The US Economy Is Vulnerable, The Fed’s Options Are Not Great

The US Economy Is Vulnerable, The Fed’s Options Are Not Great

The US Fed’s economists are the Umbrella People, they prepare for Rain on Sunny days.

Even as no FOMC member has forecast a recession in the next 3 years, a shaky global environment has dampened the US economic outlook.

With the Fed’s main policy rate stuck at Zero+ since December 2008, that means Fed is mulling other ways to stimulate economic growth.

Below are 3 tools at Fed policy makers’ disposal, along with their benefits and drawbacks as seen by the experts, as follows;

1. More forward guidance

What that means

The Fed could offer more hints to participants about when it will raise rates and at what speed. If those communications suggest policy makers will raise rates more slowly than investors had expected, borrowing costs could decline, which may spur borrowing and spending.

Pro: This is the easiest option because it costs nothing, and it was also the last tool the Fed used to squeeze extra stimulus out of its current Zero+ rate policy.

Con: The punch from this stimulus could be limited because short-term yields, the place where the Fed can most credibly guide investors on rates, are already low. The US Treasury’s 3-yr Note yields just 0.90%.

“The market is not going to need any forward guidance if there is a recession and 2-, 3-, and 4-yr rates are down to Zero,” says Roberto Perli, a partner at Cornerstone Macro LLC in Washington and former member of the Fed’s Division of Monetary Affairs.

2. More QE

What that means

The Fed could buy more bonds in a policy known as QE (quantitative easing).

Pro: This is very effective in a financial crisis, according to researchers at the Peterson Institute for International Economics in Washington. They reported that “economically meaningful and long-lasting reductions in longer-term interest rates” in the last rounds of quantitative easing.

Cons: In a recession where financial stress is not the Key feature, bond purchases may be less effective. Even longer-term bond yields are already low, so there is not much to be gained. The US 10-yr Note yields about 2% now compared with 3.11% when the central bank began purchasing bonds outright in Y 2008. There are also the potential complications of exiting a balance sheet that swelled to $4.5-T from previous rounds of QE. The political blowback in a Republican controlled Congress, where QE is not popular, could cause more headaches at the central bank.

3. Negative interest rates

What that means

The Fed could lower its main policy rate (fed funds) below Zero+, something it has never done. The target rate is currently at between Zero and 0.25%.

Pros: Countries like Sweden have started to experiment with this, and there does not seem to be a lot of financial instability associated with it. It could weaken the USD Vs other major currencies, which would help American exporters. Faced with having to pay a bank to hold their money, depositors may choose to take on more risk by shifting funds into assets with longer maturities, pushing down interest rates further along the yield curve. They could also end up spending more money.

The idea has support from at least 2 regional Fed bank presidents: Naryana Kocherlakota of Minneapolis and John Williams of San Francisco.

Cons: The US financial system is more diverse than Europe’s. The American banking system is populated with thousands of community banks that rely almost solely on depositors for loanable funds.

A migration away from small banks into Zero-yielding products: cash, debit cards, or money-market funds that might find a way to keep returns less negative than a bank deposit could disrupt credit creation. That would defeat the purpose of the policy.

“Individuals expect a return for parking their money in a local bank,” said Paul Merski, chief economist for the Independent Community Bankers of America in Washington. “The lower that return, the less lending” if deposits migrate.

The goal of investment in short-term assets, says a money market strategist at Barclays in New York, becomes “losing less money,” and the distortions that creates may not be worth the trouble.

“You are really entering a point where fiscal policy is called for,” he says. “You have reached the end-point of sensible monetary policy.”

The Bottom Line

The Fed does not have very many good options, and that is why Fed officials are arguing that the Southside risks of raising interest rates too soon are larger than the risks of being too late and triggering faster inflation in the future. The current target rate is 2.0%.

The Fed knows how to fight inflation.

Have a terrific weekend.

HeffX-LTN

Paul Ebeling

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