Thursday, July 08, 2010

What might the Fed do?

by Bill McBride on 7/08/2010 04:02:00 PM

Neil Irwin at the WaPo discusses some possible future actions at the Fed: Federal Reserve weighs steps to offset slowdown in economic recovery

Federal Reserve officials, increasingly concerned over signs the economic recovery is faltering, are considering new steps to bolster growth.
Irwin mentions a few possibilities, such as the Fed expanding the "extended period" language in the FOMC statement to describe an even longer period, or buying more agency MBS (mortgage backed securities).

Professor Krugman weighs in with some analysis: How Much Can The Fed Help?

I think it might be useful to revisit Bernanke's 2002 speech for hints of the roadmap: Deflation: Making Sure "It" Doesn't Happen Here This entire speech is worth rereading. Bernanke suggests several policies (many have been used), but this might be a clue to the next possible action:
One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.

... if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years.
In the 2002 speech, Bernanke mentioned the possibility of a "specified period" for holding short rates low, as opposed to the "extended period" language (Irwin suggested this in the WaPo article).

However Bernanke clearly prefers targeting longer term maturities. So if the Fed decides to take action, the FOMC might announce "explicit ceilings for yields on longer-maturity Treasury debt" - just like they do with the Fed funds rate at each FOMC meeting. Although the Fed purchased longer term Treasury securities during the crisis, the FOMC didn't announce an explicit interest-rate ceiling.

Below is a table of recent yields. There isn't much the Fed can do at 6 months or 1 year, but the Fed could announce lower targets for the 3 year and the 5 year and flatten the yield curve.
Treasury constant maturities
1-month0.07%
3-month0.17%
6-month0.22%
1-year0.30%
2-year0.62%
3-year1.03%
5-year1.83%
7-year2.49%
10-year3.05%
20-year3.82%
30-year4.01%

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