Markets could force Fed to empty the chamber
By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.
Markets could force the Federal Reserve to use up the rest of its arsenal. Although investors found comfort in the central bank’s stated “range of policy tools” on Tuesday, by Wednesday morning they had a change of heart. The slide could press Fed Chairman Ben Bernanke to fire sooner rather than later to keep recession at bay. Trouble is, he’s packing a BB gun not a bazooka.
All of the Fed’s remaining options are controversial and none looks promising. But the Federal Open Market Committee’s decision to put a firm date — two years out — on its near-zero rates, over the objections of three members, indicates just how much the market turmoil has spooked policymakers already worried about the economy.
One possibility would be an updated version of “Operation Twist” from the 1960s. With it, the Fed could change the composition of its nearly $3 trillion balance sheet to favor longer-dated debt, in a bid to knock rates even lower.
There are two ways to do this. One, the Fed could reinvest proceeds from interest payments and maturing debt in longer-dated Treasuries. The other way would be to sell shorter-term bonds to buy, say, 10-year and 30-year bonds. But after the Fed’s bold action on Tuesday, the “Twist” looks too weak to accomplish much. Yields on 10-year Treasuries, after all, are already hovering around 2 percent.
The Fed also could opt to lower the measly 0.25 percent rate it pays banks to keep funds on deposit. Such a move, however, creates the potential for some nasty side effects, including endangering struggling money market funds.
And that leaves the printing presses. Theoretically, there’s no limit to the size of the Fed’s balance sheet. With every $200 billion of bond purchases equal to about a rate cut of 25 basis points, quantitative easing must still be high on the list for policymakers worried about recession and the possible deflationary pressures it would bring with it.
Inflation expectations aren’t signaling any worrying fall in prices on the horizon. They’ve been holding around 3 percent. That is higher than the 2.2 percent of a year ago, when Bernanke set the stage for QE2 in Jackson Hole, Wyoming, and might be enough to keep the Fed’s finger off the trigger. But Bernanke is headed back this month for his annual trip to the Wild West. If the market bloodshed persists, he may feel the need to fire off his peashooter when he’s there.