Faced with stalling economic growth and rising fears about deflation in consumer prices, the Federal Reserve took a small and mostly symbolic step on Tuesday toward more aggressive stimulus policies.
In an anxiously awaited announcement, the central bank left most of its policies unchanged but said it would keep its massive bond portfolio from shrinking by reinvesting money from mortgage-backed securities as they mature.
The move amounted to tinkering at the margins of monetary policy, a way of reassuring investors that the Fed would be ready to take stronger action if it becomes necessary. But it also highlighted the reluctance of Fed officials to restart anything like the trillion-dollar bond-buying program it carried out at the depths of the recession.
Investors initially reacted with relief that the Fed was taking at least some action, but the relief soon fizzled. Stock prices jumped immediately after the Fed announcement at 2:15 p.m. but then fell back and ended the day down. The Dow Jones Industrial Average closed down 0.51 percent at 10,644.
The events were somewhat reminiscent of the Fed’s meeting almost exactly three years ago, in August 2007, just as the first wave of the financial crisis was hitting credit markets. At that time, the Fed refused to lower interest rates and kicked off a panic in financial markets. A little more than one week later, Fed officials hastily convened a follow-up meeting and lowered the rates on emergency loans to banks. It was the first step in a rescue effort that ultimately involved trillions of dollars.
A 'More Modest' Recovery
In the Fed’s statement after Tuesday’s meeting, policy makers acknowledged that the pace of economic recovery would be “more modest’’ than it had originally expected. It also admitted what most investors already knew: that consumer spending is weak, that the housing market is still “depressed” and that bank lending has “continued to contract.”
A slew of discouraging data has elevated fears of a double-dip recession. Private-sector job growth has been below 100,000 jobs every month since April – too slow to reduce the unemployment rate from its current level of 9.5 percent. Housing sales and home prices have fallen sharply since a special home-buyer’s tax credit expired last spring. And consumers have become more cautious. Last week, the government estimated that economic growth slowed to an annual pace of 2.4 percent in the second quarter, a big slow-down from 3.7 percent in the first quarter.
But policymakers stopped well short of announcing any big new action, which reflected both internal disagreements about how to respond and the dwindling number of tools at their disposal.
The benchmark Federal funds rate on overnight loans between banks has been at virtually zero since December 2008. On top of that, the central bank has tried to push down long-term interest rates by buying nearly $2 trillion in Treasury bonds and mortgage-backed securities. That program ended in March, and Fed officials had until recently focused on how and when to start unwinding those positions before inflation started to kick in.
“Monetary policy can’t solve the problems of the world,’’ Frederic Mishkin, a professor of economics at Columbia University who served as a Fed governor during much of the financial crisis, said in an interview with The Fiscal Times. “The Fed can manage inflation in the long run and that has to be one of its most important objectives. But it cannot manage every squiggle in the business cycle.”
The Stimulus Options
Ben S. Bernanke, chairman of the Federal Reserve, has outlined a number of options for providing more stimulus but cautioned that each option has its risks and costs. One option was for the Fed to toughen its pledge to keep the Federal funds rate at almost zero. For months, the Fed has said it plans to keep the funds rate low for “an extended period” and implied that it wouldn’t raise it as long as unemployment remained high and inflation expectation were still low. But most analysts had already predicted that the Fed wouldn’t raise rates until sometime in 2011, and it wasn’t clear how Fed officials could hint at a longer commitment without sacrificing valuable flexibility.
A second option was to stop paying interest on the $1 trillion in reserves that banks keep on deposit at the Fed. That would encourage banks to use their reserves rather than simply parking them at the Fed, but the difference would have been small because the Fed only pays a quarter of a percentage point on reserves.
The Fed’s most powerful option was to resume its massive purchases of long-term bonds, a strategy known as “quantitative easing.” That program ended in March, and wags have referred to a possible resumption as “QE2.”
But the Fed is already under fire from many conservatives for “printing money’’ and potentially stoking future inflation. Beyond that, it wasn’t clear how much impact the effort would have. Interest rates on 10-year Treasury bonds have fallen to about 2.8 percent, and many corporations are sitting with huge idle cash reserves.
Fed policymakers remain divided between inflation hawks and employment doves. Despite the recovery’s recent slowdown, a few members of the policy-making committee argue that the Fed’s last round of support will kick off a new round of inflation if the central bank doesn’t start tightening soon.
Thomas M. Hoenig, president of the Kansas City Fed, dissented from Tuesday’s decision, saying that the Fed should no longer be promising to keep the Fed funds rate at zero for an “extended period” and that it should not try to keep the Fed’s bond portfolio at its current size.
But other Fed officials are increasingly worried about the sluggishness of the recovery. In a staff paper on Monday, a visiting scholar at the Federal Reserve Bank of San Francisco warned that a double-dip recession was “a significant possibility sometime in the next two years.”
And in a recent paper that startled many analysts, the president of the St. Louis Fed, James Bullard warned that the United States was “closer to a Japan-style outcome than at any time in recent history.” Bullard, considered a centrist on the Fed’s policy-making committee, argued that the Fed should be ready to resume big purchases of Treasury bonds if the economy experiences another “negative shock.”