Thursday, July 15, 2010

The Fed Is Not Omnipotent

The softening tone of the economic data in recent weeks has turned the spotlight to the issue of what additional action the Fed may need to take to provide new fuel to the underwhelming economic recovery. This emerging debate was also highlighted in yesterday's front page Wall Street Journal article (
as well as in the release of the minutes of the June 22-23 FOMC meeting (

Although the Fed's conclusion at the late June meeting was that no additional measures were deemed necessary at that point, the ongoing weakness in the economic data- showcased again in this morning's disappointing Philly Fed and Empire Fed manufacturing surveys for July- is likely to keep the debate alive and probably intensify it.

A discussion as to what further action the Fed can take to reinvigorate the recovery is understandable but based on the premise that monetary policy-making does indeed have the power, or leeway, to achieve that goal in the current environment. With the federal funds rate close to zero and an enormous amount of liquidity slashing around in the the financial system, this is not so obvious.

The Fed has seemingly exhausted the array of the most potent tools it possesses to promote economic growth, that is short-term rates and quantitative easing. In fact the entire structure of interest rates remains extremely growth-friendly, with not only Treasury yields near record-lows but also with credit spreads at historically tight levels. The economic recovery's inability to inspire great confidence, nearly a year after its onset, is not the result of market yields that are not low enough or the financial system having inadequate liquidity. It is mostly the result of a lengthy healing process following a devastating financial crisis and recession that is preventing the low interest rates and abundant liquidity from having a more textbook-like stimulative effect on economic activity.

It would simply not be credible to argue that the Fed's facilitating of another 7 to 10 basis points decline in the federal funds rate form its recent 17 to 20 basis point average would have any effect on the economy at this point. Similarly, injecting more liquidity via the resurrection of some of the special temporary liquidity facilities that were put in place after the Lehman affair and were winded down by the beginning of this year would do nothing to promote economic activity, as those facilities were largely meant to stabilize a financial system on the brink of collapse and offset a disastrous liquidity squeeze in the aftermath of Lehman. The financial system is currently swimming in liquidity and it is far from clear that the doubling of the LIBOR rate since the beginning of the year is an issue that can be addressed with more liquidity injection by the Fed via such temporary facilities.

Against this backdrop the only possible remaining course of action for the Fed would be the resumption of the Fed's program of asset purchases, which ended in March. The objective would presumably be to help bring market yields lower, both in the Treasury and MBS markets, which would help provide a boost to the economic recovery. Appealing as this avenue may appear at first, a less impulsive, facts-based, examination of its implications raises some caution flags.

The Fed's staff has reportedly conducted some studies showing that the central bank's asset purchase program- which has led to an increase in its balance sheet by $1.5 trillion today compared to before the financial crisis- may have lowered market yield by as much as 50 basis points. The precision of those studies usually leaving a lot to be desired, and given that a 50 basis point estimate was presented as an upper limit, it is probably more realistic to assume that the effect of the Fed's asset purchases on long term yields has been somewhat smaller.

Both long-term Treasury yields and mortgage rates are lower today compared to the prevailing ones at the time when Treasury purchases and MBS purchases by the Fed ended (in October 2009 and March 2010 respectively). In the meantime, the momentum of the economic recovery has slowed. Arguing that the Fed's possible resumption of an asset purchases program could engineer another 20 to 30 basis point decline in yields that would prove to be materially helpful to economic activity is a highly questionable proposition. Besides, the idea of the Fed embarking on another massive program of asset purchases that would increase its portfolio by another $500 to $800 billion suffers from a cost-effectiveness problem. Such an additional increase in the Fed's balance sheet would complicate enormously further the Fed's ultimate exit strategy, given the bigger amount of liquidity to be absorbed at that time.

If the pace of the economic recovery slows to a disconcerting degree ahead, the Fed may be under extreme pressure to show that it is responding by taking some action and perhaps resume some asset purchases. In reality, though, the economic recovery is not suffering from interest rates that are not low enough or from a banking system that is not liquid enough and this calls into question the true effectiveness of any such action. Inasmuch as the Fed is often perceived as powerful enough to manipulate economic growth at will, the effectiveness of monetary policy is seriously compromised in the midst of circumstances like the current ones. Japan has already found that out.

Anthony Karydakis