Bernanke is running out of magic bullets

If US interest rates were above zero it would be an easy choice for the Federal Reserve to lower them this week. But the tools at hand are ones Ben Bernanke will be more reluctant to use.

Another summer, another US slowdown, another Federal Reserve meeting to decide what to do about it. The drama has become rather routine.

If the script is to be the same this year as it was in 2010 and 2011, then August should mark the opening move, followed by a Jackson Hole speech from chairman Ben Bernanke, and then the main event in September.

But any drama driven by the economy is unpredictable and this one could still go in a different direction. This week’s meeting of the rate-setting Federal Open Market Committee, which concludes on Wednesday, is finely balanced.

The Fed goes into the meeting with a strong easing bias but not a lot of new data with which to untangle a complicated economic outlook. Growth in the second quarter came in at an annualised rate of 1.5 per cent – feeble but not in itself enough to suggest a downward economic spiral – while the eurozone meanders towards a crisis without quite getting there.

What makes the US economy so hard to read is that the fundamentals are improving: banks are better capitalised, it looks like the housing market has hit bottom, and households have shed debt.

Yet a range of pressures – a fiscal squeeze in the US, financial turmoil from the eurozone, and an emerging market slowdown – are holding the economy back. All of those pressures have the potential to turn into shocks: a plunge off the US fiscal cliff, a panic in the eurozone, or a sudden stop in emerging economies.

The mixture is tough for policy makers. Given the underlying improvement, the natural forecast is that growth should pick up; given the risks, there is an uncomfortably high chance that it will not.

If short-term interest rates were above zero then the choice would be easy: cut them and offset some of the risk. But the only tools that remain close at hand are quantitative easing – buying securities in an effort to drive down long-term interest rates – or communicating a forecast that rates will stay low beyond 2014. Those actions are less easily reversed.

Put together, this may add up to caution on Wednesday, with perhaps a change in the late 2014 forecast but no more. Waiting would let the Fed see payrolls data for August and September, formally update its economic forecasts, and use Jackson Hole to clarify where it stands.

The combination of a volatile economic outlook with cumbersome policy tools also explains why the Fed is so eager to find new ways to influence the economy.

Bernanke has made clear that the Fed is studying the Bank of England's new "funding for lending" scheme. In testimony to Congress, he noted the Fed’s discount window as a possible policy tool, although this work remains at an early stage.

The goal of such a scheme would be to gear up the monetary transmission mechanism so that that low Fed interest rates turn into low rates on mortgages and consumer loans – but the challenge is to work out where that mechanism is breaking down.

Any kind of Fed operation would have to start with a cut in its discount rate – the penalty rate at which it makes short-term loans – from the current 0.75 per cent. That would make funds cheap enough to be attractive. The Fed would also have to apply some kind of condition.

Unlike in the UK, US banks that want to lend have little difficulty in securing funds, so simply offering funding on the condition of lending more would probably make no difference. The issue in the US is new and refinanced mortgages, where competition has fallen, credit is unavailable at any price without a large down payment, and banks worry about bad loans coming back to them from the mortgage agencies Fannie Mae and Freddie Mac.

It is not obvious how any tool offering a funding advantage to banks that do make such loans will solve the problem – but that is the challenge. If anybody can come up with a way to use conditional Fed loans to revitalise the US mortgage market it would provide an alternative to QE3. Answers on a postcard to 20th Street & Constitution Avenue, Washington DC.

Copyright The Financial Times 2012.

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