Fighting a Double Dip: What Weapons Does the Fed Have Left?

Ben Bernanke, chairman of the Federal Reserve, faces daunting challenges as the economy weakens. When Chairman Ben Bernanke and the Federal Reserve's rate-setting Federal Open Market Committee (FOMC) meet Tuesday, they'll face some daunting challenges. The economy is unquestionably weaker -- the U.S. Labor Department reported a net loss of 131,000 jobs in July -- and the threat of deflation is getting scarier. Faced with these concerns, what's the Fed likely to do? Actually, what can it do?

The Fed's options are somewhat limited because it has already adopted a zero-interest rate policy because the rates it charges banks are already set at their lowest possible point of between 0% and 0.25%. Interest rates can't go any lower, so further easing of rates isn't an option.

Paul Sheard, global chief economist at Nomura Securities, believes the Fed will act decisively to signal to the markets that its policy is changing because of the new risks.

"We think at this point it makes sense for them to say the outlook has deteriorated, the risks around deflation are higher than they were six months ago and it is time to send a signal that the Fed is absolutely determined not to let the economy slip into a slump or deflationary situation," Sheard says.
Is Printing More Money an Answer?

Hans Redeker, head of foreign exchange strategy at French bank BNP Paribas, says he thinks the Fed will go beyond merely changing its language and will accelerate a monetary policy known as quantitative easing.

Quantitative easing was first used by the Japanese government to try to reverse stubborn deflation during the 1990s. It has also been called printing money. Essentially, the Fed issues new money and uses that invented cash to buy assets such as mortgage-backed securities or Treasury bonds from banks. The banks can then, in turn, lend that money to customers and -- presto! -- the money supply has been expanded, supposedly stimulating the economy.

After the crash of 2008, the Fed deployed quantitative easing on a large scale, buying $1.25 trillion worth of mortgages and debts of state agencies. While its balance sheet in normal times had been $850 billion, it has now reached a whopping $2.3 trillion.
In fact, the Fed had started to let its balance sheet shrink as the economy improved. It closed several credit programs, such as one designed to bolster the market for commercial paper, and in March it stopped buying mortgage-backed bonds and Treasury bonds, which it had been doing since the depths of the financial crisis. But there are signs that policy may be changing.

Reviewing All the Options

James Bullard, president of the Federal Reserve Bank of St. Louis, spooked the financial markets last week by releasing a 23-page research paper titled "Seven Faces of the Peril," in which he warned that continuing zero interest rates could lead to a situation similar to what happened in Japan, where deflation took hold for more than a decade (and is still present).

"A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities," he wrote.

As a member of the FOMC, Bullard obviously has a lot of clout. While his hawkish views aren't widely shared by other members, more quantitative easing is hardly out of the question.

Two weeks ago, Chairman Bernanke told Congress that the economic outlook is "unusually uncertain," but that the Fed was still reviewing its options and wasn't ready to take any specific steps to fix the situation. Some possible moves, Bernanke said then, include making a public announcement about the expected path of interest rates in the future, cutting interest the Fed pays on bank reserves and expanding the Fed's balance sheet, which is another way of saying quantitative easing.

Could Quantitative Easing Cause Hyperinflation?

Still, there have been plenty of dissenting voices as well, which say more quantitative easing could set the stage for a bout of hyperinflation further down the road.

"The market may be getting ahead of itself with regard to [qualitative easing] expectations," Geoffrey Yu, a foreign exchange strategist at Swiss Bank UBS wrote in a note to clients. "There are plenty of reasons why the Fed would not want to turn the taps back on."

That may be true, but if the Fed does nothing, the markets are likely to take it as a negative sign. A further sharp sell-off on the world stock markets is the last thing Bernanke wants, because it would make declining prices -- the definition of deflation -- more likely to happen.

"Putting Down a Marker"

But whether the Fed ultimately chooses to do more quantitative easing or not, Sheard thinks it will first issue a statement -- at the end of its two-day meeting on Wednesday -- to signal that things may be changing. The language will likely reflect the deteriorating economy and may also help keep the balance sheet from slowly shrinking as it has since March, he says.

"The significance of this would be putting down a marker that policy could head in a different direction, and the next move could be further quantitative easing," Sheard says. "You have to stop the ship before you turn it around."

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Linda

Lots of names got booted with the new format but WashyWizard wasn't one of them.

August 10 2010 at 12:51 PM +1
ajgorm

With deflation the gap between what we owe and what we can pay grows more negative. The dollar buys more while we are stuck paying yeterdays bill working even harder to pay debt. It is reverse inflation it would be great if we had zero debt with lots of savings and money to spend. The fact is we have too much debt making every dollar we pay back worth more and less savings and no new jobs to help pay debt. We have fewer jobs. We are the poor fools that were blind sided by poor regulation.. Sinking us to pay debt while they live off of us slaves. Greenspan called it over exhuberance. Counting our chickens before the eggs hatched as the fox stole the eggs and the chickens leaving a bill for the farmer to pay.

August 10 2010 at 12:35 PM +2
Linda

Double dipping isn't always that bad. I use to get a double dip ice cream cone at Thrifty's when I was a kid...only 10 cents. 5 cents a scoop...those were the days.

August 10 2010 at 12:16 PM -3
3 replies to Linda's comment
apatriotofusa

Heard AOL was cracking down on these types of posts and see this announcement above: We welcome your comments! Please stay on topic and respect the opinions of others. Off-topic comments, vulgarity and abusive language are subject to deletion, and offenders will be blocked. ===================== Guess not judging from some sick posts I'm seeing. Shame as they will lose advertisers.

August 10 2010 at 12:09 PM
5 replies to apatriotofusa's comment
ajgorm

debt and inflation to more debt and deflation is not good. As the banks spin in their recovery mode buying treasuries and we the people deflate trying to pay inflated debt on under water deflating homes in a time of Global chaos,,,uhhh the only weapon we have is conservatism and to take back local governments and replace them with people that know what communities need to survive the great melt down. FAFF.. As we reduce miltary spending to cover debt we will have higher unemployment to deal with. Hit the reset button.

August 10 2010 at 12:05 PM +4
2 replies to ajgorm's comment
apatriotofusa

No easy answers. Spending isn't going to fix the problem.

August 10 2010 at 12:06 PM
Linda

I always fly with an umbrella...you never know when you might have to jump.

August 10 2010 at 11:54 AM -5
3 replies to Linda's comment
ajgorm

The question is will we see a tripple dip and more national debt. How many dips can we have before the debt ballon pops for good. It may last for ever at this rate. If we deflate to zero then we can all become Marxists.

August 10 2010 at 11:51 AM +1
ajgorm

Take the next step now we have a jobless recovery. Do we know how this happens ? Bail Outs 101 at the top not at the bottom. The government is waiting for us to start buying things again. We are back to before 1999 and in worse shape. WHY ? because it was a fake economy that could not possibly last. Our government is printing money as usual to pay our debt. Hocus pocus all of a sudden we will gat growth with this much debt and a ballooned fake recovery. We are toast. The government and banks will need to go deeper in debt , reverse the 1999 ruling that put us here and stick with slow growth again .

August 10 2010 at 11:46 AM
Linda

thadrock...I got that email from you today. I'm not sure what kind of animal that is you're with but it's pretty disgusting. I reported it to AOL...they will no longer tolerate such filth.

August 10 2010 at 11:44 AM +1
1 reply to Linda's comment
ajgorm

If I can sell bubble gum at $ 100 k a stick because tax payers will insure the deal , I can make a lot of money. When congress signed off on the deal were they blind to the facts...no...Why do you think they had regulation ??? Did they know why we had these rules ...YES ..did they do it any way ...YES...Now when you go to the bank the bank wants to make easy money betting on mortgages doubling they want to make money of every deal knowing they cant lose being insured. Hey we know they cant pay history proved it but you did it anyway making the same mistake . Why do we teach history if we keep making the same mistakes. OHhh this time it will work BS..

August 10 2010 at 11:37 AM