studied such policy options while at the Fed and is now at the American Enterprise Institute, a think-tank, believes they will work if they are big enough. “There is some size of the central bank’s balance-sheet that will restart financial markets.”
The Fed seems to believe its actions matter more for psychology than in influencing the supply of and demand for long-term debt. A senior official says the Fed is not explicitly attempting to lower long-term rates; instead it wants to narrow the unusually wide spread between yields on MBSs and Treasuries. By reassuring investors that a committed buyer is in the market, it hopes to reduce the illiquidity premium pushing yields up.
Psychology does seem to matter. The Fed has not yet bought any MBSs, but their yields have dropped from 5.45% to 3.9% since it proposed doing so. One-quarter of a percentage point of that came after this week’s announcement. If this is sustained, the conventional 30-year mortgage rate should fall to around 5%, says Nicholas Strand of Barclays Capital, from over 6.5% in early November. Still, over two-thirds of the drop in MBS yields resulted from falls in Treasury yields. Even though the Treasury now explicitly supports Fannie and Freddie, MBS spreads remain wide, owing in part to reduced buying by the companies themselves and by foreign investors, Mr Strand says.
Amid falling consumer spending and soaring unemployment there are some hints that policymakers’ actions are making a difference. Home sales are stable and the drop in mortgage rates should help them. A bottom in housing is probably necessary to start the healing process elsewhere in the economy. Share prices have risen since late November.
The Fed’s gung-ho leadership may also nudge other central banks towards easing more aggressively. The dollar fell sharply, particularly against the euro, after the Fed’s action. That may weaken the European Central Bank’s reservations about cutting rates again. Similarly, if the weaker dollar takes pressure off sterling, the Bank of England may be more willing to ease again.
The dollar’s drop may also reflect some fear that the Fed will be slow to reverse course, leading to inflation. That, however, is a worry for another day. Falling petrol prices triggered the largest monthly drop in American consumer prices on record in November. With unemployment likely to increase further, the immediate concern is that inflation could fall too low.