End of QE2: 6 Tools Left in Bernanke's Toolbox

Before you go, we thought you'd like these...
No one expects Federal Reserve Chairman Ben Bernanke to pull a rabbit out of his hat after quantitative easing ends today, but he may still have a few tricks up his sleeve if the economic picture fails to improve.

For now, the Fed is set to sit tight. Along with investors, Bernanke is looking for a silver lining in economic data. If this summer's numbers turn bleaker, then Bernanke's team will be forced to go back to the drawing board, that is, if it hasn't already done so. Bears will of course say, "I told you so."

Traditionally, the central bank has three tools for monetary policy -- buying and selling treasuries in the open market, setting the discount rate and dictating reserve requirements -- all of them blunt at best.

We stretched our imaginations to find the leftovers in Bernanke's toolbox. Not surprisingly, the following list comes with big caveats from analysts. And don't forget, Bernanke has his own warning too: "All of these things are somewhat untested."


More from TheStreet.com
10 CEOs Who Became Job Killers
Best-Performing Stocks Under $5 in 2011
10 Top-Performing S&P 500 Stocks of 2011

1. Cut the interest rate on excess reserves

The current rate that the central bank pays banks holding more deposits than required is 0.25%, about the rate at which banks lend to each other. If the Fed lowers the rate on excess reserves, the mechanics say that banks should loan out more, both to each other and to the public.

Can this work?

Sponsored Links
"It should," says Steve Blitz, economist at ITG Investment Research.

"Looks promising," says Peter Cardillo, chief market economist at Avalon Partners.

However, just because banks might be more willing to supply money, lenders won't necessarily jump at the opportunity to borrow. The Fed can essentially toy with the "supply side," explains Blitz, but if a corporate America doesn't want the extra cash (and corporations do have a lot of cash sitting on their balance sheets already), then forcing more liquidity is pretty useless.

2. Buy more securities and structure them differently

Otherwise known as a third round of quantitative easing in disguise. The Fed has already said it will keep buying up long-term Treasuries in the months to come. Total purchases will likely add up to at least $300 billion. Investing in corporate bonds is still an option on the table. Albeit we were in quite different times during the housing bubble when the central bank dumped $1.25 trillion in mortgage-backed securities, we've learned that the Fed is ready to move on new methods when necessary.

The verdict from analysts?

"It's clear that a couple of reserve members have already said enough is enough," says Robert Johnson, director of economic analysis at Morningstar, who doesn't think we'll see a QE3.

"Unlikely," says Blitz. "We've been down this road with QE2... Bernanke already stated that we are in a different position than we were in a year ago, given that unemployment is better and deflation risk is smaller."

"Buying different types of securities might capture people's attention because it's bizarre and new," says James Paulsen, chief investment strategist at Wells Capital Management. However, Paulsen says that because there is so much liquidity already, pumping in more is akin to dumping a bucket of water into the sea.

3. Give guidance on the Fed's balance sheet

The Fed could be more transparent in its plans for structuring the $3 trillion-worth of securities currently on its balance sheet. That might mean more clarity in the breakdown of long verses short term securities. This is similar to tool #2 in which the Fed would formally announce which securities it plans to buy.

4. Set an inflation target

Targeting a low inflation rate should help anchor expectation. Americans might feel more confident about spending and businesses might feel more willing to invest. However, the Fed might hit a roadblock in determining which measure of inflation to target. Energy and food inflation hit consumers the hardest but some of the inflation comes from factors abroad rather than domestic.

The analysts were overwhelming negative on this one. Bernanke's answer in his last speech was lukewarm (it's "worth considering").

"We can't be that accurate in setting inflation," says Paulsen.

"I don't think this is going to help out," says Johnson. "By law, the Fed probably can't do it."

"It's a nice thing for the long term" but setting a target comes with many nuances, says Blitz.

5. Define what the Fed means by "extended period"

Reporters at the last Federal Open Market Committee meeting pushed Bernanke to pinpoint exactly how long the Fed intends to keep the federal funds rate near zero. It seems unlikely that Bernanke will hash out the language here further given that he already said the timeline depends on how the economy, inflation and unemployment evolve. "...The reason we use terms like 'extended period' is not be intentionally opaque," said Bernanke. "The reason is that we don't know exactly how long."

Bernanke appeased the public somewhat by revealing the Fed would not take action for at least the next two or three FOMC meetings.

Analysts seem to sympathize with Bernanke: "The Fed wants to leave itself some leeway and not put itself in a box," said Morningstar's Robert Johnson. After all, "they don't want people to say, you're a liar and a cheat."

6. Take a bold stance

We all know the Fed is in a pickle. It can try to fiddle with the fundamentals, but if confidence in America's economy doesn't budge, a downturn becomes a self-fulfilling prophesy.

Wells Capital's James Paulsen proposes a raise in the interest rate to 50 basis points.

The Fed's actions are hurting the American psyche, he explains. Raising the interest rate would signal to the markets "hey, we want you to know that the economy is sustaining in its recovery."

-- Written by Chao Deng in New York.
Read Full Story

People are Reading

The Latest from our Partners
1 - 3 of 15