Would the Fed's Gentle Nudges Help?

As the calls for the Federal Reserve to take action for economic stimulus grow louder, the central bankers may be starting to listen. A new report indicates that policies intended to speed up growth and lower unemployment are being discussed by some Fed officials. That, of course, is in addition to already leaving short-term interest rates near zero for an "extended period." Could the changes being mulled over help?

The Washington Post reports on three strategies being pondered. Let's consider each separately:

One pro-growth strategy would be to strengthen language in Fed policy statements that the central bank's interest rate target is likely to remain "exceptionally low" for an "extended period." The policymakers could change that wording to effectively commit to keeping rates near zero for even longer than investors now expect, perhaps adding specifics about which economic conditions would lead them to raise rates. Such a move would be opposed by many members of the Fed policymaking committee who are wary of the "extended period" language, arguing that it limits their flexibility.

The so instead of saying they'll leave interest rates low for a really long time, instead they'll say that rates will stay low for a really, really long time. It's hard to see how this could make much difference to investors. They already expect rates to be extraordinary low for an incredibly long period. They're also smart enough to know that if inflation suddenly begins to soar, any promises that the Fed made could be broken. It has incredible flexibility to change policy direction, unlike Congress which would have to pass a new bill. It's hard to see how this would accomplish much.

Another possibility would be to cut the interest rate paid to banks for extra money they keep on reserve at the Fed from 0.25 percent to zero. That would give banks slightly more incentive to lend money to customers rather than park it at the Fed, although it also could cause technical problems in the functioning of certain credit markets.

This also appears to be a very weak step for two reasons. First, 0.25% interest isn't very much. Yes, it's more than zero, but it's not like suddenly banks won't know how to make a profit because their reserves are accruing 0.25% less interest. Second, they can already loan this cash out at a much higher rate, but they are obviously choosing not to do so because they're worried about the risk such loans pose. Lowering the reserve interest a little isn't going to alter banks' view of the loan market.

A third modest possibility would be to buy enough new mortgage securities to replace those on the Fed balance sheet that are paid off as people take advantage of low interest rates to refinance.

This might be a good idea if high mortgage interest rates were stifling home buying or refinance activity. They aren't. In fact, they're at record lows. We're actually experiencing a mini-refinance boom right now as a result. But these ultra low rates still aren't enough to get new purchase volume up, as it remains at 1997 lows. If the Fed buys more mortgage securities, maybe the rate could decline a little more from the already mid-4% range. It's just not likely that the benefit would be worth the harm. A little more refinance activity and a handful of additional purchases won't outweigh the long-term economic distortions that would result, explained here.

These measures aren't likely to make much difference. If the Fed really wants to have an impact, it would probably have to do something nutty like guarantee non-recourse loans made to businesses or individuals without regard to credit risk. In other words, it would have to give away free money. Little nudges here and there won't fool the market into thinking the economy is healthy again.

Additionally, if the Fed does decide to take any such actions, they aren't likely to happen any time soon. There was no mention of such intentions in its June Open Market Committee meeting. So unless it schedules an emergency meeting, it wouldn't be able to vote on any new monetary policy changes until August. So any Fed intervention would likely be weak and far off. That's not the recipe for a game-changer.