The Financial Times Limited, December 11 2008 20:20
By Krishna Guha in Washington
The meeting, which concludes on Tuesday, comes as the Fed has already moved into unorthodox territory – doubling the size of its balance sheet and moving beyond collateralised loans to direct purchases of commercial paper and securities issued by Fannie Mae and Freddie Mac, the mortgage groups now under government control.
But as interest rates approach zero, the debate shifts entirely to the other tools the Fed can use against the economic crisis, presenting the central bank with tough conceptual, governance and communications challenges.
The first decision the Fed has to take is where to end its conventional easing cycle – at zero or a positive interest rate. Zero rates would create problems for money-market funds and the repo market.
However, there are benefits to zero rates as well. Moreover, the Fed may not be able to keep the actual fed funds rate much above zero even if it maintains a higher target rate, while conducting unconventional easing on a grand scale.
The bigger decision is over where the Fed goes next.
The central bank can push forward on either or both of two fronts. It could try to lower longer-term risk-free interest rates. And it can try to use unconventional measures to reduce risk premiums or “spreads” in particular markets.
When Japan was mired in economic stagnation a decade ago, Ben Bernanke, chairman of the Fed, recommended that its central bank should focus on driving down long-term risk-free rates.
He this month reminded the markets that the Fed could also do this, for instance by purchasing long-term Treasury bonds. This would reduce the benchmark rate on to which spreads – for instance, on corporate bonds – are added.
But the long-term risk-free rate on US government bonds has already fallen dramatically. So buying Treasuries may not be the immediate priority for the Fed.
Mr Bernanke believes that the US, with its very low risk-free rates but high actual costs for most borrowers, is in a very different situation to Japan a decade ago, when actual borrowing costs were low across the board.
That suggests the Fed will continue for now to emphasise large-scale, targeted interventions that aim to reliquify particular financial markets and hammer down spreads. The top candidate is further huge purchases of securities issued by Fannie and Freddie to reduce home loan rates.
Indeed, there is renewed speculation that the US authorities could soon announce a plan in which banks offer home loans at 4.5 per cent, possibly for refinancing as well as new purchases, that would be securitised by Fannie and Freddie. The Fed could purchase such securities. The Fed could also step up its purchases of asset-backed securities and commercial paper, potentially pushing into longer-term corporate debt. But this would require capital support from the Treasury.
The Fed’s unconventional operations bear some resemblance to the “quantitative easing” eventually adopted by Japan – but with differences. Japan set out to increase bank reserves in the hope that this would stimulate lending while committing it to keep rates near zero for a long time.
The Fed’s strategy also increases bank reserves but more as a byproduct of its liquidity operations than an end in itself. Fed policy is driven by the asset side of its balance sheet rather than the liabilities side.
There is “quantitative easing” – an increase in reserves – but there is also “qualitative easing” – a shift in the composition of the Fed’s assets. In the US case, the game is not simply about flooding the system with reserves, since a dollar of commercial paper lending, mortgage-backed securities purchases or Treasury purchases are not equivalent.
How to explain all of this in a brief policy statement without completely confusing the markets will be extremely difficult.
The Fed approach does not easily reduce to a numerical target for reserves or the 10-year bond rate.
The US central bank may simply state that it will maintain low rates for as long as needed and will adopt additional measures, including unconventional ones, as required to support growth.