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.
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."