July 24, 2012 at 4:31 PM ET
WASHINGTON/NEW YORK -- When economists at Bank of America piped headlines from minutes of the Federal Reserve's June meeting down to the firm's trading floor, one sentence elicited an audible gasp of excitement: the Fed was exploring "new tools" to support growth.
Investors are now trying to cull hints about just what Fed Chairman Ben Bernanke, who showed a willingness to stretch the boundaries of conventional monetary policy during the financial crisis, might have up his sleeve.
Two principal options have emerged as eligible candidates: following the Bank of England's lead in some sort of "funding for lending" plan that favors banks that are actively making loans; lowering the rate the central bank pays financial institutions for parking their reserves at the Fed, currently at 0.25 percent.
The search for new tools is in part a response to the severe negative reaction the U.S. central bank received both at home and abroad from its second round of bond purchases.
The Fed says it is still considering a third bout of quantitative easing, or QE3, and some analysts expect recent weakness in the U.S. economy could prompt policymakers to launch such a program as early as September.
But officials, seeing an economy that continues to show resistance to monetary stimulus, are already starting to think about what other steps they might take down the line to keep the recovery on track.
U.S. gross domestic product expanded just 1.9 percent in the first quarter, and economists believe second-quarter growth was even softer. At the same time, recent progress on bringing down the jobless rate, now at 8.2 percent, has stalled.
Against that difficult backdrop, made even more tenuous by Europe's ongoing sovereign debt debacle and a slowdown in large emerging economies, it's no wonder Fed policymakers are scrambling to restock their depleted toolkit.
"Funding for lending might be a more prudent approach than just buying up securities without any strings attached," said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management Group.
In response to the financial crisis and deep recession of 2007-2009, the Fed cut official borrowing costs to effectively zero and bought some $2.3 trillion in mortgage and Treasury securities in an effort to keep long-term rates down and boost economic activity.
A recent Reuters poll of U.S. primary dealers, banks that do business directly with the Fed, found that 70 percent expect another round of stimulus via bond buys. But yields on Treasuries are at or near record lows, casting doubt on what good yet more purchases can bring.
Little action, if any, is expected at the next policy meeting, July 31-August 1, when some economists think the Fed could push further into the future its conditional pledge to keep rates near zero through late 2014.
Market analysts first seized on the idea of a lending incentives program after Bernanke's surprisingly forthcoming response to a question about the Bank of England's new plan during his post-meeting press conference in June.
"Throughout the crisis, we've looked for new programs, new ways to help the economy," Bernanke told reporters. "This will be a type of thing that will be on the list of programs that we look at."
Though details are still sketchy as to how such a program might work, the Fed could tailor the collateral it accepts from primary dealers in a way that encourages them to lend to areas of the economy that need help.
In one possible approach, the Fed could accept longer-maturity collateral for loans only if the banks prove they will lend to, for example, small businesses, which have generally struggled more than big firms to borrow.
In another approach, the central bank could accept certain mortgages as collateral to stimulate demand for mortgage-backed securities and encourage lending to homebuyers having trouble getting loans.
Still, some economists wonder whether such measures could be effective if the true problem is a lack of demand for new loans, rather than an inadequate supply of credit.
"They have a hammer and they're looking for a nail," said Alan De Rose, managing director of government trading and finance at Oppenheimer. "What do you get from all this?"
There is also a chance that a funding-for-lending scheme would be less appropriate for the U.S. banking system, which is seen as healthier than the UK's.
"Banks in Great Britain are facing some difficulties with the cost and availability of funding," said Michael Feroli, chief U.S. economist at JP Morgan and a former Fed staffer. "This appears to be much less of a problem in the U.S. where both deposit and wholesale funding is inexpensive and plentiful."
Indeed, Fed data on commercial and industrial loans suggest activity has been picking up steadily.
Another alternative that seems to have been resurrected is the possibility of cutting the rate of interest on excess bank reserves (IOER), now at a quarter percentage point, all the way to zero -- or even making it negative.
That option would lead the Fed down a path already taken by the Danish monetary authorities and now also being pondered by the European Central Bank, which recently cut its rate on bank deposits to zero.
One key source of opposition to a cut in the IOER has come from money markets, whose guaranteed-return model is already challenged by extremely low interest rates. Fed officials fear a crash in money markets could spread to other parts of the financial system, and they see the funds as a key potential source of contagion from Europe's financial crisis.
There is also a sense that such a marginal move would not have much of an impact.
Then there are the unthinkables -- steps that have loosely entered the market's imagination but have little chance of being implemented in the foreseeable future.
Most prominent among these is nominal GDP targeting or price-level targeting, in which the Fed would give itself greater wiggle room on inflation. Bernanke has been adamant in opposing any effort to actually aim for higher consumer prices, citing the Fed's inflation-fighting credibility that was hard-won by former Fed Chairman Paul Volcker and sustained by his successor Alan Greenspan.
Another idea is to buy government bonds of Spain, the euro zone's fourth largest economy and at the crux of the euro zone debt crisis, which is posing a global threat of contagion. Bernanke shot down that idea at the June press conference, but some economists, like Dean Baker of the liberal Center for Economic and Policy Research, think that approach would provide much more bang for the Fed's buck than Treasury purchases because it would actually tackle the source of the problem threatening the global economy.
There is also something the Bank of Japan has tried doing after years of battling deflation: purchasing stocks from private firms in order to support corporate investments. Such a move would be highly controversial and would require Congressional approval, which is why some see it as having little chance of becoming reality.
Or as the headline of Feroli's recent research note to clients put it: "Sorry, the Fed won't be buying your equities from you."
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