(Jerry’s Comments: Here it is. The Fed is now threatening to pull out the big guns. Among the strategies on the table, to offer “exceptionally low” for an “extended period,” and a major new asset-purchase program. I have bolded important statements in the story below.)

Federal Reserve weighs steps to offset slowdown in economic recovery

Washington Post Staff Writer
Thursday, July 8, 2010

Federal Reserve officials, increasingly concerned over signs the economic recovery is faltering, are considering new steps to bolster growth.

With Congress tied in political knots over whether to take further action to boost the economy, Fed leaders are weighing modest steps that could offer more support for economic activity at a time when their target for short-term interest rates is already near zero. They are still resistant to calls to pull out their big guns — massive infusions of cash, such as those undertaken during the depths of the financial crisis — but would reconsider if conditions worsen.

Top Fed officials still say that the economic recovery is likely to continue into next year and that the policy moves being discussed are not imminent. But weak economic reports, the debt crisis in Europe and faltering financial markets have led them to conclude that the risks of the recovery losing steam have increased. After months of focusing on how to exit from extreme efforts to support the economy, they are looking at tools that might strengthen growth.

“If the economic situation changes, policy should react,” James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview Wednesday. “You shouldn’t sit on your hands. . . . I think there’s plenty more we could do if we had to.”

One pro-growth strategy would be to strengthen language in Fed policy statements that the central bank’s interest rate target is likely to remain “exceptionally low” for an “extended period.” The policymakers could change that wording to effectively commit to keeping rates near zero for even longer than investors now expect, perhaps adding specifics about which economic conditions would lead them to raise rates. Such a move would be opposed by many members of the Fed policymaking committee who are wary of the “extended period” language, arguing that it limits their flexibility.

Another possibility would be to cut the interest rate paid to banks for extra money they keep on reserve at the Fed from 0.25 percent to zero. That would give banks slightly more incentive to lend money to customers rather than park it at the Fed, although it also could cause technical problems in the functioning of certain credit markets.

A third modest possibility would be to buy enough new mortgage securities to replace those on the Fed balance sheet that are paid off as people take advantage of low interest rates to refinance.

Role of mortgage rates

None of those steps amounts to the kind of massive unconventional effort to drive down mortgage rates and prop up growth that the Fed took in late 2008 and early 2009, when the economy was in a deep dive. Then, the Fed began buying Treasury bonds, mortgage securities and other long-term assets — more than $1.7 trillion worth by the time the purchases concluded in March.

Some economists have encouraged the Fed to launch a new asset-purchase program, saying that with the unemployment rate at 9.5 percent and little apparent risk of inflation, the Fed should use every tool at its disposal to get the economy back on track.

Fed leaders view such a strategy as likely to have only a small impact on the economy and as carrying a risk of slowing growth.

One of the key ways the earlier securities purchases stimulated the economy was by driving down mortgage rates, which in turn propped up the housing market. But with mortgage rates near all-time lows, it is not clear that actions to lower rates another, say, quarter percentage point would result in much additional home sales or refinancing activity.

Moreover, the Fed’s purchases of mortgage securities have reduced the role of private buyers in that market, and some leaders at the central bank fear that further intervention could delay the resumption of normal market functioning.

“The Fed probably believes that unconventional policy does not have much traction as market functioning gets better,” said Vincent Reinhart, a resident fellow at the American Enterprise Institute and a former Fed official.

Asset-purchase plan

Another risk is that global investors could lose faith that the Fed will be able or willing to pull money out of the economy in time to prevent inflation. That would lead the investors to demand higher interest rates on long-term loans, which could reverse the rate-lowering effects of the Fed’s asset purchases.

When the Fed was buying $300 billion in Treasurys in mid-2009, part of its try-everything approach to dealing with the crisis, rates on 10-year bonds temporarily spiked amid concerns that the Fed was “monetizing the debt,” or printing money to fund budget deficits. With deficit concerns having deepened in the past year, such fears could be even more pronounced now.

All that said, Fed officials do not rule out launching a major new asset-purchase program. Rather, they say they would consider one only if their basic forecast — of continued steady expansion in the economy — proves to be wrong. A key factor that would build support for new asset purchases would be a rise in the risk of deflation, or a dangerous cycle of falling prices — which has become more of a concern as the world economy slows.

Fed officials express confidence that they have tools to address the economy further if conditions worsen.

“I think we do have a variety of tools available, and we shouldn’t rule any tool out,” Eric Rosengren, president of the Federal Reserve Bank of Boston, said in an interview. “If we’re uncomfortable with how long it’s going to take us to reach either element of our dual mandate [of maximum employment and stable prices], we’ll have to make some adjustments to policy.”

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