Fed looks at third round of easing

The recent slowdown in US economic growth is forcing the Federal Reserve to consider something for which it has always set the bar very high: a third round of quantitative easing.

A decision on whether to launch another round of asset purchases remains in the balance as the central bank wrestles with a complicated economic outlook and uncertainty about the costs and benefits of its easing tools.

In an interview with the Financial Times, John Williams, president of the San Francisco Fed, said that the weak outlook and the extent of downside risks “would argue for further action” but the counter-argument was doubts about tools such as QE3.

However, Fed officials are determined to ensure that the economy makes progress towards lower unemployment. In June, the rate-setting Federal Open Market Committee still forecast a decline in the unemployment rate over the next few years, albeit very slowly. Any downgrade to that forecast would be a likely trigger for further action.

“We are looking very carefully at the economy, trying to judge…whether or not the economy is likely to continue to make progress towards lower unemployment,” said Ben Bernanke, the Fed chairman, in recent testimony to Congress. “If that does not occur, obviously we have to consider additional steps.”

The Fed will not formally update its forecasts until September but crucial data due for release this week will weigh at its next meeting, which concludes on August 1. The Bureau of Economic Analysis is due to publish revisions to its gross domestic product data going back to 2009, along with its first estimate of growth in the second quarter of 2012.

In 2010 and 2011, annual revisions to GDP revealed that the recession was much deeper than previously thought, and spurred the Fed towards greater easing.

If the Fed does choose to ease further the most likely option is more asset purchases, QE3, aimed at driving down long-term interest rates. Such a programme would probably target mortgage-backed securities at least in part, both because the Fed already owns a large share of outstanding long-term Treasuries, and for an extra effect on mortgage rates.

In the wake of the European Central Bank’s decision to cut its deposit rate, the Fed is reviewing the idea of cutting the 25 basis points of interest that it pays banks on their excess reserves, but it continues to see relatively small benefits that must be offset against dangers to market functioning.

The Fed is also researching whether the Bank of England’s new “funding for lending” scheme could be applied in the US. That work remains at an early stage and is a long way from becoming a policy option for the FOMC.

Under the BoE’s scheme it will provide cheap funding to banks that increase their lending to households and businesses. Although Fed officials think that such a programme could be legal under the Federal Reserve Act, they do not think that funding costs are a big problem in the US, and hence doubt its effectiveness.

However, the FOMC remains hungry for new tools beyond asset purchases, and so the Fed is likely to keep studying whether there is a way to use its discount window to overcome hurdles such as the need for very high downpayments when households take out or refinance a mortgage.
FT