Fed set to keep policy unchanged

Financial Time– A lack of simple options for monetary easing and big unanswered questions about the economy mean the US Federal Reserve is set to leave policy unchanged when its rate-setting committee meets on Tuesday.

Ben Bernanke, Fed chairman, has spelt out the economic conundrum in testimony to Congress: the US labour market seems to be doing better, but this has not been not matched by a rise in production, demand or consumer spending.

“The fundamentals that support spending continue to be weak. Real household income and wealth were flat in 2011 and access to credit remained restricted for many potential borrowers,” Mr Bernanke said. Some Fed officials also fear the surge in oil prices could undermine consumer confidence.

Data do little to resolve the divergence between jobs and spending. There was strong net jobs growth of 227,000 in February, but weak numbers on trade and incomes have led many economists to expect dismal economic growth for the first quarter of 2012.

The Fed’s economic forecast suggests inflation at 1.8 per cent in 2014 – below its 2 per cent goal but quite close – and unemployment still high in 2014.

As long as it expects to miss both its objectives, the Fed is likely to keep a strong bias towards further monetary easing, but it needs to weigh the risk that consumer spending will soon accelerate to match the strength of the labour market.

The other problem is that the Fed’s remaining tools are hard to use on a small scale and come with costs, so the central bank is unlikely to try to “fine-tune” its policy.

One option under active debate among Fed officials is giving clearer information, most likely through the minutes of a meeting, about the economic conditions that will eventually lead to a rise in interest rates.

All that remains beyond that is balance sheet changes. The current “Operation Twist”, a $400bn switch into Treasury securities with longer to run until maturity, will use up almost all of the shorter-term Treasuries that the Fed has to sell and take its holdings of some long-term Treasuries close to limits on market liquidity. The scope for any “Operation Twist 2” is very limited.

The more obvious choice would be a third round of quantitative easing – QE3 – focused on mortgage-backed securities. But most Fed officials still think it is only possible to do this on a fairly large scale, with hundreds of billions of dollars of purchases and the attendant risk of a backlash, so it will only move to the centre of Fed debate if the demand side of the economy continues to stall.

The idea of “sterilising” further easing – offsetting any asset purchases by borrowing for a few months rather than overnight so there is no increase in bank reserves – has long been on the central bank’s list of options. However, it has received little active attention from Fed officials in recent weeks.

In the standard model used by most Fed officials, sterilisation would make very little difference to the economy. Its advantage would be to reassure people who think that bank reserves are inflationary; on the other hand, it could push up short-term interest rates and complicate the Fed’s eventual exit from easy monetary policy.

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