The Fed Can Not Only Lead A Horse To Water, It Can Also Turn On The Hose

By / 8.10.2010

The Federal Reserve’s outlook on the economic recovery continues to get gloomier.  In its statement released following the FOMC meeting today, the Federal Reserve acknowledged that “the pace of recovery in output and employment has slowed in recent months,” and “economic recovery is likely to be more modest in the near term than had been anticipated.”  Not good news, especially when interest rates are already about as low as they can go.  With today’s announcement that it is committed to keeping rates at rock-bottom levels ”for an extended period” going forward, the Fed also signaled that it is ready to go beyond rate setting to strengthen the economy.

After keeping the federal funds at historic lows for so long, with only disappointment to show for it, the Fed has decided that it’s no longer enough to lead the U.S. economy to water and wait for it to drink.  So as part of its announcement today, the Fed signaled that it will once more resort to quantitative easing to pump money directly into the economy.  Because there are risks to this strategy (see Krugman), the Fed couched this move in modest terms, explaining that it will be buying long-term Treasury notes to “keep constant” the level of assets on its balance sheet, which currently includes a large portfolio of mortgage securities it purchased to stabilize markets during the financial crisis.

The Fed will simply be rolling over its portfolio into Treasuries as the mortgage securities retire, which is actually not putting new money into the economy, as much as it is preventing the money supply from shrinking if the Fed’s portfolio were allowed to get smaller.  But there are signals here for those who have been anticipating a new push for quantitative easing from the Fed.

The First Signal: The Fed is clearly ready to buy market securities to inject money into the economy as needed.  This baby step toward quantitative easing is likely a preview of more dramatic asset purchases if the Fed sees real evidence of deflation or a double-dip recession.  Be prepared for more.

The Second Signal: The Fed is not necessarily interested in using mortgage securities as an asset vehicle for expanding the money supply.  Doing so would keep mortgage rates low, which would help prop up an ailing housing market.  But mortgage rates are already the lowest on record, and that hasn’t helped sales much, so the Fed doesn’t need to waste time trying to lead another horse to water in housing markets.

The overall signal from today’s FOMC statement is not good news for the economy.  The Fed is becoming less optimistic and less certain about the future.  Bernanke and company are apparently convinced that stronger actions may still be needed for sustained stimulus.  The fact that they are coming around to that view may do some good for restoring confidence in Fed policy.  And the Fed needs all the help it can get these days, because it’s running out of useful monetary tools to boost the economy.

Hopefully the signals from today’s statement will be heard in Congress, where lawmakers still have a lot of steps they can take before the end of the year to bring better stimulus and more confidence to the economy.

Photo Credit: Ken_Mayer’s Photostream