mortgage

3 actions the Federal Reserve may take

Highlights
  • Federal Open Market Committee meets Tuesday.
  • Speculation abounds that Fed will announce measures to boost economy.
  • Fed has three main options, but likely effectiveness is unclear.

The Federal Open Market Committee meets today, with an announcement expected around 2:15 p.m. Eastern. There is a lot of conjecture the Federal Reserve will unveil new measures to boost the economy.

On July 30, Nomura Securities forecast the Federal Reserve will officially announce more "quantitative easing" at this meeting. And that prediction came before a disappointing July jobs report.

More Federal Reserve coverage
For more on the Fed, check out Bankrate's Federal Reserve News coverage.

Rather than handicapping whether the Fed will take further action -- we'll find that out this afternoon -- the more relevant point is whether it will work. Just what are the Fed's options and what impact would each have?

Option No. 1: Resume purchase program

The Federal Reserve could restart the program of buying Treasuries and mortgage-backed bonds in an effort to bring longer-term interest rates lower. While this might indeed help bring rates lower, it will have a limited economic effect.

Why? Corporations already have been taking advantage of ultra-low debt costs to borrow and that hasn't exactly kicked the economy into overdrive.

Mortgage rates continue to set new record lows, but driving them even lower doesn't hold any great promise. The pool of mortgage refinancing candidates has dwindled mightily due to falling home prices, unemployment and earlier refinancing at what were already low rates. After all, its not like mortgage rates just dropped off a cliff from 8 percent -- they've been below 5.5 percent for almost a year.

And low mortgage rates alone won't resuscitate the housing market as long as prospective buyers are nervous about jobs. In fact, a Federal Reserve decision to begin buying Treasuries and mortgage-backed bonds could further damage confidence by setting off the "Fed must really be worried" alarm bells.

Option No. 2: Reduce rate paid to banks

Another option is for the Fed to reduce the interest rate paid to banks on the excess reserves they hold. This step could spur lending, as it removes the incentive for banks to park funds at the Federal Reserve and earn a risk-free return. Even if it boosts the incentive to lend, there is no assurance it will boost actual lending, as lenders remain risk-averse.

Further, most of those excess reserves sit with "primary dealers" that buy and sell securities directly with the Fed and not the neighborhood community banks and credit unions in closest contact with small businesses.

Detractors say such a step would hurt money market mutual funds -- but it would be difficult to inflict more pain upon funds than they're already experiencing, with the one-year Treasury at 0.27 percent and falling.

Option No. 3: Reinvest proceeds

The final option is for the Federal Reserve to begin reinvesting the proceeds received as its bond holdings mature or are paid off early as homeowners refinance mortgages.

This would be a token measure, given the level of dollars involved, but it could help to avoid causing the market to "freak out." If any action is taken at this meeting, this option becomes the most likely candidate, as it buys some time to evaluate if further action is needed in the coming months.

The recent surge in stock prices, however fleeting, may remove some of the urgency that existed a few weeks ago. But as the July jobs report showed, hiring in the private sector remains very weak, and the economy and the Federal Reserve's decision-making currently revolves around jobs, jobs, jobs.

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