Would Smaller-Scale, Open-Ended Bond Buying by the Fed Work?

In the Federal Reserve's Open Market Committee meeting earlier this month, the economists made clear that they weren't expanding monetary stimulus further -- yet. But the statement said that the central bank was ready to act if necessary. That is, if the economy worsens, then the Fed will step in. According to a report from Jon Hilsenrath in the Wall Street Journal today, it might be considering a different asset buying approach for a future quantitative easing program. Rather than set a target for how much debt the central bank would purchase, it may engage in smaller-scale buying and leave the program open-ended.

The Advantage: Flexibility

The clear advantage from this approach is that the Fed would have far greater flexibility. If, for example, it announced that it will purchase $1 trillion in mortgage securities, then it sets that clear expectation for the market. But this has a few disadvantages.

If the Economy Improves

Right now we're in a period of extreme economic uncertainty. We appear to be in a very weak recovery, but if consumers begin feeling much more confident that could quickly change as they start spending again. If the economy does begin improving more quickly, but the Fed commits to purchasing a large quantity of securities, then it might worry about inflation. The flexibility this new proposal provides would help to avoid that.

If the Economy Worsens

Similarly, what happens if consumer sentiment plunges even further and threatens to trigger a double dip? A previously announced close-ended purchase plan might not have been enough. Then the Fed must meet again and have the committee agree again to another program to buy even more securities. But if this proposed open-ended program is already in place, then the Fed could act very swiftly.

A Pacifier

Finally, there's some possibility that the Fed could get more for its money due to psychology with an open-ended program like this. Even if they don't buy a lot of securities, the mere fact that the market perceives that they would be willing and able to do so could enhance investor confidence.

The Disadvantage: Uncertainty

From that analysis, a smaller-scale, open-ended program sounds great, right? It also has its drawbacks, however. There is something to be said for certainty.

Adding to One of the Economy's Biggest Problems

Arguably, the economy's two biggest problems right now are consumer sentiment and uncertainty. Yet, if the Fed isn't clear about precisely what any further intervention will consist of, then uncertainty will increase. Will the Fed continue to buy more securities next month if the amount it bought this month doesn't seem to help? Maybe, but how much? If inflation starts increasing mildly, will it suddenly stop its purchases? Again, it's unclear.

A Muted Effect

Due to this uncertainty, the program could be less effective than if the Fed simply committed upfront to some value of bonds to purchase. That would put more downward pressure on interest rates. Instead, each subsequent month that an open-ended purchase plan is in place, interest rates might decline. But those smaller declines may not add up to as large a move that a big monetary stimulus shock might create in the market.

So is the program a good idea, or not? It kind of depends on your view of the world. If you worry about inflation, then a smaller-scale open-ended program allows the flexibility to respond quickly if prices begin to rise aggressively. But if you're more worried about a double dip, and believe quantitative easing would make a big difference, then you would probably prefer an announcement of a large sum of monetary stimulus to try to jumpstart the economy with a big market shock.