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The next meeting of the Federal Reserve Open Market
Committee (FOMC) is on tap for next week. It’s slated to be an
important and maybe a contentious one, with Chairman Bernanke having scheduled
some extra time for members to more carefully mull the options (or perhaps to
fight among themselves). There is a near-universal expectation that Big Ben
will emerge from behind the closed doors announcing or at a bare minimum
hinting at some proactive steps the Fed will take to help the economy. Hence,
the blogosphere has been rife with speculations and prognostications of late.
In what direction might the Great Beard go?
No question the Fed has a bag with a few tricks
still remaining in it. So, let’s stick our hand in there and see what
we find. This is not intended to be an exhaustive list, but I think we can
cover the likely moves, as well as a few unlikely ones that are yet within
the range of possibility, very broadly defined.
Do nothing. This may seem like the easiest course of action,
especially since there have been repeated denials that any form of QE3 is
coming. But the pressure on the FOMC to do something has to be
ratcheting up as the long, stagnant summer comes to an end. Doing nothing,
and letting the market sort out its own problems, is almost certainly
preferable to further interventions, especially in the long run. However, it
would be wildly unpopular. Thus, it may simultaneously be the best possible
decision and the least likely outcome.
End interest. The Fed is currently paying interest on reserve
deposits banks have left with it. With the housing slump still very much in
evidence, banks are reluctant to take the risk of beginning seriously to lend
money again. They consider it more advantageous to earn the pittance of
interest the Fed is paying out. Ending interest payments would provide banks
with more incentive to withdraw some of the money and put it into
circulation, thereby (hopefully) boosting the overall economy, which is the
Fed’s putative goal. This is a soft option that would offend hardly
anyone and just might have a positive effect.
Encourage withdrawals. With or without an end to interest payments, the
Fed can be a little more aggressive, and encourage banks to take back
deposits and put them into circulation. It even has sufficient authority to pressure
banks into doing this, should its attempts at gentle persuasion meet with
resistance. Again, the aim would be to turn money that is sitting idle to
productive purposes. That would mean more monetary inflation on top of QE2
– and thus price inflation somewhere down the road – but that
would be acceptable to all or most committee members if it were accompanied
by actual economic growth.
Initiate QE3. They won’t call it quantitative easing, of
course, since the last round flopped so utterly. But in their minds further
“stimulus” surely seems necessary. They could accomplish this end
by buying more Treasuries – and in fact they eventually may be forced
to do so simply to ensure that there will not be a failed auction that
devastates dollar confidence and sends interest rates north. In order to not
seem to create new funds out of thin air this time, they could try to offset
the money creation with sales of some of the toxic securities they took off
the banks’ hands during the crash. Almost certainly at a loss, of
course. But few will care. Or even notice, for that matter.
Operation Twist. This was a ‘60s-era scheme wherein the
central bank sold shorter-dated securities and bought longer-dated ones, out
in the 7-10-year range, in an effort to drive down long-term rates and spur
growth. With all the economic uncertainty, inflows into bond funds have been
high, as many investors remain highly risk averse and look to Treasuries not
just as a safe haven, but as an income producer. Driving rates even lower
than they already are might shake some money loose, but it’s risky if
inflation increases and the value of the debt declines.
Analysts are sharply divided on whether the Fed would consider taking such a
risk.
Operation Torque. This term, coined by Morgan Stanley, refers to an
Operation Twist pushed to the extreme. Under the scenario, the Fed would sell
all of the current debt it holds that is less than two years from maturity
– nearly $300 billion – and buy all the way out to the 30-year
bond. Morgan Stanley believes the result would be to “remove duration
supply from the market, and not simply to push yields lower. With less supply
in the market, risk premiums for spread products should decrease, driving
easier financial conditions” and leading to “lower credit rates,
lower borrowing costs, and lower mortgage rates.” Of course, as with
Operation Twist, the success of something like this depends on whether an
economic rebound would be jump-started by a further beat-down of interest
rates, a highly dubious proposition.
Fifty Years??? As preposterous as it may sound, creating a 50-year
bond in order to extend the debt even further out may be under consideration
at the Fed. Emphasis on the “may,” as the Treasury Department has
denied it is working with the Fed on this. And who would buy such a thing?
Only the Fed and perhaps some ultracautious pension funds. But precisely
because it would give the Fed an easy way to extend the duration of its
portfolio, it is being discussed, insists Jeff Kilburg, senior
development director at Treasury Curve, an online trading platform. “This is a viable option for
them,” he says, “an important tactic that would instill some
confidence, clarity and vision and provide a template for the European
problems.” Well, maybe. But chances are this one ranks right down there
with doing nothing.
Start raising interest rates. Okay, that’s a joke. That probably
doesn’t even belong on the list, because it’s the one thing
Bernanke has specifically said they won’t do, at least for the next two
years. Such a dramatic course reversal would be the maximum shocker of this
or any other year. It would also be a very sane thing to do, despite the
short-term pain it would cause. So even holding out a shred of hope for it is
foolish.
Each of the above carries with it a distinct
risk/reward profile, and that’s the issue with which the committee is
going to have to wrestle. This is one FOMC meeting at which the chances of
harmony prevailing are near nil. It’s probable that several of the
available options will have its strong proponents as well as its critics.
That leaves the Great Beard with the unenviable task of formulating a policy that
everyone can live with and of at least creating the appearance of consensus. No
small job.
We can afford to play the guessing game, but while
the Fed will end up guessing too, it’s a different kind of game for
them. They’re at a pretty serious crossroad here. Even they know
they’re facing the real prospect of a double-dip recession… or
worse. The flip side of this is rampant inflation, or at best, stagflation.
There’s a lot hanging in the balance, and about all they can hope for
is to do the least amount of harm. On September 21 we should know what tool
they’ve chosen for damage control.
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