Analysis: The uncomfortable mathematics of monetary policy

Bigger, as the Federal Reserve may soon discover, is not always better.

The prospect of a renewed effort by the U.S. central bank to drive down already super-low borrowing costs raises the issue of whether such measures can help stimulate a recovery that is faltering due to a lack of consumer demand.

The sorry state of the U.S. economy, despite all the monetary and fiscal firepower the Fed and the Treasury have deployed, already befuddles the experts. Worries about a double-dip recession are rampant, and were the topic du jour at the Fed's annual Jackson Hole conference.

Speaking at the event on Friday, Fed Chairman Ben Bernanke signaled he would be willing embark on yet another round of asset purchases should the economy weaken further, even if he currently believes that will not happen.

But there is a growing fear within and outside the central bank about whether the risks of such purchases outweigh the benefits. One concern is that it may take an ever larger amount of bond buying to get the same effect.

"If it's buying Treasuries, which is what the Fed is talking about lately, I think it has low returns period, and maybe diminishing returns to scale," said Alan Blinder, Princeton economist and former Fed vice chair, on the sidelines of the Fed symposium.

That's partly because most of the impact of Fed easing, especially that which is accomplished through unorthodox means, comes from the "announcement effect" on market expectations, rather than the purchases of securities themselves.

In an example of just how meek the effects of unconventional policy might be, Larry Meyer, a former Fed governor now with Macroeconomic Advisers, once estimated that $100 billion in Treasury purchases might lead only to a 0.10 percentage point drop in long-term interest rates.

Drop in the Bucket

So just how much bond buying would the U.S. central bank have to do to get reticent consumers spending again?

The figures bandied about are eye-popping. When the Fed first embarked on its policy of asset purchases, known as quantitative easing, Goldman Sachs economists estimated Fed credit to the banking system might have to expand to as much as $4 trillion to $5 trillion in order to grapple with the scope of the financial crisis.

According to Meyer, the Goldman estimates were in line with those of Fed staffers. However, the central bank's policy committee saw this as complicating an eventual exit strategy, and stopped well short.

Instead, the Fed, in addition to slashing official borrowing costs to effectively zero, bought over $1.5 trillion in Treasury and mortgage bonds, bringing its balance sheet to a still-lofty $2.3 trillion from pre-crisis levels around $850 billion. Back then, this tack was widely seen by investors as the Fed pulling out the big guns.

But the policy, coupled with the government's $800 billion stimulus, has not exactly gone as planned. While analysts say the measures likely prevented an even worse outcome, the U.S. economy, after rebounding from its worst recession since the Great Depression, seems to be slipping again.

"A gazillion dollars in stimulus and this is the best we can do?" said Keith Springer at Capital Financial Advisory Services, in Sacramento California.

Unemployment, currently at 9.5 percent, shows no sign of coming down and manufacturing, which had led the recovery, appears to be running out of steam.

"We've got to do something different because what they did before hasn't worked," said Allen Sinai, chief global economist at Decision Economics, also at the Jackson Hole event.

Monetary Depletion, Fiscal Exhaustion

The problem is that conventional policy tools look spent.

Politicians in Washington, having spent billions of dollars rescuing the banking system and the economy from the brink, are now bickering over large budget deficits, so another major fiscal stimulus package looks unlikely.

The Fed, in the meantime, says there is plenty it can do to ease monetary conditions further. Earlier this month, officials announced they would begin using the proceeds from maturing mortgage bonds to buy more Treasuries, thereby preventing bank reserve credit from slowly shrinking.

The central bank has also argued it could bolster its commitment to keep interest rates low for an extended period, or lower the rate it pays on bank reserves, but those approaches appear on the backburner for now.

Bernanke made it clear that buying Treasuries is the most likely and palatable course of action if the economy goes off track.

Unfortunately, an economic slowdown is already under way. Revisions to second-quarter gross domestic product showed the economy limping along at a 1.6 percent annualized growth rate. Economists now see the possibility of a negative reading for the third quarter.

Despite this grim outlook, Bernanke faces stiff opposition from some of the more hawkish members of the Fed, who believe further easing could have problematic consequences.

"The Fed cannot do much to affect economic activity right now, which is slow because of the devastating hit to wealth suffered by consumers in 2008 and 2009," said Dean Croushore, professor of economics at the University of Richmond and a former Philadelphia Fed economist.

"The Fed's latest actions are thus unlikely to have a positive impact. They simply keep a large volume of excess reserves at banks, threatening higher future inflation."

[Source: By Pedro Nicolaci da Costa, Reuters, Jackson Hole, Wyoming, 28Aug10]

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