No new monetary easing initiatives for now


The Federal Reserve has more arrows in its quiver. If the committee does decide the economy needs more accommodation, these are some of its options.

Tinkering with forward policy guidance

In September, the FOMC took the unprecedented step of explicitly stating that the federal funds target rate will remain close to zero until mid-2013.

Since then, however, some FOMC members -- Charles Evans, president of the Chicago Federal Reserve Bank, and Federal Reserve Governor Janet Yellen -- have publicly stated that using specific inflation and unemployment numbers as barometers could provide more clarity. For example, "saying we're not going to raise the federal funds rate above zero until the unemployment rate goes under a certain level" might be a better gauge than a future time frame, says Gregory Daco, principal economist at IHS Global Insight, an economic forecasting and analysis firm.

Reducing or eliminating interest paid on excess reserves

Despite multiple attempts at reviving the moribund housing sector by regulators and all levels of government, nothing has really worked so far.

One problem is that no matter how low rates remain, the people who want to buy houses are generally not able to get approval for loans, and the people to whom the banks would prefer to lend are not biting.

One way the Fed may be able to prod banks into lending is by scaling back or eliminating the interest paid on the excess reserves banks park at the Federal Reserve.

If the Federal Reserve stops paying interest on excess reserves, "then banks will not have an incentive to keep all that cash as reserves and instead will now have a greater motivation and incentive to lend it out," says Bernard Baumohl, chief global economist at the Economic Outlook Group in Princeton, N.J.

"These days, the only way banks can make any money is to actually lend money out to the public and make a profit on the difference between the cost of borrowing and the rate that they charge. I think the Fed is encouraging banks to do that," he says.

Buy more mortgage-backed securities

The Fed may try to target the housing sector directly through monetary policy. The way it would do that is through additional purchases of mortgage-backed securities, or MBS.

In a recent speech, Fed Governor Daniel K. Tarullo stated that a large-scale MBS purchase program "could also have more direct effects on the housing market. By increasing demand for MBS, such a program should reduce the effective yield on those MBS, which in turn should put downward pressure on mortgage rates.

"The aggregate demand effect should be felt not just in new home purchases but also in the added purchasing power of existing homeowners who are able to refinance," he said in the Oct. 20 speech at the World Leaders Forum at Columbia University.

"To a certain extent, they are trying to influence lending by the banks. The move to make it easier to refinance is trying to free up funds of individuals. If people could go back and refinance at a lower interest rate, they could have more discretionary spending and stimulate the consumption side of the economy," says Jerry Lynch, professor of economics at Purdue University.

One way the Federal Reserve could target the housing sector without expanding the balance sheet would be through more purchases of MBS in Operation Twist and fewer purchases of longer-dated Treasuries, Baumohl says.


Yellen and William Dudley, president of the Federal Reserve Bank of New York, have indicated that a third round of quantitative easing is on the table should the economic situation warrant it.

Though he voted against the actions taken at the previous two meetings, in a recent speech Federal Reserve Bank of Philadelphia President Charles I. Plosser outlined the conditions he feels would deserve further action from the Fed.

"If deflationary fears were to become a real threat again and we saw signs that the economy was moving to a sustained disinflation with declining inflation rates and inflation expectations, then we would need to consider further action to stabilize inflation expectations," he said in an Oct. 12 speech at the Wharton School at the University of Pennsylvania.


Show Bankrate's community sharing policy

Connect with us