The Fed Has More Work to Do; How Much and When is to Be Determined
The Federal Reserve is charting a course into unknown waters as it sizably expands its balance sheet. But the Fed is just trying to do the job it has been assigned by Congress. Up until 2007, the Fed’s asset base was about $900 billion, largely consisting of U.S. Treasury securities. Since the 2008-2009 Financial Crisis, the central bank has boosted its holdings to $2.9 trillion, and with more variety. Treasuries still make up most of the mix, but there is also a significant amount of mortgage-backed securities on the central bank’s books. Some observers feel that the Fed will ultimately need to take its balance sheet up to $4 trillion before its work is done. Getting there would obviously entail significant new asset purchases, which is a point of some contention.
The ultra-conservative stance is that the creation of the banking system reserves that the Fed uses to pay for its asset purchases is potentially highly inflationary. Inflation can be extremely difficult to tame, and damaging to the economy once it takes root. So the feeling by hardliners is: Don’t even get started down that road. The elevated price of gold these past several years probably best reflects the markets’ concern over global central banks’ use of money creation to buy assets.
However, the Fed feels its unconventional asset-purchasing strategy is now battle-tested, and the concerns about a broad-based rise in inflation are not showing up in the empirical data. Except for occasional jumps in food and energy prices, which are deemed outside the so-called “core’’ rate of inflation, prices for most goods and services are largely viewed as under control. The lack of inflation provides the Fed with the leeway it needs to move forward with another round of bond-buying, if it so chooses.
It may well be that the Federal Reserve is taking on too much of a load by itself, but there doesn’t seem to be many alternatives. The central bank has been given the dual mandate by Congress of achieving full employment in the economy (normally considered to be at about a 5% unemployment rate) while maintaining price stability. And with the Senate and the House of Representatives divided between the two major political parties, the chances are slim that new, significant fiscal policies will be forthcoming. As a result, the Fed is the only major player ready and able to advance major policy initiatives to stimulate the economy.
But the Fed is still left with the question as to whether new moves are now needed. The answer would appear to be yes, with the economy chugging along at a slow rate of growth and unemployment stuck above 8%. The biggest step, a third round of quantitative easing, or bond-buying, may not happen right away, though. The central bank might first announce that it plans to keep interest rates near zero beyond its current “at least through late 2014’’ target. The Fed could also lower the interest rate it pays to banks for excess reserves. These types of smaller steps might be taken while the Fed waits to see what type of action the heads of Europe take to address the festering sovereign-debt crisis across the Atlantic.
Overall, there is a good chance the Fed will initiate another round of bond-buying, possibly by yearend. It would be a better sign for the economy if such measures didn’t need to be taken, and if the Fed were to draw down its balance sheet by allowing existing assets to mature. But it probably shouldn’t be a surprise if more special steps are utilized to recover from the toughest financial conditions since the Great Depression. Meantime, stock market investors already seem to have priced in a prospective QE3.
At the time of this article, the author did not have positions in any of the companies mentioned.