Economy: What's Left in Bernanke's Toolbox?

Unmentioned but not impossible: Last-ditch options.

Aug. 25, 2011 -- Federal Reserve Chairman Ben Bernanke goes before the microphones on Friday to announce what, if anything, the Fed will do next to buck up the stumbling and disheveled U.S. economy. Critics question whether the Fed has anything left in its toolbox it hasn't already tried. The box, they insinuate, is empty--or virtually so.

Is that true? Does the Fed really have no new means at its disposal?

The world's stock markets seem to believe otherwise. They rose this week, in part on anticipation that the Fed will take new steps to keep the U.S. from sinking further into recession.

Truth is, there's plenty the Fed still could do. A number of unused tools remain, but none is without controversy. Some, politically, are too hot to touch. And still others are so potent that their use cannot be imagined, short of some doomsday scenario.

It was just one year ago that Bernanke announced a second round of so-called "quantitative easing," dubbed QE2. As with its predecessor, QE1, announced in March 2009, the idea was for the Fed to buy private debt on a massive scale, thus keeping interest rates low and invigorating the U.S. economy with a booster of inexpensive cash. The stock markets of the world have benefitted, and traders this week were cheered at the prospect that Bernanke, on Friday, will announce QE3 or something like it.

It's far from sure, however, that Bernanke will choose that tool.

The effectiveness of first two QEs has been questioned. Critics acknowledge that easing has brought temporary benefits, but they argue those have accrued primarily to the stock market. They question whether flooding the markets with yet more cheap money is a good thing for the economy long-term.

Lance Roberts, chief strategist for Streettalk Advisors, calls quantitative easing just so much "heroine." The first two shots of it, he says, indeed invigorated markets. But the effect was short-lived. Another round of it might help the U.S. "temporarily avoid a double dip," but it would not solve "our long-term fiscal problems."

It's not only Fed outsiders such as Roberts who reject QE3. Some Fed insiders oppose it. In a rare instance of internal dissent, three regional Fed presidents (Dallas, Philadelphia and Minneapolis) earlier this month voted against Bernanke's decision to keep interest rates low through 2013. President Richard Fisher of Dallas said in a speech that the U.S. economy already is "awash with liquidity."

Access to cheap cash, he said, is not the problem. Rather, political gridlock in Washington has produced uncertainty among business leaders and unease among consumers, both of whom, as a result, have decided "to forego or delay some discretionary expenditure[s]."

So, if not QE3, then, what?

"That's the $64 million question!" says Roberts. We could see, he speculates, "massive loan-forgiveness. But there would have to be federal support to keep the banks solvent." And such a move, he notes, would only encourage the non-forgiven to walk away from their debts. "Bernanke has very little other choice at this point. All the Fed has available to it is the power to continue to suppress interest rates."

Ah, but which rates?

The consensus expectation among Fed watchers seems to be that on Friday Bernanke will opt to bring down long-term rates. He could do that, for example, by selling 2-year Treasuries and buying 10-year notes. A similar move, dubbed Operation Twist, was tried with success in the 1960s, says Christopher Low, chief economist with FTN Financial.

What would that mean for consumers? Nariman Behravesh, chief economist with economic consultants IHS, says that would-be home buyers looking for a long-term mortgage would see rates fall to historic lows. The step would give a needed boost to the abysmally depressed housing market. It would be good news, too, for any business person looking, say, for a 5-year business loan.

Bernanke also could reduce the rate of interest paid banks on reserves they deposit with the Fed. That now stands at 1/4 percent. Lowering the rate would make it less attractive for banks to park their money and more attractive for them to put it to some other use--e.g., extending loans, says Low.

No one expects Bernanke will move to raise inflation; but that doesn't mean the Fed lacks tools to raise the inflation rate, if it wanted. Bernanke could, if he so chose, raise the Fed's medium-term target for inflation.

Some economists, including New York Times columnist Paul Krugman, believe higher inflation would have a salutary effect. "Even some Republican economists," wrote Krugman in a June column, "have argued that a bit of inflation might be exactly what the doctor ordered." Right now inflation "outside the price of oil" remains low, he argues. Both small businesses and workers are being hurt "far more by the weak economy than they would be by, say, modest inflation that helps promote recovery."

Christopher Low says Bernanke doesn't have to raise the medium-term inflation target. He could get much the same result by mentioning the mere possibility inflation might rise. That would "plant the seed in people's minds," says Low, that the Fed regards a higher rate as possible. That would cause them "to accelerate their purchases."

What else might the Fed do? In theory, anything, says IHS's Behravesh. The Fed is a private entity, not beholden to government. It isn't answerable in any direct way to Congress or to the general public.

Says Behravesh, "Only imagination sets limits on what the Fed could do." If Europe's economic crisis were to worsen, threatening the U.S. economy, the Fed could buy up European debt. I could undertake swap arrangements with European banks. If there were a domestic credit card crisis, it could buy credit card-backed securities. Three years ago, says Behravesh, the Fed did just that, in a limited way.

No one expects Bernanke to pull the pin on anything that might be called a doomsday weapon, but the Fed's toolbox does contain them. An example, says Low, would be the Fed's "eliminating altogether the interest paid on banks' reserves." That would have, he predicts, "a very dramatic effect, because banks currently have $2.75 trillion tied up in reserves. About $2 trillion of that would flow out the door in a couple of days."

Because banks as a group, he says, are at the moment "only marginally profitable," losing all interest on those reserves "would be painful." The resulting "enormous injection of liquid into the system" would appear to the consumer almost immediately as a significant drop in, say, mortgage rates: "You'd see 3.5 percent mortgages," says Low, "that kind of thing."