Saturday, July 24, 2010

Harding: Looser Fed polciy

The Fed identifies a range of options if it does need to act but all of them come with risks, opponents on the Federal Open Market Committee, and uncertainty about their effects. The two simplest measures will be to stop paying interest on bank reserves, encouraging banks to lend the money out instead, or to start reinvesting capital repayments from the Fed’s portfolio of mortgage-backed securities.

Neither is a drastic move but the Fed will expect quite a strong signalling effect from its first change towards looser policy.

Cutting interest on bank reserves has the advantage of being easy to reverse but could lead to serious distortions in the money markets.

Another possibility is a change of communication. One option that the Fed has begun to study is linking its pledge of low rates to an external condition.

At the moment, the Fed says rates are likely to stay “exceptionally low” for an “extended period”. Instead, it could say that they will stay low until a variable, such as the price level, has reached a certain target.

Academic research suggests this could be effective in preventing deflation because it commits the central bank to keeping rates at zero until the goal is reached. It would not distort markets and is more flexible than a crude promise to keep rates at zero for a fixed period.

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