The Federal Reserve Debates Tools to Combat Slowdown

By Daniel Indiviglio

It settled on announcing its intention to keep interest rates near zero through mid-2013, but five other possibilities were also discussed

600 fed ap Jin Lee.jpg

When the Federal Reserve chose to try to stimulate the economy with its words earlier this month, the market wasn't impressed. The Fed attempted to provide investors more certainty on interest rates, saying they would remain near zero through mid-2013. But the market wanted some more tangible action, like another round of asset purchases. In the Fed's detailed August meeting minutes, we get a glimpse of how this and other tools were considered. The discussion provides a preview of how the Fed might intervene if the economy continues to struggle.

Tool #1: The Time-Based Language Tweak (what the Fed chose)

As its August 9th statement indicated, the Federal Reserve intends to leave interest rates near zero not just for a vague extended period, but through mid-2013. By providing this specificity, the Fed hopes to prevent rates from creeping up if some in the market expect them to rise sooner than the Fed might prefer.

But the Fed clarified something key about its intentions here: they aren't written in stone. The minutes say:

Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects. (my emphasis)

In some sense, this weakens the impact of this language change. Prior to August 9th, the market knew that interest rates were going to remain very low until the economy picked up and the Fed decided that it was time to raise them. This understanding doesn't appear to have changed. But now we have a timeline for how long the Fed expects that the economy will remain too weak to accommodate an interest rate hike. The Fed does not appear committed to the mid-2013 date if conditions evolve in unexpected ways.

Tool #2: The Economic Indicator-Based Language Tweak

A different alternative was provided to the mid-2013 guidance. Instead, the committee considered basing its timeline on economic indicators. Some Fed economists suggested conditioning interest rates on "explicit numerical values for the unemployment rate or the inflation rate."

This would have been a logical way to construct the Fed's guidance. After all, what will -- and should -- ultimately control its decision to raise interest rates will be unemployment and inflation. So why not bake that into the market's guidance?

The minutes don't explain why this option was pushed aside for a date. It only says that some members of the committee "raised questions about how an appropriate numerical value might be chosen." Is it really easier to pick an appropriate date? A date actually seems far more arbitrary than saying if unemployment hits, say, 7%. Will something magical happen in mid-2013 that the rest of us don't know about that led the Fed to choose this as its date for when interest rates will finally rise?

The real reason this sort of guidance wasn't chosen is more likely flexibility concerns. The Fed could easily say in early 2013 that the economy has improved quicker than it anticipated so it is raising interest rates earlier. But it can't as easily say that it's raising rates earlier than a strict numerical trigger based on unemployment and inflation would have stipulated. This might be what those Fed economists were alluding to when they worried about appropriate numerical values. A date is easier to pull out of the air arbitrarily (and ignore) than an unemployment rate. If a numerical economic indicator is used, the Fed might have to actually explain its logic.

Tool #3: Additional Asset Purchases (a.k.a. "quantitative easing" or "QE3")

Lo and behold, QE3 was discussed. This should shock no one, but the proposal must not have had sufficient support. The minutes are vague on how many of the committee's economists championed this approach, but it says "some participants" noted the option. They asserted that additional asset purchases could lower longer-term interest rates, just like the last round of quantitative easing.

Tool #4: Swapping Out Short-Term Securities for Longer-Term Securities

But here's a different spin on pushing down longer-term interest rates: what if it could be done without the Fed expanding the size of its portfolio? Such an idea was considered.

The policy would have involved the Fed selling short-term securities and using those proceeds to purchase longer-term securities. This might increase the interest rates on those shorter-term securities, but perhaps slightly higher short-term rates could lead to more significantly lower longer-term rates.

The Fed tabled the idea for the time being. We could see this idea brought back up in the future meetings, however. It's a pretty novel way for the Fed to intervene without actually injecting any additional money into the financial system.

Tool #5: Cutting Reserve Balance Interest Rates

Another way in which the Fed could encourage economic activity would be to discourage the saving of the institutions that keep reserves with the Federal Reserve Banks. The Fed could accomplish this by lowering the interest rate that those banks receive on those deposits. If they're making less interest, then they might decide to instead put their money to work through lending or investing. This idea may also be considered in the future if the Fed seeks to intervene further.

Option #6: Leave the Tools in Their Box

Finally, according to the minutes, "some participants judged that none of the tools available to the Committee would likely do much to promote a faster economic recovery." This should not come as a surprise: three committee members ultimately dissented on the decision to tweak the statement's language to provide the mid-2013 guidance. Some Fed economists appear to feel that the Fed's tools aren't going to provide much more help at this point and could actually harm the economy by creating inflation.

Think of it this way. Imagine if the Fed's toolbox consisted of different sized straight-head screwdrivers and the unemployment problem was a loose Phillips-head screw. By attempting to tighten that screw with its tools, the Fed might not accomplish much, but could instead end up stripping the screw (creating too much inflation).

All the Fed can ultimately do is make the market more conducive to economic expansion. It can provide cheap credit to the market, but it can't force it to apply for loans. If businesses don't demand loans and/or if banks choose not to supply loans, then those great credit conditions won't help.

Looking to September

The Fed meets again on September 20th. At that time, we can expect the Fed to continue to consider these and other tools to help revive the recovery. In fact, the minutes note that the Fed will meet for a day longer than originally planned to provide additional time to discuss such options. Over the past few months, we have seen a number of troubling economic indicators. Just today, we learned that consumer confidence in August was the lowest in more than two years. As we await Friday's ever-important unemployment report, the U.S.'s economic path remains uncertain.

Image Credit: AP/Jin Lee

This article available online at:

http://www.theatlantic.com/business/archive/2011/08/the-federal-reserve-debates-tools-to-combat-slowdown/244349/