America's economy

Adding to the stimulus

More unconventional measures to stimulate America's economy

THE Federal Reserve’s interest-rate target is near zero. The recession is deepening. No wonder that speculation is mounting about when America’s economic policymakers will start using truly unconventional measures to stimulate the economy.

The answer is that they already have. Since early September, without any formal declaration, the Fed has radically expanded its balance sheet to counter the credit crunch. Under the guise of successive new programmes, each with a less memorable acronym than the last, the Fed is substituting its balance sheet with that of the contracting private financial system in the hope of keeping the economy from being starved of credit.

The current credit crisis is not a temporary shock like the September 11th 2001 terrorist attacks, which briefly severed the financial system’s internal plumbing. Rather, a radical reassessment of what constitutes acceptable levels of capital, leverage and interest rates is underway. Those financial institutions that have not failed are intent on reducing leverage—their volume of loans for each dollar of capital. The Fed has no hope of stopping this process; it is merely trying to slow it down by providing a home for the assets that the financial sector is shedding. The alternative is plunging asset values, a complete withdrawal of credit and economic catastrophe.

There is no predetermined end game. Ben Bernanke, the Fed chairman, has repeatedly promised to use “all of the powers at our disposal” to get credit flowing again. This week saw a slew of big new initiatives. The Fed and Treasury agreed to guarantee $306 billion of Citigroup's assets. They then created a $200 billion facility to buy asset-backed securities. Most radically, the Fed promised to buy up to $500 billion of mortgage-backed securities (MBS) guaranteed by government-sponsored entities including now-nationalised mortgage agencies, Fannie Mae and Freddie Mac, and up to $100 billion of direct debt. The 30-year conventional mortgage rate fell to 5.8% on Wednesday from a little over 6% before the Fed's announcement, according to Bankrate.com

The MBS purchases are significant; for the first time they turn the Fed into a direct lender to consumers. Many homeowners, though they do not know it, will now send their monthly mortgage payment to the Fed. The Fed will finance these programmes with newly created reserves; that is, it will print money. Its balance sheet, which has ballooned from $900 billion in August to $2.2 trillion now, could grow by an additional $800 billion, which would make it a larger lender than any commercial bank.

It is tempting to look to Japan for a road map to where the Fed goes next. Faced with sinking asset prices, insolvent banks, moribund growth and deflation, the Bank of Japan eventually lowered its policy rate to zero in 1999. In 2001 it then announced “quantitative easing”. Through large-scale purchases of government bonds it aimed to fill banks with excess reserves that it hoped they would lend out, to stimulate loan growth.

These routes are open to the Fed. It could cut its federal-funds rate target from 1% to zero, though that would make it hard for some parts of the money market to function. And it may not do much good, since the actual funds rate is already trading well below the 1% target. To give it more impact, the Fed could commit to keeping the funds rate at zero for some period of time or until the economy or inflation meet some predetermined conditions, though such a commitment could drag down yields on long-term Treasuries.

Alternatively, the Fed could target long-term rates via purchases of Treasury bonds, as it did from 1942 to 1951. That strategy might gain appeal if big government deficits start to force bond yields higher. Academics have concluded that Japan’s quantitative easing had little benefit except to buttress expectations that its policy rate would be zero for a long time.