October 7, 2010
Faced with painfully slow economic growth and stubbornly high unemployment for at least three more years, the Federal Reserve appears set to resume large purchases of longer-term Treasury securities in order to add more money to the economy and bring down already low long-term interest rates.
The move is controversial and won't be popular with some officials on the policymaking Federal Open Market Committee, but public statements by a number of other officials indicate Fed Chairman Ben S. Bernanke has enough support to get approval for it at the next committee meeting, which concludes Nov. 3, the day after the midterm congressional elections.
Such unconventional action is needed because the Fed's target for overnight interest rates is already effectively at zero and can't be lowered any further. As is often the case, market interest rates have already dropped as investors have become convinced the Fed is going to act. For example, yields on three-year Treasury notes were down to just over half a percentage point, while those on 10-year notes -- which help determine rates on 30-year home mortgages -- were at 2.37 percent.
The big unknown is whether lower rates will in fact spur the lagging economy. Mickey Levy, chief economist at Bank of America, is skeptical. "The economy is growing," Levy said in an interview with The Fiscal Times. "What's holding it back from growing faster? It's not the Fed. It's the need for consumers to save and all the obstacles in the housing market. I desperately wish it would help. I just don't think it would."
The urgency for fast action was underscored by William C. Dudley, president of the New York Federal Reserve Bank, in a speech last week. "The current situation is wholly unsatisfactory. Given the outlook that the upturn appears likely to strengthen only gradually, it will likely be several years before employment and inflation return to levels consistent with the Federal Reserve’s dual mandate," he said.
Fed officials simply don't use words such as "wholly unsatisfactory" to describe the economic outlook unless they are prepared to do something about it, and do it soon. Bernanke and his colleagues have hoped the outlook would brighten, but for months the leading economic indicators have signaled stagnation or even a downturn. With Congress unlikely to agree to any significant additional spending measures that might stimulate economic activity, pressure has been building on the Fed to act -- although the options are limited.
The internal opposition to buying up large quantities of bonds comes from a number of regional Federal Reserve Bank presidents, including Thomas J. Hoenig in Kansas City, Richard W. Fisher in Dallas, Charles I. Plosser in Philadelphia and Jeffrey M. Lacker in Richmond. In recent public statements, Fisher has argued that large scale asset purchases, or LSAPs, are not needed, would not lead to more job creation, and might cause excessive inflation later.
Hoenig, the only one of the four with a vote on the Federal Open Market Committee this year, has dissented from the majority at all six regular meetings because he believes keeping the target for overnight rates very low for an extended period will lead to new investment bubbles and excessive inflation.
However, Bernanke's hand was strengthened last week by Senate confirmation of women to fill two of the three vacancies on the Fed Board. One of them, Janet L. Yellen , who is the new Fed vice chairman, has long been a supporter of action to lower unemployment. She was already on the FOMC as president of the San Francisco Fed, but was not in the voting rotation. The other new member, Sarah Bloom Raskin, was a banking regulator in Maryland, but it is very unlikely that she would oppose the Fed chairman at her first FOMC meeting.
Among the strongest recent arguments for LSAPs came not from a Fed official but from Adam Posen, an American economist at the Peterson Institute for International Economics in Washington who is also an "external" member of the Bank of England's Monetary Policy Committee -- that central bank's equivalent of the FOMC.
Posen, who has studied Japan's economic travails over the past two decades, when the collapse of a property price bubble brought on more than a decade of stagnant growth and deflation, said in a speech late last month that central banks--specifically the Bank of England and the Fed -- "should continue to be aggressive about promoting recovery" and "should not settle for weak growth out of misplaced fear of inflation."
Weighing the Risks
"The risks that I believe we face now are the far more serious ones of sustained low growth turning into a self-fulfilling prophecy," Posen said, warning, "Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy's productive capacity, and by investors to avoid risk and prefer cash. Those tendencies are already present, and insufficient monetary response is likely to worsen them."
Last year and early this year, the Fed bought $300 billion worth of Treasury securities and about $1.4 trillion in government- insured mortgage-backed securities and debt. The presumption is that all the new purchases will be Treasurys, which is the key reason that yields have tumbled in recent days. It is not known how aggressive Bernanke and his supporters may want the purchases to be.
Brian Sack, an executive vice president at the New York Fed, runs the Fed's open market desk, which would do the buying. In a speech this week, Sack both defended the likely positive impact on the economy from the purchases and said they would not disrupt the Treasury market. For one thing, with the large federal budget deficit, an additional $1.2 trillion worth of longer-term securities are expected to be issued over the next year.
As for what quantity a central bank should buy, Posen said they should keep buying until "we have clear indications that our policies are moving the desired variables--market interest rates, wages, output, employment and inflation expectations -- sufficiently and in the right directions on a sustained basis."