The limits of the unconventional

In an era when the word  “policy” is usually closely followed by “paralysis”, it’s of some comfort that at least one organization is willing and able to move when circumstances require. Four weeks ago, the Federal Reserve had no inclination to act at its policy meeting June 20th. Then, America’s employment figures turned down and the euro crisis hotted up. The result is that it has announced its seventh instalment of unconventional monetary policy since late 2008, when short-term interest rates fell, in effect, to zero. In its latest salvo, the Fed said it would purchase $267 billion of long-term bonds by the end of the year, paid for from the proceeds of sales of short-term bonds in its portfolio. 

The move extends a programme, nicknamed Operation Twist, announced last autumn and due to expire this month, under which the Fed swapped $400 billion of short-term bonds for long-term ones. Previous unconventional initiatives have included purchasing bonds with newly created money (“quantitative easing”, or QE), reinvesting the proceeds of maturing bonds, and verbally committing to keeping rates near zero for ever longer periods. All are designed to drag long-term interest rates down in the hope of stimulating demand.

Like its predecessors, this latest round of monetary easing was motivated by clear evidence the economy would not live up to the Fed’s forecast. Members of the Federal Open Market Committee (FOMC), the Fed’s main policymaking body, now expect growth of between 1.9% and 2.4% this year, down sharply from their April forecast of growth between 2.4% and 2.9%. This time a year ago, FOMC members were expecting growth of about 3.5% in 2012. In its statement, the Fed said:

    The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.

At $44.5 billion per month, Operation Twist 2 similar in scale, though not duration, to Operation Twist 1. But it was still on the minimalist side of available options. Its previous six significant unconventional easings included two rounds of outright quantitative easing (buying longer-term bonds by creating new money), reinvesting the proceeds of maturing bonds purchased through QE, committing to zero interest rates until 2013 and then through 2014. It could have announced a larger Operation Twist, another round of QE, purchases of mortgage bonds instead of Treasurys, or extension of its low-rate commitment through 2015.

The big question, given its  downbeat forecasts, is why the Fed eschewed such courses of action. The pessimistic answer is that it is at its limits. In theory, QE allows unlimited purchases of debt, of many different flavours. But Ben Bernanke, the Fed chairman, frets over the risks of doing so. Asked in his press conference why the Fed, despite a 2% inflation target, sees inflation at or below that level throughout its forecast horizon, Mr Bernanke said:

    There is an issue about whether or not there’s sufficient stimulus in the economy . We are now at the zero bound [of interest rates] and the types of unconventional programmes that are available … we know less about them, they have various costs and risks and for that reason, we might get a different amount of financial accommodation in this kind of regime than one where short term interest rates can be varied freely.

What are those costs and risks? Mr Bernanke warned of a bigger balance-sheet that is harder to shrink later; impaired markets; and financial instability, a euphemism for bubbles. What the world really needs, he suggested, is beyond the Fed’s control: Europe needs to fix its crisis and America’s politicians need to avoid the “fiscal cliff,” the near-simultaneous squeeze of tax increases and spending cuts programmed to occur at yearend. On Europe, Mr Bernanke said:

    We hope it doesn’t get worse. I think it’s already one of the factors that has been a drag on the US recovery …We think that the policy makers in Europe have very strong incentives to get this right …But again it’s also important for us to be prepared for any further problems that might emerge from Europe.

A more optimistic interpretation is that, before long, the Fed will do more. Mr Bernanke repeatedly promised the Fed will act if needed. At present, it is trying to sort through the economic data to figure out how much of the recent weakening in America’s economy is real, rather than a statistical fluke. It is also awaiting the outcome of events in Europe. Sadly, developments on both sides of the Atlantic seem likely to call for more action.

What form would such action take?  By the end of Twist 2, the Fed will have exhausted its supply of one- to three-year paper. It could conduct “Operation Twist 3” by selling some of  three- to six-year bonds (it had $583 billion as of May 30th, according to Macroeconomic Advisers) but Mr Bernanke seemed to rule that out, leaving QE as the favoured option. The Fed could also expand the range of assets it buys, to include mortgage-backed securities.

Mr Bernanke also seemed intrigued by a programme announced last week by Britain’s treasury and the Bank of England under which the latter would make low-cost long-term loans to banks provided they then lent to business and individuals. One criticism of the Fed’s efforts is that they have not eased the supply of credit for people that really need it. He noted, however, that such a programme might have fiscal costs which would require the cooperation of the Administration and, possibly, Congress.

As to when the Fed would act, that could come at any time. Conveniently, Operation Twist will expire after the presidential election campaign. At that point, the Fed can act without being accused of helping one candidate or another. If the economy really appears to be heading over the fiscal cliff, the Fed will not want to worsen the impact by holding back a monetary cushion.