Federal Reserve weighs new ‘sterilized’ QE

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Fed watchers may be on the edge of their seats next week in light of a new report in The Wall Street Journal stating that the central bank is weighing a new strategy for quantitative easing, or QE.

The Federal Open Market Committee, or FOMC, has reportedly been considering new ways of utilizing its bond-buying capability should more quantitative easing become necessary. Even so, it’s unlikely the rate-setting team of the Federal Reserve will make any moves at its March 13 meeting.

The Wall Street Journal reported March 7 that Fed officials are considering so-called sterilized bond buying, which would limit the amount of liquidity introduced into the banking system using complicated financial transactions known as reverse repurchase agreements, or reverse repos.

Previous bond-buying programs involved creating money with which to make outright securities purchases. Critics contend that printing money willy-nilly and leaving it sloshing around could prove inflationary once the economy is up to speed. The new strategy should mitigate those concerns, the Journal reported.

“It does introduce a new variable, but I still think next week will be a wait-and-see meeting,” says Dan Greenhaus, chief global strategist at BTIG, a global financial services firm.

The FOMC meets eight times per year to discuss monetary policy and set the federal funds rate, or the short-term rate banks charge each other for overnight loans. The rate, in turn, influences CD and savings rates, credit card interest rates and other loan rates.

But interest rates have been a moot point as of late. The federal funds rate is currently targeted between zero percent and 0.25 percent and will be until 2014, as of the last Fed meeting. More salient these days is the likelihood of further rounds of quantitative easing.

Despite the Journal’s report, the probability remains low — for now.

Two underlying reasons foreshadow a lighter meeting: some improvements in the economy and a fairly significant meeting in January.

Last Fed meeting

The January convergence of the FOMC offered a veritable cornucopia of information to wonk out on. To recap: The Fed disclosed its inflation target of 2 percent and trounced any expectations of policy tightening in the form of rate increases before 2014. They also added a new component to the Summary of Economic Projections that includes two charts revealing FOMC participants’ estimates of the appropriate timing of policy firming and the projected target federal funds rate at the end of the year. The Summary of Economic Projections is released four times a year.

While there wasn’t a change to monetary policy per se, it was a leap in transparency for the historically opaque institution. Additionally, by tinkering with the forward guidance language, the FOMC was able to gently tamp down long-term interest rates without actually doing anything or adding to the already bulging balance sheet as with QEs 1 and 2, the Fed’s two-step quantitative-easing program.

“There wasn’t really a consensus about QE3, so they decided to take an intermediate step and try and influence interest rates through short-term rates and extending the forward guidance,” says Paul Edelstein, director of financial economics at IHS Global Insight, an economic consulting firm.

Concerns about sluggish growth spurred their actions last month. And the strategy has worked to some degree.

“They clearly flattened the interest rate curves as they sucked out the expectation of tightening anytime in 2013. And that had an effect on interest rates across the curve. You see this most acutely in the Treasury market where, despite the economic improvement, despite the improvement in the equity market, the yield on the 10-year is still, as of (March 6) 1.95 percent,” says Greenhaus.

From the Fed standpoint, it had kind of the desired effect, he says.

Economic two-step

Since the last Fed meeting, the economy has shown teasing glimpses of continued improvement in some well-known metrics. For instance, the unemployment rate dropped in January, marking the fifth straight month of declines and putting the headline number at 8.3 percent. February’s numbers turned out to be slightly encouraging; payrolls rose by 227,000, slightly above expectations, while the unemployment rate remained 8.3 percent.

In his testimony before the Senate Banking Committee on Feb. 29, Bernanke alluded to the drop in unemployment and growth in other areas, but any recent developments were tempered with caveats and reservations.

Despite an advance in household spending in the second half of 2011, “The fundamentals that support spending continue to be weak: Real household income and wealth were flat in 2011, and access to credit remained restricted for many potential borrowers,” Bernanke told the Senate.

Other forces working against the economy include the persistent black cloud hanging over the European Union and the quagmire in the domestic housing and mortgage markets.

Bernanke’s greatest hits

The statement released following the March FOMC meeting is likely to hit the same notes: There has been some improvement, but it could be a lot better.

The recent rise in energy prices will also be addressed.

“They have to be worried about what inflationary pressures are coming over the summer. They haven’t forecast anything, but with oil and gas prices starting to rise, that has to be a little bit of a concern,” says John Stewart, managing director of Vantage Economics, an economic consulting and research firm.

As happened last year, the Fed will likely categorize increases in energy prices as transitory spikes that don’t warrant a change to inflation expectations.

Despite the unwelcome increase in energy costs and myriad drains on economic growth, the improvements in the economy have likely been enough to squelch a third round of quantitative easing — for now.

“Clearly over the last couple of weeks, the probability of QE3-style program has gone down in terms of market sentiment. With respect to what the Fed really cares about, the economy, it is not really improving quite dramatically enough,” Greenhaus says.

Unless growth picks up throughout the spring, the likelihood of QE3 could emerge down the road.

Stewart says it could happen “if we don’t see fairly decent job growth, more toward 300,000 jobs per month toward the middle and end of the year. And, of course, if anything goes wrong in Europe, due to the financial contagion that could take place.”

Should the economy deteriorate, the Fed has a collection of tools at hand, including easing measures already tried; purchases of Treasury securities or mortgage-backed securities; or exchanging short-term Treasuries for long-dated securities, as in Operation Twist. Plus the new wrinkle, sterilized bond buying, could be used.

For this meeting at least, monetary policy likely will remain as is. The Fed, and everyone else, will have to wait to see what happens next.